State and Local Government Retiree Benefits: Current Funded	 
Status of Pension and Health Benefits (29-JAN-08, GAO-08-223).	 
                                                                 
Pension and other retiree benefits for state and local government
employees represent liabilities for state and local governments  
and ultimately a burden for state and local taxpayers. Since	 
1986, accounting standards have required state and local	 
governments to report their unfunded pension liabilities.	 
Recently, however, standards changed and now call for governments
also to report retiree health liabilities. The extent of these	 
liabilities nationwide is not yet known, but some predict they	 
will be very large, possibly exceeding a trillion dollars in	 
present value terms. The federal government has an interest in	 
assuring that all Americans have a secure retirement, as	 
reflected in the federal tax deferral for contributions to both  
public and private pension plans. Consequently, the GAO was asked
to examine: 1) the key measures of the funded status of retiree  
benefits and 2) the current funded status of retiree benefits.	 
GAO analyzed data on public pensions, reviewed current		 
literature, and interviewed a range of experts on public retiree 
benefits, actuarial science, and accounting.			 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-08-223 					        
    ACCNO:   A80230						        
  TITLE:     State and Local Government Retiree Benefits: Current     
Funded Status of Pension and Health Benefits			 
     DATE:   01/29/2008 
  SUBJECT:   Accounting standards				 
	     Contingent liabilities				 
	     Funds management					 
	     Government retirement benefits			 
	     Health care cost control				 
	     Health care costs					 
	     Health care planning				 
	     Health care programs				 
	     Health care reform 				 
	     Local governments					 
	     Pension plan cost control				 
	     Pensions						 
	     Reporting requirements				 
	     Retirees						 
	     Retirement 					 
	     Retirement benefits				 
	     State governments					 
	     State taxes					 
	     Strategic planning 				 

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GAO-08-223

   

     * [1]Results in Brief
     * [2]Background

          * [3]Financing of State and Local Retiree Benefits
          * [4]Oversight of State and Local Retiree Benefits

     * [5]Key Measures of the Funded Status of Retiree Benefits Are Co

          * [6]Three Measures, Viewed in Relation to One Another over Time,
          * [7]Comparing the Funded Status of Different Plans Is Difficult

               * [8]Actuarial Cost Methods
               * [9]Smoothing Periods

     * [10]Most Public Pensions Have Assets to Pay Benefits over Severa

          * [11]Most Public Pension Plans Have Enough Funds to Pay for Benef
          * [12]Some Pension Sponsors Do Not Contribute Enough to Improve Fu
          * [13]Unfunded Retiree Health Liabilities Are Large for Many State

     * [14]Concluding Observations
     * [15]Agency Comments
     * [16]GAO's Mission
     * [17]Obtaining Copies of GAO Reports and Testimony

          * [18]Order by Mail or Phone

     * [19]To Report Fraud, Waste, and Abuse in Federal Programs
     * [20]Congressional Relations
     * [21]Public Affairs

Report to the Committee on Finance, U.S. Senate

United States Government Accountability Office

GAO

January 2008

STATE AND LOCAL GOVERNMENT RETIREE BENEFITS

Current Funded Status of Pension and Health Benefits

GAO-08-223

Contents

Letter 1

Results in Brief 2
Background 4
Key Measures of the Funded Status of Retiree Benefits Are Contributions,
Funded Ratios, and Unfunded Liabilities of Individual Plans over Time 8
Most Public Pensions Have Assets to Pay Benefits over Several Decades,
Though Contributions Vary, While Unfunded Liabilities for Retiree Health
Are Significant 14
Concluding Observations 22
Agency Comments 23
Appendix I Objectives, Scope, and Methodology 24
Related GAO Products 27

Tables

Table 1. Effective Dates for GASB Statements 43 and 45, Requiring Public
Employers to Estimate Health Care Liabilities 7
Table 2: Normal Cost Calculations for Three Most Commonly Used Actuarial
Cost Methods 12

Figures

Figure 1. Relationship among the Key Measures of the Funded Status 11
Figure 2: Division of the Current Value of Future Benefits among Time
Periods 12
Figure 3: Percentage of State and Local Government Pension Plans with
Funded Ratios above or below 80 Percent, by Fiscal Year 16
Figure 4: Percentage of State and Local Government Pension Plans for which
Governments Contributed More or Less Than 100 Percent of the ARC, by
Fiscal Year 18

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Abbreviations

ARC: annual required contribution: 
AAL: actuarial accrued liability: 
ERISA: Employee Retirement Income Security Act: 
GASB: Governmental Accounting Standards Board: 
NASRA: National Association of State Retirement Administrators: 
PFS: Public Fund Survey: 
PBGC: Pension Benefit Guaranty Corporation: 
PPCC: Public Pension Coordinating Council: 

United States Government Accountability Office
Washington, DC 20548

January 29, 2008

The Honorable Max Baucus: 
Chairman: 
The Honorable Charles E. Grassley: 
Ranking Member: 
Committee on Finance: 
United States Senate: 

Nearly 20 million employees and 7 million retirees and dependents of state
and local governments--including school teachers, police, firefighters,
and other public servants-- are promised pensions, and many are promised
retiree health benefits. Many of these benefits are guaranteed by state
law or contract and represent actuarial accrued liabilities1 for state and
local governments and ultimately the taxpayer. Typically, pension benefits
are paid from a fund made up of assets from employers' and employees'
annual contributions and the investment earnings from those contributions.
Such a fund has an unfunded liability when the actuarial value of assets
is less than actuarial accrued liabilities. Accounting standards have
called for state and local governments to report their unfunded pension
liabilities since 1986. But accounting standards have only recently been
established that call for reporting the size of unfunded retiree health
liabilities. While few state and local governments have as yet officially
reported these unfunded liabilities, some studies have estimated that they
may exceed $1 trillion dollars nationwide in present value terms. Such
estimates raise concerns about the fiscal challenges that state and local
governments will face in the coming decades. As discussion of the unfunded
liabilities of state and local governments has increased, questions have
been raised by some about how to understand these amounts.

State and local retiree benefits are not subject, for the most part, to
the federal funding requirements that apply to pensions sponsored by
private employers. Nevertheless, the federal government has an interest in
assuring that all Americans have a secure retirement, as reflected in the
federal tax deferral for contributions to both public and private pension
plans. Given the concerns about unfunded liabilities for state and local
retiree benefits, we are reporting on: 1) the key measures of the funded
status of retiree benefits and 2) the current funded status of retiree
benefits.

1 Actuarial accrued liabilities, referred to in this report as
"liabilities," are the portion of the present value of future benefits
that is attributable to employee services in past periods, under the
actuarial cost method utilized.

To address these objectives, we reviewed literature and interviewed a
range of experts and stakeholders, including national associations of
state and local officials, labor unions, bond raters, and actuarial and
accounting professionals, among others. To describe the funded status of
state and local pension plans, we analyzed self-reported data from the
Public Fund Survey (PFS) as well as surveys by the Public Pension
Coordinating Council (PPCC).2 This report represents one of two recent
reports on state and local government retiree benefits. The other report,
State and Local Government Retiree Benefits: Current Status of Benefit
Structures, Protections, and Fiscal Outlook for Funding Future Costs (
[22]GAO-07-1156 ), provides a descriptive overview of such benefits.

