What’s the Magic Number? At What Point Can A Public Sector Pension Plan Can Be Considered To Be Well Funded?

For years, the easy rule of thumb that experts pointed to was 80 percent. When the Pew Charitable Trusts began its seminal work into public sector pensions well over a decade ago, that was the number it used, based largely on a 2007 GAO report that said that “a funded ratio of 80 percent or more is within the range that many public sector experts, union officials and advocates view as a healthy pension system."

That number still lives on in many circles – though not at Pew -- despite the fact that Keith Brainard, Research Director at the National Association of State Retirement Administrators, has long argued that a fixed metric such as this, taken as a rule of thumb, is more likely than not to be misleading or misguided. Moreover, the 80 percent figure has recently been out of the reach of many states. In 2017, the aggregate funded ratio for state and local pension funds was 72 percent according to the Center for Retirement Research. That number is cited and put into interesting context in A “Pension Crisis” Mentality Won’t Work., a paper sponsored, in part, by the Government Finance Research Center.

Philadelphia, a city with a deeply underfunded plan has set its initial goal for funding to be 80 percent by 2030, and 100 percent funded thereafter. But the city’s director of finance, Rob Dubow, one of the most candid men or women in that position, notes that they use it primarily because it’s a widely accepted target, not because there is a particular magic to the 80% threshold. Philadelphia’s goal, in any case, is to improve the long-term health of the fund by becoming fully funded with sustainable contribution levels and sound actuarial assumptions.

Pew’s senior director, Kil Huh, meanwhile, indicates that Pew now recommends a far more thoughtful approach – one that may include a number, but doesn’t rely on it as an on/off switch for appropriate funding.

Fitch’s rating service, meanwhile, generally considers a funded ratio of 70 percent or more to be adequate and less than 60 percent to be weak, while noting that Fitch only uses the funded ratio as one of many factors considered in its analysis.  The Volcker Alliance, somewhat similarly, looks for a ratio of 90 percent, but only uses that number as part of its overall evaluation of state legacy costs.

Meanwhile, there are some who say that all cities and states should aim to be 100 percent funded. The Reason Foundation, for example argues that “pension plans must be 100 percent funded to prevent expensive intergenerational inequality.”

But there are certainly some issues here. First of all this is an extremely difficult hill to climb According to data from the Volcker Alliance, only two states met or exceeded that hurdle in 2017. Some organizations, for example, the Mercatus Center, believe that pensions with funding ratios in excess of 100 percent are overfunded.

It’s important to note here that we’re talking about funded ratios for pension plans; not the percentage of the actuarially determined contribution that should be paid annually. For the latter measure, it seems to be nearly unquestioned that states and localities should be aiming for 100 percent. (Though, in our opinion, the world of pensions might be a better place if cities and states were encouraged to overfund in healthy fiscal years, allowing for equal underfunding in hard times. That would leave them with an average actuarially defined contribution of 100 percent but permit them to acknowledge that their capacity to pay is a cyclical venture.)

So, what do you think? Is there a right number for cities, counties and states to use as a goal for funding? What does your community, county or state use? And if you want to eschew hard and fast funding figures altogether, what should be used to keep pension funding in line, otherwise?