“Fiscal Democracy,” Autopilot Spending, And Pension Underfunding: A New Report

What is “autopilot spending”?  According to a new report by the Urban Institute, “Fiscal Democracy in the States: How Much Spending on Autopilot?“, this is spending that “is determined before governors propose or lawmakers negotiate a budget.”  And according to their analysis, based on a high- and low-end estimate (that is, varying definitions of what parts of the budget are “restricted”),

As much as 70 to 90 percent or as little as 25 to 50 percent of total state spending (including federal funds) was restricted in 2015. At the high end of our estimates, 71 percent of Illinois’s and 86 percent of California’s spending was at least partially restricted in fiscal year 2015. At the low end, 27 percent of Virginia’s and 47 percent of New York’s spending was restricted in that year.

What kinds of spending is restricted?  It’s a mix of spending that’s fixed by legal obligations, such as debt repayment, or constitutionally-mandated spending; and spending that’s required by existing law that’s difficult to change, e.g., a school funding formula that theoretically can be changed, but is far more politically difficult to achieve than ordinary budget negotiations.  Some other examples include prison spending:  whatever policy changes intended to reduce incarceration rates may be implemented, the impact on spending would take years to materialize; the acceptance of Medicaid and CHIP federal funds locks states into minimum spending levels; statutory transportation spending requirements; and statutory budget stabilization fund deposits.

The report also determines to estimates – an “upper bound” and a “lower bound” in which some types of spending are most strictly restricted and others are simply very difficult to alter.

The Urban Institute did not study all fifty states, but did not cherry-pick, either — they reviewed budgets for the five most populous states, California, Florida, Illinois, New York, and Texas, and added Virginia in,

to bring additional geographic, population, and political diversity to our case studies and because Virginia was prominently featured in the State Budget Crisis Task Force (2012c) analysis

that is, in part because some of the work had already been done there.

And why does this headline figure – “as much as 70 to 90 percent” – matter?

One might wish that in every state budget, there was enough money to meet every identified need in every spending area for which the state takes responsibility:  roads, universities, even state parks.  But resources are finite (no matter the degree to which legislators fighting for their share of the pork for pickleball courts might not seem to understand this) and budgeting is a matter of priority-setting; legislators who lock the state into their priorities in any given year tie the hands of future legislators when needs might shift.

But with all this as a (sorry, overly long) preface, here’s where pensions come in:

Quite some time ago, I wrote what an “explainer” (I’ve since become fond of using the label “actuary-splainer” for such articles) that I titled, “Why Public Pension Pre-Funding Matters” in which I attempted to build the case as clearly as I could, based on recent events in the news, that states which fail to pre-fund their pensions set their residents up for future pain, as they must pay for retirement benefits promised by long-retired legislators, regardless of their current fiscal state.  This new report outlines the impact of each of these individual states’ funding policies, which I’ve summarized below, but, in the interest of not exhausting the patience of readers seeking the bottom line, here’s the key take-away:

Once upon a time, back in the days when large employers commonly offered Defined Benefit plans, one of their selling points was flexibility in funding.  Having a banner year?  Send some extra money into the pension plan because that’s tax deductible as long as you don’t exceed certain maximum contribution limits.  Is cashflow tight?  Just make the minimum contribution.  In fact, an employer that had made more than the minimum required, one year, got to take credit for it and pay in less than what would otherwise have been required, the next year.

But employers, and Congress, realized eventually that this comes at a cost, in the form of pensions which are then insufficiently funded when market crashes, drops in interest rates, or other events disrupt the happy narrative of “extra contributions during good times to keep the funding levels up” — and employers realized that predictable, stable funding of their employees’ retirement benefits, in the form of, yes, Defined Contributions/401(k)s and contributions being made routinely with every paycheck.

And similarly, of course, where the Urban Institute laments the degree to which states lose flexibility, there’s always a trade-off.  Illinois is notorious for having taken contribution holidays in its pensions, and did so, so frequently that it seems overly-generous to label this as an honest deliberation over competing priorities rather than simple disinterest in pension funding; there was no practice during the fat years of increasing contributions to prepare for lean years.  And despite the report’s analysis of states which lock in pension contributions vs. allow legislators discretion, this doesn’t necessarily guarantee sufficient funding from year to year.

Even in the winner among these six states, New York, with its 95% funding ratio and track record of paying the actuary’s required contribution each year, this comes as a cost, as contributions have been highly volatile and escalating:  in order to maintain near-100% funding, the New York State Teachers plan’s contributions grew from 0.5% of payroll in 2002 to 17.5% in 2015 before declining to 9.8% in 2018; for the State and Local Employees plan, contributions bounced between 0.7% of pay in 2001 to 12.4% in 2005, down to 7.5% in 2010, up to 21% in 2014, and back down to 14.8% in 2018.  (Readers can view charts and look at other plans at the link.)

Which means that, once again, the only way to avoid the Scylla and Charybdis twin perils of underfunding or volatility and unsustainably high contributions is a Defined Contribution plan (or, failing that, risk-sharing pension plan) in which contributions are nothing more than a routine part of payroll expenses, year-in and year-out.