We conducted our work in Washington, D.C.; New York; and Connecticut from
July 2006 to January 2008 in accordance with generally accepted government
auditing standards.

Results in Brief

Three key measures help to understand different aspects of the funded
status of state and local government retiree benefits. First, governments'
annual contributions indicate the extent to which they are keeping up with
the value of benefits as they are accumulating. Second, the funded ratio
indicates the percentage of a plan's liabilities covered by its assets.
Third, unfunded liabilities indicate the excess, if any, of liabilities
over assets in dollars. Low funded ratios correspond to high unfunded
liabilities and require larger future contributions to pay benefits, which
may create future budget problems and means future generations will bear
more of the cost. Governments have been reporting these funded status
measures for pensions for years. However, new accounting rules will also
call on governments to report the funded status of retiree health benefits
in a similar manner, even though many have not made any contributions to
build assets to cover liabilities. These funded status measures should be
reviewed using several years of data because in some years fiscal
pressures may encourage governments to choose other budget priorities.
Also, the value of assets can fluctuate from year to year with changes in
investment returns, so examining a single year of funding data can be
misleading. Because governments use a variety of methods and actuarial
assumptions to calculate the funded status, different plans cannot be
easily compared.

2 The PFS is sponsored by the National Association of State Retirement
Administrators and the National Council on Teacher Retirement. In 2005,
the PFS data we used represented 58 percent of total assets invested in
public pension plans nationwide, and 72 percent of total members. PFS data
covered years beginning with 2001. PPCC data covered years 1994, 1996, and
2000.

Currently, most state and local government pension plans have enough
invested resources set aside to pay for the benefits they are scheduled to
pay over the next several decades, but governments that offer retiree
health benefits generally have large unfunded liabilities. Many experts
consider a funded ratio of about 80 percent or better to be sound for
state and local government pensions. According to the self-reported PFS
data, 58 percent of 65 large public pension plans were funded to that
level in 2006, a decrease since 2000 when about 90 percent of plans were
so funded. While most plans' funding may be sound, a few plans have
persistently reported low funded ratios. Low funded ratios will eventually
require the government employer to improve funding, for example, by
reducing benefits or by increasing contributions. Increasing contributions
may require revenue increases or reductions in non-benefit spending.
However, even for many plans with lower funded ratios, benefits are
generally not at risk in the near term because current assets and new
contributions may be sufficient to pay benefits for several years. Still,
many governments have often contributed less than the amount needed to
improve or maintain funded ratios. Low contributions raise concerns about
the future funded status, and may shift costs to future generations. For
retiree health benefits, various studies estimate that the total unfunded
liability for state and local governments lies between $600 billion and
$1.6 trillion although the estimates are based on samples of governments
that are not necessarily representative. The unfunded liabilities are
large because state and local governments typically have not set aside any
funds for future retiree health benefits in the way they have for
pensions. Instead, their practice has been to pay for the retiree health
benefits due in a given year from the revenues for that year, like many
private employers. This financing approach can leave little flexibility
for governments, and therefore may stress future budgets. As a result, as
health care costs increase, governments may face even greater pressure to
reduce benefits or increase revenues. However, our analysis shows that the
annual amount paid for retiree health benefits is currently low compared
to pensions, but growth of health costs will be faster and less
predictable.

The Internal Revenue Service and experts in the field provided technical
comments, which we incorporated as appropriate.

Background

State and local governments will likely face daunting fiscal challenges in
the next few years, driven in large part by the growth in health-related
costs.3 Medicaid and health insurance for state and local employees and
retirees make up a large share of such costs. In contrast, our analysis
shows that state and local governments on average would need to increase
pension contribution rates to 9.3 percent of salaries--less than .5
percent more than the 9.0 percent contribution rate in 2006 to achieve
healthy funding on an ongoing basis.

With few exceptions, defined benefit pension plans still provide the
primary pension benefit for most state and local workers. About 90 percent
of full-time state and local employees participated in defined benefit
pension plans as of 1998.4 A defined benefit plan determines benefit
amounts by a formula that is generally based on such factors as years of
employment, age at retirement, and salary level.5 A few states offer
defined contribution or other types of plans as the primary retirement
instrument.6 In fiscal year 2006, state and local government pension
systems covered 18.4 million members and made periodic payments to 7.3
million beneficiaries, paying out $151.7 billion in benefits.

Many state and local governments also offer retirees health care
benefits--in addition to Medicare benefits provided by the federal
government--the costs of which have been growing rapidly. One study
estimated that state and local governments paid $20.7 billion in fiscal
year 2004 for retiree health benefits. For retirees who are under age 65
(that is, not yet Medicare-eligible), many state and local employers
provide access to group health coverage with varying levels of employer
contributions. As of 2006, 14 states did not contribute to the premium for
this coverage, while 14 states picked up the entire cost, and the
remainder fell somewhere in between. For virtually all state and local
retirees age 65 or older, Medicare provides the primary coverage. Most
state and local government employers provide supplemental coverage for
Medicare-eligible retirees that covers prescription drugs.7

3 GAO, State and Local Governments: Persistent Fiscal Challenges Will
Likely Emerge within the Next Decade, [23]GAO-07-1080SP (Washington, D.C.:
July 18, 2007).

4 The last year for which the Bureau of Labor Statistics published these
data was 1998. U.S. Department of Labor, Bureau of Labor Statistics,
Employee Benefits in State and Local Governments, 1998 (Washington, D.C.:
2000).

5 In contrast, for defined contribution plans, the key determinants of the
benefit amount are the employee's and employer's contribution rates and
the rate of return achieved on plan assets (made up of the amounts
contributed to an individual's account over time). Defined contribution
plans include 401(k)s.

6 Two states (Alaska and Michigan) and the District of Columbia offer
defined contribution plans as their primary plan for general public
employees. Two states (Indiana and Oregon) offer primary plans with both
defined benefit and defined contribution components; and one state
(Nebraska) offers a cash balance defined benefit plan as its primary plan.

Financing of State and Local Retiree Benefits

Both government employers and employees generally make contributions to
fund state and local pension benefits. States follow statutes specifying
contribution amounts or determine the contribution amount each legislative
session. However many state and local governments are statutorily required
to make yearly contributions based either on actuarial calculations or
according to a statutorily specified amount. For plans in which employees
are covered by Social Security, the median contribution rate in fiscal
year 2006 was 8.5 percent of payroll for employers and 5 percent of pay
for employees, in addition to 6.2 percent of payroll from both employers
and employees to Social Security. For plans in which employees are not
covered by Social Security, the median contribution rate was 11.5 percent
of payroll for employers and 8 percent of pay for employees.

Actuaries estimate the amount that will be needed to pay future benefits.
The benefits that are attributable to past service are called the
"actuarial accrued liabilities." (In this report, the actuarial accrued
liabilities are referred to as "liabilities.") Actuaries calculate
liabilities based on an actuarial cost method and a number of assumptions
including discount rates and worker and retiree mortality. Actuaries also
estimate the "actuarial value of assets" that fund a plan (in this report,
the actuarial value of assets is referred to as "assets"). The excess of
actuarial accrued liabilities over the actuarial value of assets is
referred to as the "unfunded actuarial accrued liability" or "unfunded
liability." Under accounting standards, such information is disclosed in
financial statements. In contrast, the liability that is recognized on the
balance sheet is the cumulative excess of annual benefit costs over
contributions to the plan. Certain amounts included in the actuarial
accrued liability are not yet recognized as annual benefit costs under
accounting standards, as they are amortized over several years.

