The Need for Guidance on Public Pension Funding Stephen P. D’Arcy Professor of Finance University of Illinois 2006 Advanced Actuarial Conference of ASPPA Boston, Massachusetts

Objective Public pension plans need clear guidelines on appropriate funding levels Pension actuaries should provide this guidance

Overview Public pension plan funding Alternative funding approaches Potential consequences of differential funding Advantage of funding guidelines Conclusion

Current Public Pension Plan Funding – Aggregate Levels Aggregate values for 125 public pension plans –13 million participants and 5 million annuitants Actuarial assets: $2.157 Trillion Actuarial liabilities:$2.481 Trillion Unfunded liability: 324 Billion Aggregate funding level 87% Source: National Association of State Retirement Administrators Fiscal year-end varies from 2003 to 2005

Public Pension Plan Funding Ratios – Aggregate Trends Source: 2006 Wilshire Report on State Retirement Systems: Funding Levels and Asset Allocation YearActuarial ValueMarket Value %112% %95% %82% %80% %86% %87%

Current Public Pension Plan Funding – By State Best funded states: –Wisconsin – Funding ratio 126%, $14 billion Worst funded states –West Virginia – Funding ratio 45% –Illinois – Unfunded liability $39 billion Of 58 plans providing FY 2005 data –1 funding ratio below 50% –3 funding ratios below 60% –9 funding ratios over 100% Sources: Wilshire Reports

Alternative Funding Approaches Pay-as-you-go –Asset level equivalent to 1-2 years of payments –Authority to tax precludes need for advance funding Full funding –Funding target of 100% –Increase funding when level falls short –Enhance benefits (or reduce funding) when level exceeds target Specified target: 90% –Illinois 1995 pension funding legislation –Target applies in 2045

Proposed Optimal Funding Target Cover all costs over lifetime of recipients Aim for level tax rate Factors to consider –Growth rate of covered workers –Growth rate of benefit levels –Growth rate of state’s population –Growth rate of per capita income –Interest rate earned on pension assets Set target funding level to cover all pension costs with constant tax rate

Proposed Target Formula where x = optimal funding ratio r = interest rate on pension fund assets e = pension growth rate d = population growth rate g = income growth rate Source: D’Arcy, Dulebohn and Oh, Optimal Funding of State Employee Pension Systems, Journal of Risk and Insurance, September 1999

Basic Results Optimal funding level = 1 in static world (no growth) If the pension growth rate exceeds the increase in the tax base, then overfunding is optimal If the increase in the tax base exceeds the pension growth rate, underfunding is optimal Example –Illinois growth factors –Optimal funding level = 97%

Pension Funding Targets Suggested optimal funding target is just one possible guideline You can think of other approaches

Potential Consequences of Differential Funding States that underfund public pension plans will –Increase future taxes –Reduce future government services Impact of these changes –Businesses will relocate to other states –Residents will move out of state As businesses and individuals leave the state, the tax burden on the remaining taxpayers rises, leading to additional migration Problem for states is much more severe than for federal system

Advantages of Funding Guidelines Would provide guidance for public officials –Pension disclosure is leading to more responsibility –Public officials are often at a loss for proper approach –Citizens need a standard to evaluate public actions Could reduce discrepancies between states Pension funding issues are complex –Pension actuarial expertise in needed –Disclosure is good first step, but without guidelines it is hard to evaluate information

Conclusion Without the involvement of the pension actuarial community, public pension plan funding problems will continue to develop Some states will experience severe funding crises –Next economic downturn –When worker retirements peak If you live in West Virginia, Illinois, Oklahoma, Louisiana, Indiana or another state with pension funding problems, this could affect your future –State tax rates –Home values