And with that being said, here are the details on the six states:

California (2017 funded ratio 68.9%, total pension debt $190 million, per the Pew summary of all state’s pension debt) has two major retirement systems.  CalPERS for state employees has a contribution set by its independent board, and the state is constitutionally obliged to pay it.  CalSTRS, the teacher’s retirement plan, has no such requirement, and the state simply defines its funding contributions by statute.  However, this differentiation in funding requirements has not had much of an effect on funding levels:  in CalPERS was 71% funded, and CalSTRS 63% funded in 2017, with the governor announcing in January plans to increase funding above the statutory minimums to boost funding ratios.

In addition, the state had been paying its OPEB (retiree medical) obligations on a pay-as-you-go basis, but began to prefund these starting in 2015, and this will tie up increasing portions of the budget in the future.  All told, this adds to $8.1 billion, out of a total 2015 spend of $250 billion.

Urban Institute’s classification of pension contributions:  definitively restricted (within their lower bound).

Florida (2017 funded ratio 79%, total pension debt $40 billion) does not have any fixed requirement (constitutionally or by statute) to fund its pensions at a given level, however,

Despite lacking a formal actuarial requirement, Florida regularly meets its pension obligation requirements; the state is motivated by a strong desire to maintain a good bond rating and a fiscal culture that considers the actuarially defined pension contribution requirements “hard numbers.” Pension and OPEB contributions constituted 2 percent of total spending and debt service constituted 3 percent in 2015.

One might quibble that a 79% funded ratio constitutes the “good health” that the Urban Institute grants it, but let’s move on.

Urban Institute’s classification of pension contributions:  not definitively restricted.

Illinois (2017 funded ratio 38%, debt $137 billion) appears on paper to have binding obligations to fund pensions:  “key Illinois informants reported that pensions are now one of Illinois’s most binding constraints,” the report states.  But we know that this is relative; new governor JB Pritzker had proposed, as a part of the 2020 budget, to revise the contribution schedule and defer payments further into the future, but backed down after criticism.  Instead, Illinoisans are left waiting to see which state assets a task force will recommend selling to fund pensions.

Urban Institute’s classification of pension contributions:  not definitively restricted.

New York (2017 funded ratio 95%, pension debt $11 billion) is actually a bright spot, when it comes to funding and fiscal responsibility.

State pensions contributions are statutorily binding and treated as fixed. In 2003, New York amended its minimum employer contribution funding requirement. The new statute required state and local government employers to contribute the greater of either 4.5 percent of payroll or the actuarial contribution as determined by the OSC (NYSLRS 2018; Snell and Marks 2003). The OSC is responsible for setting an actuarially determined contribution rate, and the state is directed to use that rate (NYSLRS 2018). The comptroller thus requests a specific level of funding from the legislature, which is responsible for appropriating at that level. Public employers, including the state, cannot suspend these payments or defer to future years, as was the case prior to the enactment of the 2003 legislation (Snell and Marks 2003). . . .

Employer contributions to the New York State and Local Retirement System have varied dramatically in response to financial crises and resultant unstable investment earnings. In 2010, attempting to mitigate employer contribution volatility that the state experienced when investment returns declined during the Great Recession, New York adopted legislation that allowed public employers to amortize their required pension contributions over time (DOB 2018b; Johnson, Haaga, and Southgate 2015, 2016).

In 2015, the state contributed $2 billion to its pension funds, out of total state spending of $140 billion.

Urban Institute’s classification of pension contributions:  definitively restricted.

Texas (2017 funded ratio 76%, pension debt $55 billion)

The report states:

We include pension contributions in the upper, but not lower, bound of potentially restricted spending in Texas because the legislature is not formally required to contribute to its pension system at an actuarially determined level. Texas also has a formal cap on pension contributions, and although the state has not yet come up against the cap, informants reported it was of future concern as the state strives to increase its contributions to actuarially determined contribution levels.

In 2015, $3.9 billion out of a total budget of $104 billion went to the pension funds.

Urban Institute’s classification of pension contributions:  not definitively restricted.

Virginia (2017 funded ratio 77.2%, pension debt $21 billion)

Unlike some states (e.g., California), Virginia has not always been formally required to contribute to its pension system at an actuarially determined level. Key informants reported that although pension costs are fixed in the long term, they become flexible in the short term because the state can delay contributions, as it did during the Great Recession. Between 2006 and 2012, the state’s contribution to the VRS fell from 101 percent to 38 percent of its actuarially required or determined contribution.

However, informants reported that in recent years, pension contributions have been treated as a fixed obligation in Virginia. In 2012, the state adopted a requirement for the GA to gradually move its pension contribution rate toward the actuarially required amount, formalizing the state’s annual contribution requirement.

In 2015, $0.6 billion out of a total budget of $35 billion went to the pension funds.

Urban Institute’s classification of pension contributions:  not definitively restricted.

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