7 States also typically offer other retiree benefits such as vision,
dental, long-term care, and life insurance, but these are generally funded
entirely by retirees. For more information on the range and types of
benefits provided, see GAO, State and Local Government Retiree Benefits:
Current Status of Benefit Structures, Protections, and Fiscal Outlook for
Funding Future Costs, [24]GAO-07-1156 (Washington, D.C.: Sept. 24, 2007).

In a typical defined benefit pension plan, employer and employee
contributions are made to a specific fund from which benefits will be
paid. The yearly contributions from employers and employees are invested
in the stock market, bonds, and other investments. Unlike most pension
plans, retiree health benefits have generally been financed on a
pay-as-you-go basis. Pay-as-you-go financing means that state and local
governments have not set aside funds in a trust reserved for future
retiree health costs. Instead, governments pay for each year's retiree
health benefits from the current year's budget.

Oversight of State and Local Retiree Benefits

The federal government has an interest in the funded status of state and
local government retiree pensions and health care, even though it has not
imposed the same funding and reporting requirements as it has on private
sector pension plans. State and local government pension plans are not
covered by most of the substantive requirements, or the insurance program
operated by the Pension Benefit Guaranty Corporation (PBGC), under the
Employee Retirement Income Security Act of 1974 (ERISA), which apply to
most private employer benefit plans. Federal law generally does not
require state and local governments to prefund or report on the funded
status of pension plans or health care benefits.8 However, in order to
receive preferential tax treatment, state and local pensions must comply
with requirements of the Internal Revenue Code. In addition, the
retirement income security of all Americans is an ongoing concern of the
federal government.

All states have legal protections for their pensions. The majority of
states have constitutional provisions prescribing how pension trusts are
to be funded, protected, managed, or governed. The remaining states have
pension protections in their statutes or recognize legal protections under
common law. Legal protections usually apply to benefits for existing
workers or benefits that have already accrued; thus, state and local
governments generally can change the benefits for new hires.9 In contrast
to pensions, retiree health benefits generally do not have the same
constitutional or statutory protections. Instead, to the extent retiree
health benefits are legally protected, it is generally because they have
been collectively bargained and are subject to current labor contracts.

8 Similarly, ERISA generally does not include funding and reporting
requirements for private companies' health benefits.

9 For more information on the protections for state and local retiree
benefits, see GAO, State and Local Government Retiree Benefits: Current
Status of Benefit Structures, Protections, and Fiscal Outlook for Funding
Future Costs, GAO-07-1156 (Washington, D.C.: Sept. 24, 2007).

Since the 1980s, the Governmental Accounting Standards Board (GASB) has
maintained standards for accounting and financial reporting for state and
local governments. GASB operates independently and has no authority to
enforce the use of its standards. Still, many state laws require local
governments to follow GASB standards, and bond raters do consider whether
GASB standards are followed. Also, to receive a "clean" audit opinion
under generally accepted accounting principles, state and local
governments are required to follow GASB standards. These standards require
reporting financial information on pensions, such as contributions and the
ratio of assets to liabilities. In contrast to pensions, the financial
status of retiree health care benefits has generally not been reported or
even estimated actuarially until recently. However, new GASB standards
(Statements 43 and 45) call for employers to quantify and report on the
size of retiree health care benefit liabilities. The new health care
reporting standards are being phased in over time to give more time to
smaller state and local government sponsors to generate estimates. Table 1
shows the respective GASB 43 and 45 effective dates, as well as to what
type of entity each statement applies.

Table 1. Effective Dates for GASB Statements 43 and 45, Requiring Public
Employers to Estimate Health Care Liabilities

GASB 43: 
Applies to: Plans administered as trusts and multiple-employer plans 
that are not administered as trusts; 
Total annual revenues as of 1999: $100,000,000 or more: Applies for 
periods beginning after 12/15/05; 
Total annual revenues as of 1999: $10,000,000 - $99,999,999: Applies 
for periods beginning after 12/15/06; 
Total annual revenues as of 1999: Less than $10,000,000: Applies for 
periods beginning after 12/15/07. 

GASB 45: 
Applies to: All employers that provide retiree health benefits. 
Total annual revenues as of 1999: $100,000,000 or more: Applies for 
periods beginning after 12/15/05; 
Total annual revenues as of 1999: $10,000,000 - $99,999,999: Applies 
for periods beginning after 12/15/06; 
Total annual revenues as of 1999: Less than $10,000,000: Applies for 
periods beginning after 12/15/07. 

Source: GASB.

Key Measures of the Funded Status of Retiree Benefits Are Contributions, Funded
Ratios, and Unfunded Liabilities of Individual Plans over Time

Understanding the financial health of pension plans can be confusing. To
help clarify, we found that three measures are key to understanding
pension plans' funded status. GASB standards require reporting all three
of these measures. First, one can look at yearly contributions governments
are making to their plans. Actuaries calculate yearly contribution amounts
needed to maintain or improve the funded status of plans over time.
Comparing this amount to the amount governments actually contribute
indicates how well governments are keeping up with yearly funding needs.
Two other measures, funded ratios and unfunded liabilities, both suggest
the extent to which current assets can cover accrued benefits. These three
measures should be viewed together and over time to get a complete picture
of the funded status. The funded status measures of different plans cannot
be compared to one another easily because different governments use
different actuarial funding methods and assumptions to estimate them.

Three Measures, Viewed in Relation to One Another over Time, Describe Funded
Status

Some officials we interviewed expressed confusion about how to understand
the funded status of public pension plans. State and local governments
report a significant amount of information on funding, required by GASB
standards. The media often report various measures of the funded status
without explaining the meaning of the terms or without enough context. In
addition, governments have been reporting these funded status measures for
pensions for years. However, the new accounting rules will also call on
governments to report the funded status of retiree health benefits in a
similar manner, even though many have not made any contributions to build
assets to cover liabilities.

We identified three key measures to help explain plans' funded status:
contributions, funded ratios, and unfunded liabilities. According to
experts we interviewed, any single measure at a point in time may give a
dimension of a plan's funded status, but it does not give a complete
picture. Instead, the measures should be reviewed collectively over time
to understand how the funded status is improving or worsening. For
example, a strong funded status means that, over time, the amount of
assets, along with future scheduled contributions, comes close to matching
a plan's liabilities.

Comparing governments' actual contributions to the "annual required
contribution" (ARC) helps in evaluating the funded status of each plan.
Each year, plan actuaries calculate a contribution amount that, if paid in
full, would normally maintain or improve the funded status.10 This amount
is referred to as the ARC, although the use of the word "required" can be
misleading because governments can choose to pay more or less than this
amount.11 If the actuarial assumptions are consistent with the plans'
future experience, paying the full ARC each year provides reasonable
assurance that sufficient money is being set aside to cover currently
accruing benefits as well as a portion of any unfunded accrued benefits
left over from previous years, instead of leaving those costs for the
future. In other words, when a government consistently pays the ARC, the
benefits accrued by employees are paid for by the taxpayers who receive
the employees' services. When the ARC is not paid in full each year,
future generations must make up for the costs of benefits that accrued to
employees in the past. In addition, the ARC can be compared to the
government's yearly budget to understand the financial burden of the
benefits, according to officials. This comparison indicates how affordable
the plan is to the government in a given year. A high ARC relative to a
government's budget may indicate that the costs of benefits are relatively
high or that payments have been deferred from previous years.

The funded ratio is the ratio of assets to liabilities. Liabilities are
the amount governments owe in benefits to current employees who have
already accrued benefits they will collect in the future. The funded ratio
indicates the extent to which a plan has enough funds set aside to pay
accrued benefits. If a plan has a funded ratio of 80 percent, the plan has
enough assets to pay for 80 percent of all accrued benefits. A rising
funded ratio over time indicates that the government is accumulating the
assets needed to make future payments for benefits accrued to date. A low
or declining funded ratio over time may raise concerns that the government
will not have the assets set aside to pay for benefits.

While the funded ratio equals the ratio of assets to liabilities, unfunded
liabilities equal the difference between liabilities and assets in
dollars. Thus, unfunded liabilities indicate the amount of benefits
accrued for which no money is set aside. Assets may fall short of
liabilities, for example, when governments do not contribute the full ARC,
when they increase benefits retroactively, or when returns on investments
are lower than assumed. Additionally, because all these financial
calculations involve estimates of future payments, they are based on a
number of assumptions about the future. Unfunded liabilities can grow if
actuaries' assumptions do not hold true. For example, if beneficiaries
live longer than anticipated, they will receive more benefits than
predicted, even if the government has been paying the ARC consistently.
Unfunded liabilities will eventually require the government employer to
increase revenue, reduce benefits or other government spending, or do some
combination of these. Revenue increases could include higher taxes,
returns on investments, or employee contributions. Nevertheless, we found
that unfunded liabilities do not necessarily imply that pension benefits
are at risk in the near term. Current funds and new contributions may be
sufficient to pay benefits for several years, even when funded ratios are
relatively low.

10 The ARC is made up of the amount of future benefits promised to plan
participants that accumulated in the current year, plus a portion of any
unfunded liabilities.

11 Contributions from both sponsors and employees, combined with investment
earnings on plan assets, must cover both future benefit payments and the
administrative expenses associated with the plan.

As described in figure 1, unfunded liabilities are calculated as
intermediate steps in the process of calculating the ARC. After
calculating the unfunded liabilities, actuaries usually determine an
amount to fund the unfunded liabilities over several years or "amortize"
the cost of the liability. That amortized portion is added to the cost of
benefits that employees accrued in the current year to determine the ARC.
If a government pays the ARC, then a portion of the unfunded liabilities
is paid off each year. When no more unfunded liabilities exist, the funded
ratio is 100 percent, and the plan has "fully funded" all the benefits
that its current employees have accrued under the plan's actuarial cost
method. However, a fully funded plan still requires yearly contributions
to maintain full funding because as employees perform additional service,
they accrue additional benefits.

Figure 1. Relationship among the Key Measures of the Funded Status

The funded status measures should be reviewed over time because several
factors can affect them. In particular, the money set aside is invested
and returns can fluctuate. If a plan's invested assets grow at a rate
significantly above or below the rate assumed for funding purposes in a
given year, it can change the funded status measures, regardless of the
government's contributions. Granting retroactive benefits also increases
liabilities and increases unfunded liabilities, even if a government has
been contributing the full ARC each year. Funded ratios and unfunded
liabilities also can reflect changes in assumptions about member
characteristics. For example, as plan members are projected to live in
retirement longer, the estimated amount expected to be paid for future
benefits rises.

Comparing the Funded Status of Different Plans Is Difficult

Under GASB reporting standards, the funded status of different pension
plans cannot be compared easily because governments use different
actuarial approaches such as different actuarial cost methods,
assumptions, amortization periods, and "smoothing" mechanisms.

  Actuarial Cost Methods

Most public pension plans use one of three "actuarial cost methods," out
of the six GASB approves. Actuarial cost methods differ in several ways.
First, each uses a different approach to calculate the "normal cost," the
portion of future benefits that the cost method allocates to a specific
year, resulting in different funding patterns for each, as described in
Table 2.

Table 2: Normal Cost Calculations for Three Most Commonly Used Actuarial
Cost Methods

Actuarial cost Method: Projected unit credit; 
Description: Projected benefits of each employee covered by the plan 
are allocated by a consistent formula to valuation years; 
How the method calculates the normal cost for the current year: Equal 
to the current value of the future benefit that each employee earned 
this year, using the employee's projected salary at retirement as a 
base. 

Actuarial cost Method: Entry age normal; 
Description: The current value of future benefits of each employee is 
allocated on a level basis over the earnings or service of the employee 
between entry age and assumed exit age; 
How the method calculates the normal cost for the current year: Equal 
to the level percentage of payroll that would exactly fund each 
employee's prospective benefits if contributed from the member's date 
of eligibility until retirement. 

Actuarial cost Method: Aggregate; 
Description: The excess of the value of future benefits of all 
employees over the current value of assets is allocated on a level 
basis over the earnings or service of the group between the valuation 
date and assumed exit. This allocation is performed for the group as a 
whole, not as a sum of individual allocations; 
How the method calculates the normal cost for the current year: The 
percentage of payroll equal to the current value of future benefits 
minus assets, divided by the current value of future salaries. 

Sources: Actuarial Standards Board, Government Accountants Journal,
Organization for Economic Cooperation and Development, American Academy of
Actuaries.

Actuarial cost methods are used to allocate the current value of future
benefits into amounts attributable to the past, to the current year, and
to future years, as shown in figure 2. The cost of future benefits that
are attributable to past years under the actuarial cost method is called
the actuarial accrued liability (AAL), while the cost of benefits accrued
under the cost method in the current year is known as the normal cost.

Figure 2: Division of the Current Value of Future Benefits among Time
Periods

The funded status of plans using different cost methods differs because
each has a different approach to dividing up the value of future benefits.
Different cost methods are designed for plans to accrue liabilities at
different rates, so the normal cost and the AAL vary according to the cost
method. For example, under some cost methods, governments accrue more
liabilities in the early part of employees' career rather than later. As a
result, two identical plans, using identical actuarial assumptions but
different cost methods, would report a different funded status.12

The Aggregate Cost Method

Some news reports have expressed uncertainty about the use of the
aggregate actuarial cost method, but experts indicated that the aggregate
method is as sound as the other methods. Experts explained that under the
aggregate method, unfunded liabilities are allocated as future normal
costs instead of being amortized and added to the normal cost. As a
result, no unfunded liabilities are reported, and the funded ratio is
often reported as 100 percent and year-to-year payments may be more
volatile. Relatively few plans actually employ the aggregate method. For
those plans, GASB recently began to require governments to report the
funded ratio using the entry age normal method.

Assumptions

In addition to the cost methods, differences in assumptions used to
calculate the funded status can result in significant differences among
plans that make comparisons difficult. One key assumption is the rate at
which governments assume their invested assets will grow. If governments
assume a high growth rate, their calculations will indicate that they do
not have to pay as much today, because the assets set aside will grow more
rapidly. In 2006, 70 percent of state and local government pension plans
assumed a return of 8.0 to 8.5 percent, while 30 percent assumed a lower
rate of return (7 percent at the lowest). If a plan's assets fail to grow
at the assumed rate of return, then the shortfall becomes part of the
unfunded liabilities. However, in other years, assets may earn more than
the assumed rate of return, reducing unfunded liabilities.

Amortization Periods for Unfunded Liabilities

In addition to actuarial cost methods and assumptions, differences in
amortization periods make it difficult to compare the funded status of
different plans. Governments amortize unfunded liabilities to reduce the
volatility of contributions from year to year. Governments can choose
shorter or longer periods over which to amortize unfunded liabilities.
GASB standards allow governments to amortize unfunded liabilities over a
period of up to 30 years.13 State and local governments can amortize their
benefits because there is little chance that they will cease to exist.

Some Call for Assuming Risk-Free Investment Returns

Some in the pension community have been advocating an alternative approach
to measuring the funded status of public plans. Proponents of this
approach point to certain implications of the field of "financial
economics" that suggest that using the expected rate of return to project
future fund earnings does not adequately take into account the risk
inherent in some investments. They believe it is preferable, for
disclosure purposes, that a plan's assets and liabilities be "marked to
market." In particular, plan liabilities should be measured, independent
of the actuarial cost method used for funding, as the cost of closing out
the plan's accrued benefit obligations based on service to date. This
implies using the cost of annuities or discounting the expected cash flows
using a risk-free rate of return and would likely result in much less
favorable funded status estimates. Further, they believe that using a
"smoothed" value of assets rather than the market value of assets obscures
the plan's risk profile and may have operational consequences as well.

Most governments do not use risk-free return assumptions to calculate
funded status. Most public plan actuaries believe that using this approach
is inappropriate because their plans do invest in diversified portfolios
with higher rates of returns than risk-free rates. Those higher returns
are reasonable to expect, they feel, based on past experience and will
decrease the contributions that would be required if assumed returns were
lower. Their current practice, they argue, produces estimates of
contributions that best reflect what will actually be required on average
over the long term. Using a risk-free return assumption would result in
higher current contribution rates, requiring current taxpayers to pay more
for the cost of future benefits.

12 Even if a single method were required for financial reporting purposes,
government sponsors could still use a different method for funding
purposes, since financial reporting standards do not dictate the fiscal
policies used to fund the plans.

  Smoothing Periods

Finally, actuaries for many plans calculate the value of current assets
based on an average value of past years. As a result, if the value of
assets fluctuates significantly from year to year, the "smoothed" value of
assets changes less dramatically. GASB does not limit the number of years
governments may use to smooth the value of assets, but in 2006, most
governments averaged the value of current assets with those of the last
zero to 5 years. Comparing the funded status of plans that use different
smoothing periods can be confusing because the value of the different
plans' assets reflects a different number of years. Given fluctuations in
the stock market from year to year, the reported value of assets for plans
that use different numbers of years for smoothing calculations could
reflect significantly different market returns.

Most Public Pensions Have Assets to Pay Benefits over Several Decades, Though
Contributions Vary, While Unfunded Liabilities for Retiree Health Are
Significant

More than half of public pension plans reported that they have put enough
assets aside in advance to pay for benefits over the next several decades,
while governments providing retiree health benefits generally have
significant unfunded liabilities. The percentage of pension plans with
funded ratios below 80 percent, a level viewed by many experts as sound,
has increased in recent years, and a few plans are persistently
underfunded. Although members of these plans may not be at risk of losing
benefits in the near term, the unfunded liabilities will have to be made
up in the future. In addition, a number of governments reported not
contributing enough to reduce unfunded liabilities, which can shift costs
to future generations. For state and local governments' retiree health
benefits, studies have estimated unfunded liabilities nationwide to be
between $600 million and $1.6 trillion, although the amounts for
individual governments vary widely. Even though annual costs for retiree
health benefits are currently low compared to pensions, continuing to pay
for current benefits with current revenues can put stress on government
budgets because health care costs are increasing rapidly.

13 Under GASB standards, sponsors can also re-amortize unfunded liabilities
each year, known as "open amortization." Under such an approach, for
example, each year sponsors can pay the annual cost for a 30-year
amortization of that year's unfunded liabilities; the following year, the
sponsor can re-amortize the remaining unfunded liabilities over an
additional 30 years, and so on.

Most Public Pension Plans Have Enough Funds to Pay for Benefits over the
Long-Term

Most public pension plans report having sufficient assets to pay for
retiree benefits over the next several decades. Many experts and officials
to whom we spoke consider a funded ratio of 80 percent to be sufficient
for public plans for a couple of reasons.14 First, it is unlikely that
public entities will go bankrupt as can happen with private sector
employers, and state and local governments can spread the costs of
unfunded liabilities over up to 30 years under current GASB standards. In
addition, several commented that it can be politically unwise for a plan
to be overfunded; that is, to have a funded ratio over 100 percent. The
contributions made to funds with "excess" assets can become a target for
lawmakers with other priorities or for those wishing to increase retiree
benefits.

More than half of state and local governments' plans reviewed by the
Public Fund Survey (PFS) had a funded ratio of 80 percent or better in
fiscal year 2006, but the percentage of plans with a funded ratio of 80
percent or better has decreased since 2000, as shown in figure 3.15 Our
analysis of the PFS data on 65 self-reported state and local government
pension plans showed that 38 (58 percent) had a funded ratio of 80 percent
or more, while 27 had a funded ratio of less than 80 percent. In the early
2000s, according to one study, the funded ratio of 114 state and local
government pension plans together reached about 100 percent; it has since
declined.16 In fiscal year 2006, the aggregate funded ratio was about 86
percent. Some officials attribute the decline in funded ratios since the
late 1990s to the decline of the stock market, which reduced the value of
assets. This sharp decline would likely affect funded ratios for several
years because most plans use smoothing techniques to average out the value
of assets over several years. Our analysis of several factors affecting
the funded ratio showed that changes in investment returns had the most
significant impact on the funded ratio between 1988 and 2005, followed by
changes in liabilities.17

14 The Pension Protection Act of 2006 provided that large private sector
pension plans will be considered at risk of defaulting on their
liabilities if they have less than 80 percent funded ratios under standard
actuarial assumptions and less than 70 percent funded ratios under certain
additional `worst-case' actuarial assumptions. When private sector plans
default on their liabilities, the Pension Benefit Guaranty Corporation
becomes liable for benefits. These funding standards will be phased in,
becoming fully effective in 2011, and at-risk plans are required to use
stricter actuarial assumptions that will result in them having to make
larger plan contributions. Pub. L. No. 109-280, sec. 112(a), S 430(i), 120
Stat. 780, 839-42.

15 In this section, we refer to our analysis of the Public Fund Survey
(PFS) and the PENDAT database. The PFS is sponsored by the National
Association of State Retirement Administrators and the National Council on
Teacher Retirement. These sources contain self-reported data on state and
local government pension plans in years 1994, 1996, and 2000 to 2006. Each
year, between 62 and 72 plans were represented in our dataset. In 2005,
the 70 plans represented 58 percent of total assets invested in public
pension plans nationwide in 2005, and 72 percent of total members.

16 K. Brainard, Public Fund Survey Summary of Findings for FY 2006,
National Association of State Retirement Administrators, (Georgetown,
Tex.: October 2007).

Figure 3: Percentage of State and Local Government Pension Plans with
Funded Ratios above or below 80 Percent, by Fiscal Year

Although most plans report being soundly funded in 2006, a few have been
persistently underfunded, and some plans have seen funded ratio declines
in recent years.18 We found that several plans in our data set had funded
ratios below 80 percent in each of the years for which data is available.
Of 70 plans in our data set, 6 had funded ratios below 80 percent for 9
years between 1994 and 2006. Two plans had funded ratios below 50 percent
for the same time period. In addition, of the 27 plans that had funded
ratios below 80 percent in 2006, 15 had lower funded ratios in 2006 than
in 1994. The sponsors of these plans may be at risk in the future of
increased budget pressures.

17 These findings may be unique to the time period examined (1988-2005). In
other periods, other factors, such as changes to benefits, may account for
more of the change in the funded ratio than the rates of return on the
investment portfolio.

By themselves, lower funded ratios and unfunded liabilities do not
necessarily indicate that benefits for current plan members are at risk,
according to experts we interviewed. Unfunded liabilities are generally
not paid off in a single year, so it can be misleading to review total
unfunded liabilities without knowing the length of the period over which
the government plans to pay them off. Large unfunded liabilities may
represent a fiscal challenge, particularly if the period to pay them off
is short. But all unfunded liabilities shift the responsibility for paying
for benefits accrued in past years to the future.

Some Pension Sponsors Do Not Contribute Enough to Improve Funding Status

A number of governments reported not contributing enough to keep up with
yearly costs. Governments need to contribute the full ARC yearly to
maintain the funded ratio of a fully funded plan or improve the funded
ratio of a plan with unfunded liabilities. In fiscal year 2006, the
sponsors of 46 percent of the 70 plans in our data set contributed less
than 100 percent of the ARC, as shown in figure 4, including 39 percent
that contributed less than 90 percent of the ARC. In fact, the percentage
of governments contributing less than the full ARC has risen in recent
years. This continues a trend in recent years of about half of governments
making full contributions.

18 Reports estimate total unfunded liabilities for public pension plans
nationwide between $307 and $385 billion, but the estimates do not cover
all state and local government plans. One study by the National
Association of State Retirement Administrators reviewed the funding status
of 125 of the nation's large public pension plans in fiscal year 2006 and
found total unfunded liabilities to be more than $385 billion. Another
study reviewed state-only pension plans and found that in 2005, the most
recent year for which substantially complete data was available, total
unfunded liabilities for 108 plans were about $307 billion. Neither study
is a random sample of state and local government pension plans that
represents all public plans nationwide. NASRA Public Fund Survey (2006).
This estimate represents 85 percent of public plan assets nationwide.
Wilshire Consulting, 2007 Wilshire Report on State Retirement Systems:
Funding Levels and Asset Allocation (2007). This study includes only state
plans, not local plans.

Figure 4: Percentage of State and Local Government Pension Plans for which
Governments Contributed More or Less Than 100 Percent of the ARC, by
Fiscal Year

In particular, some of the governments that did not contribute the full
ARC in multiple years were sponsors of plans with lower funded ratios. In
2006, almost two-thirds of plans with funded ratios below 80 percent in
2006 did not contribute the full ARC in multiple years. Of the 32 plans
that in 2006 had funded ratios below 80 percent, 20 did not contribute the
full ARC in more than half of the 9 years for which data is available. In
addition, 17 of these governments did not contribute more than 90 percent
of the full ARC in more than half the years.

State and local government pension representatives told us that
governments may not contribute the full ARC each year for a number of
reasons. First, when state and local governments are under fiscal
pressure, they may have to make difficult choices about paying for
competing interests. State and local governments will likely face
increasing fiscal challenges in the next several years as the cost of
health care continues to rise. In light of this stress, the ability of
some governments to continue to pay the ARC may be questioned. Second,
changes in the value of assets can affect governments' expectations about
how much they will have to contribute. Because a high proportion of plan
assets are invested in the stock market, the decline in the early 2000s
decreased funded ratios and increased the unfunded liabilities of many
plans. Such a marked decline in asset values was not typical in the
experience of public pension funds, according to one expert. Reflecting
the need to keep up with the increase in unfunded liabilities, ARCs
increased, challenging many governments to make full contributions after
they had grown accustomed to lower ARCs in the late 1990s. Moreover, some
plans have contribution rates that are fixed by constitution, statute, or
practice and do not change in response to changes in the ARC. Even when
the contribution rate is not fixed, the political process may take time to
recognize and act on the need for increased contributions. Nonetheless,
many states have been increasing their contribution rates in recent years,
according to information compiled by the National Conference of State
Legislatures. Third, some governments may not contribute the full ARC
because they are not committed to pre-funding their pension plans and
instead have other priorities, regardless of fiscal conditions.

When a government contributes less than the full ARC, the funded ratio can
decline and unfunded liabilities can rise, if all other assumptions are
met about the change in assets and liabilities.19 Increased unfunded
liabilities will require larger contributions in the future to keep pace
with the liabilities that accrue each year and to make up for liabilities
that accrued in the past. As a result, costs are shifted from current to
future generations.

19 When a government does not contribute at least the normal cost plus
interest on the unfunded liability (which is an amount less than the full
ARC), unfunded liabilities will increase.

Unfunded Retiree Health Liabilities Are Large for Many State and Local
Governments

Our review of studies estimating the total retiree health benefits for all
state and local governments showed that liabilities are between $600
billion and $1.6 trillion.20 The studies noted that, like many private
employers, few governments have set aside any assets to pay for these
obligations. The projected unfunded liabilities do not have to be paid all
at once, but can be paid over many years. Some governments do not pay for
any retiree health benefits and therefore do not have any unfunded
liabilities. Others may have large unfunded liabilities. For example,
California has estimated its unfunded retiree health benefits liabilities
at $70 billion, while the state of Utah estimates $749 million.

Estimates of unfunded liabilities for retiree health benefits are subject
to change substantially because projecting future costs of health care is
difficult. Compared to the future payments for pension benefits, payments
for health care benefits are significantly more unpredictable. Pension
calculations generally use salaries as a base for calculations and result
in a predictable benefit amount per year. But the cost of providing health
care benefits varies with the changing cost of health care as well as with
each individual's usage. In addition, state and local governments usually
have the ability to reduce or eliminate benefits.

Unfunded liabilities for retiree health benefits are high because unlike
pension plans, nearly all state and local government retiree health
benefits have been financed on a pay-as-you-go basis. In other words, most
governments have not set aside funds in a trust dedicated for future
retiree health benefit payments. As a result, governments do not pay a
yearly ARC, but rather pay for retiree health benefits as they become due
from annual funds. However, the new GASB accounting standards will require
state and local governments to report their funding status on an accrual
basis. In other words, for the first time, most governments will begin to
calculate and report their funding status in a manner similar to the way
they report pensions' funding status, whether or not they are prefunded.

20 Chris Edwards and Jagadeesh Gokhale. "Unfunded State and Local Health
Costs: $1.4 Trillion." Tax and Budget Bulletin, no. 40 (Cato Institute:
2006); David Zion and Amit Varshney, "You Dropped a Bomb on Me, GASB:
Uncovering $1.5 Trillion in Hidden OPEB Liabilities for State and Local
Governments," Equity Research, Accounting and Tax (Credit Suisse: 2007);
Brian Whitworth, Igor Balevich, and Jim Kelly OPEB for Public Entities:
GASB 45 and other Challenges (J.P. Morgan: 2005). These estimates of
health care liabilities are limited by their methodologies. For example,
the reports generalize about all state and local governments' liabilities
from a non-representative sample, and the reports did not consider the
variation in actuarial methods and assumptions in the calculations (See
app. I). The studies base their estimates on actuarial valuations and
public reports that have been performed by some state and local
governments in advance of the deadlines for the new GASB standards. The
studies then extrapolate the findings to calculate a nationwide total for
all state and local governments.

Officials told us that state and local governments have not prefunded
retiree health benefits for several reasons. First, for many governments,
retiree health benefits began as an extension of employee health care
benefits, which are usually paid for from general funds. Governments did
not view retiree health as a separate stream of payments. Second, retiree
health benefits were established at a time when health care costs were
more affordable, so paying for the benefits as a yearly expense was less
burdensome. Third, the inflation rate for health care is less predictable
than for pensions, so calculating the current funding status is difficult.
Fourth, given that specific retiree health benefits are generally not
guaranteed by law, employers are freer to modify benefits; as a result,
state and local governments are reluctant to commit funds to an obligation
that may be reduced or eliminated in the future. Finally, changes in
national health care policy and health insurance markets can affect what
benefits state and local governments cover, so state and local governments
may have resisted locking in their commitment to pay for future retiree
health benefits by prefunding, and instead preferred to finance on a
pay-as-you-go basis.

Although the unfunded liabilities for retiree health benefits are
generally much higher than for pensions, their current annual payments are
considerably lower. According to our analysis presented in our recent
report on this topic,21 in 2006, the aggregate state and local
contribution rate for pensions was about 9 percent of salaries, and the
pay-as-you-go expense for retiree health benefits was about 2 percent of
salaries. However, if retiree health continues to be financed on a
pay-as-you-go basis, the pay-as-you-go amount is estimated to more than
double to 5 percent of salaries by 2050 to keep up with the growth in
health costs, adding to budgetary stress. Pay-as-you-go financing also
leaves less budgetary flexibility because state and local governments must
pay the full costs of each year's benefits. In contrast, under
pre-funding, benefits are paid from a fund that already exists, so
government contributions can be reduced when fiscal pressures are great.
As a result, governments may face even greater pressure to reduce benefits
or shift the costs of benefits to beneficiaries, for example, by
restricting eligibility, reducing coverage, or increasing premiums. Still,
pre-funding retiree health benefits would require significantly higher
contributions in the short term than pay-as-you-go financing would
require.

21 [25]GAO-07-1156 , pp. 27-30. As noted in that report, the simulations
of future contribution rates are very sensitive to assumptions about the
growth rate of health care costs and to assumptions about the rate of
return on investments.

Concluding Observations

Understanding the funded status of state and local government retiree
benefits requires examining, on a plan-by-plan basis, whether funding
levels are improving over time and whether governments are making the
contributions recommended by the plan's actuary each year. The variety of
actuarial funding methods and assumptions makes it difficult to compare
funded status across different pension plans. However, funded status
information is not intended to help compare plans, but rather to determine
contributions that will achieve full funding over time and to assess a
given plan's funded status over time.

The funded status of state and local government pensions overall is
reasonably sound, though recent deterioration underscores the importance
of keeping up with contributions, especially in light of anticipated
fiscal and economic challenges. Since the stock market downturn in the
early 2000s, the funded ratios of some governments have declined.
Governments can gradually recover from these losses. However, the failure
of some to consistently make the annual required contributions undermines
that progress and is cause for concern, particularly as state and local
governments will likely face increasing fiscal pressure in the coming
decades. While unfunded liabilities do not generally put benefits at risk
in the near-term, they do shift costs and risks to the future.

In the case of retiree health benefits, pay-as-you-go financing has been
the norm up to the present day. The initial estimates of the unfunded
liabilities will be daunting. But that is a natural consequence of
pay-as-you-go financing. Just as the unfunded liabilities did not
accumulate overnight, it may be unrealistic to expect them to be paid for
overnight. Rather, state and local governments need to find strategies for
dealing with unfunded liabilities, and such strategies will take time,
will require difficult choices, and could be affected by changes in
national health policy.

Agency Comments

We provided officials from the Internal Revenue Service, GASB staff, and
other external reviewers knowledgeable about the subject area a copy of
this report for their review. They provided us with technical comments
that we incorporated, where appropriate.

As agreed with your offices, unless you publicly announce the contents of
this report earlier, we plan no further distribution until 30 days from
the report date. At that time, we will send copies of this report to
relevant congressional committees, the Acting Commissioner of Internal
Revenue, and other interested parties. Copies will also be made available
to others upon request. In addition, the report will be available at no
charge on the GAO Web site at [26]http://www.gao.gov . Please contact me
at (202) 512-7215, if you have any questions about this report. Other
major contributors include Tamara Cross, Assistant Director; Ken
Stockbridge; Anna Bonelli; Temeca Simpson; Amy Abramowitz; Joseph
Applebaum; Rick Krashevski; Jeremy Schwartz; Walter Vance; Charles
Willson; and Craig Winslow.

Barbara D. Bovbjerg
Director, Education, Workforce, and Income Security Issues

Appendix I: Objectives, Scope, and Methodology

The objectives of this report were to examine 1) the key measures of the
funded status of retiree benefits and 2) the current funded status of
state and local pension and retiree health benefits.

To describe the key measures of the funded status of retiree benefits, we
interviewed experts on state and local government pension and retiree
health benefits such as national organizations, bond rating agencies, and
representatives from one local government retiree benefit system. We also
spoke with experts on actuarial science such as the Actuarial Standards
Board, the American Academy of Actuaries, and independent actuaries. We
spoke to staff of the Governmental Accounting Standards Board to
understand accounting practices and principles. We also reviewed actuarial
literature and attended conferences. In addition, we conducted the
following analysis:

           o To understand the impact of various economic factors on the
           funding ratio of public pension plans, we developed a simple model
           of the determinants of the funding ratio and conducted
           "counterfactuals" holding rates of return on investments constant.
           To do this, we used the following data sources:

           o funding ratio data from the Public Fund Survey (PFS) for years
           2001 to 2005 and the Survey of State and Local Pensions for years
           1988 to 2000;

           o market value of pension assets from the Federal Reserve's Flow
           of Funds Accounts;

           o contributions and benefits data from the Bureau of Economic
           Analysis's National Income and Product Accounts database; and

           o data on returns on pension fund portfolios by analyzing market
           data.

           o Our methodology and data sources for this analysis include some
           limitations. First, annual data are not available in the Survey of
           State and Local Pensions for 5 years during the period. For those
           years, values were imputed by using the average growth between the
           two closest values. In addition, the funding ratios are available
           on a fiscal year basis and were subsequently adjusted to a
           calendar year period. Second, assumptions may not be
           representative of all pension plans, such as the assumptions based
           on smoothing functions and the real expected returns on
           investments. Last, counterfactuals do not include policy
           adjustments that may occur because of different rates of return.

To describe the funded status of state and local governments' pensions, in
addition to a literature review, we analyzed pension funding data provided
by the National Association of State Retirement Administrators (NASRA).
The data come from two different databases. The first database is the PFS
and is sponsored by NASRA and the National Council on Teacher Retirement
(NCTR). Data from years 2001 to 2006 were available. PFS data are gathered
by reviewing publicly available financial documents from the state and
local government plans. The second database is called the PENDAT database
and was sponsored by the Public Pension Coordinating Council. PENDAT data
are available in fiscal years 1992, 1994, 1996, 1998, and 2000.1 PENDAT
data were collected via a survey sent to the administrators of a sample of
plans nationwide.

           o The PFS and PENDAT databases do not include all of the same
           entries. We matched individual entries from PENDAT to PFS,
           resulting in a sample with between 63 and 71 plans that had data
           across each of the available years from 1994 to 2006. In fiscal
           year 2005, these plans represented 58 percent of plan assets
           nationwide, and 72 percent of state and local government pension
           plan members.

           o We reviewed the PFS and PENDAT data and found them to be
           reliable for our purposes. To do this, we reviewed all entries of
           key data points in the PFS data using publicly available sources
           from the state and local government plan sponsors and made
           adjustments to the data as needed. The corrections made to the PFS
           data were not material. To review the PENDAT database, we reviewed
           the methodology used to collect the data and verified the data of
           23 percent of entries using external sources. The corrections were
           not found to be material.

           o The information contained in the PFS and PENDAT databases have
           limitations: 1) surveys, including PENDAT, are subject to several
           kinds of error such as the failure to include all members of the
           population in the sample, nonresponse error, and data processing
           error; 2) the funding ratio and other funding indicators represent
           the financial status for the fiscal year with the most recent
           actuarial valuation, and thus do not all represent the same fiscal
           year's financial status; 3) the plans included in the analysis are
           not necessarily representative of all state and local government
           pension plans nationwide; and 4) data for every plan is not
           available in each year.

1 Few entries were available from 1998, so we did not use any data from
this year.

To obtain information on the funded status of retiree health benefits, we
interviewed experts on retiree health benefits funding from national
organizations, bond rating agencies, and one local government retiree
benefits system. We also reviewed studies conducted by various
organizations estimating the funded status. These organizations each
obtained information about retiree health benefits liabilities from a
number of different state and local governments and then extrapolated
these figures to generate a nationwide estimate of all state and local
governments. We reviewed the following studies:

           o Credit Suisse, You Dropped a Bomb on Me, GASB, 2007. Limitations
           of this study include: only states in the analysis, not local
           jurisdictions, are included; assumes that those government
           entities for which Credit Suisse was able to find estimates of
           future retiree health benefit obligations were representative of
           governments overall in terms of age distribution and funding
           levels; and does not consider the variation in actuarial
           assumptions and methods between the different plans.

           o Cato Institute, Unfunded State and Local Health Costs: $1.4
           Trillion, 2006. Limitations of this study include: includes states
           only in the analysis, not local jurisdictions; assumes that those
           government entities for which Cato was able to find estimates of
           future retiree health benefit obligations were representative of
           governments overall in terms of age distribution and funding
           levels; does not consider the variation in actuarial assumptions
           and methods between the different plans; it is not clear how many
           employees were covered by the sample because there were so many
           localities; and figures on the percentage of employees covered by
           health care plans in state and local government jurisdictions may
           not be precise.

           o OPEB for Public Entities: GASB 45 and Other Challenges, JP
           Morgan, 2005. Limitations of this study include: assumes that
           those government entities for which they were able to find
           estimates of future retiree health benefit obligations were
           representative of governments overall in terms of age distribution
           and funding levels; and does not consider the variation in
           assumptions and methods between the different plans.

We conducted our work in Washington, D.C.; New York; and Connecticut, from
July 2006 to January 2008 in accordance with generally accepted government
auditing standards.

Related GAO Products

State and Local Government Retiree Benefits: Current Status of Benefit
Structures, Protections, and Fiscal Outlook for Funding Future Costs.
[27]GAO-07-1156 . Washington, D.C.: September 24, 2007.

State and Local Governments: Persistent Fiscal Challenges Will Likely
Emerge within the Next Decade. [28]GAO-07-1080SP . Washington, D.C.: July
18, 2007.

Retiree Health Benefits: Majority of Sponsors Continued to Offer
Prescription Drug Coverage and Chose the Retiree Drug Subsidy.
[29]GAO-07-572 . Washington, D.C.: May 31, 2007.

Employer-Sponsored Health and Retirement Benefits: Efforts to Control
Employer Costs and the Implications for Workers. [30]GAO-07-355 .
Washington, D.C.: March 30, 2007.

State Pension Plans: Similarities and Differences Between Federal and
State Designs. [31]GAO/GGD-99-45 . Washington, D.C.: March 19, 1999.

Public Pensions: Section 457 Plans Pose Greater Risk than Other
Supplemental Plans. [32]GAO/HEHS-96-38 . Washington, D.C.: April 30, 1996.

Public Pensions: State and Local Government Contributions to Underfunded
Plans. [33]GAO/HEHS-96-56 . Washington, D.C.: March 14, 1996.

(130608)

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Highlights of [41]GAO-08-223 , a report to the Committee on Finance, U.S.
Senate

January 2008

STATE AND LOCAL GOVERNMENT RETIREE BENEFITS

Current Funded Status of Pension and Health Benefits

[42]transparent illustrator graphic

Pension and other retiree benefits for state and local government
employees represent liabilities for state and local governments and
ultimately a burden for state and local taxpayers. Since 1986, accounting
standards have required state and local governments to report their
unfunded pension liabilities. Recently, however, standards changed and now
call for governments also to report retiree health liabilities. The extent
of these liabilities nationwide is not yet known, but some predict they
will be very large, possibly exceeding a trillion dollars in present value
terms.

The federal government has an interest in assuring that all Americans have
a secure retirement, as reflected in the federal tax deferral for
contributions to both public and private pension plans. Consequently, the
GAO was asked to examine: 1) the key measures of the funded status of
retiree benefits and 2) the current funded status of retiree benefits. GAO
analyzed data on public pensions, reviewed current literature, and
interviewed a range of experts on public retiree benefits, actuarial
science, and accounting.

[43]What GAO Recommends

GAO is not making recommendations in this report. Experts on public
benefits funding provided technical clarifications, which were
incorporated as appropriate.

Three key measures help to understand different aspects of the funded
status of state and local government pension and other retiree benefits.
First, governments' annual contributions indicate the extent to which
governments are keeping up with the benefits as they are accumulating.
Second, the funded ratio indicates the percentage of actuarially accrued
benefit liabilities covered by the actuarial value of assets. Third,
unfunded actuarial accrued liabilities indicate the excess, if any, of
liabilities over assets in dollars. Governments have been reporting these
three measures for pensions for years, but new accounting standards will
also require governments to report the same for retiree health benefits.
Because a variety of methods and actuarial assumptions are used to
calculate the funded status, different plans cannot be easily compared.

Currently, most state and local government pension plans have enough
invested resources set aside to keep up with the benefits they are
scheduled to pay over the next several decades, but governments offering
retiree health benefits generally have large unfunded liabilities. Many
experts consider a funded ratio of about 80 percent or better to be sound
for government pensions. We found that 58 percent of 65 large pension
plans were funded to that level in 2006, a decrease since 2000. Low funded
ratios would eventually require the government employer to improve
funding, for example, by reducing benefits or by increasing contributions.
However, pension benefits are generally not at risk in the near term
because current assets and new contributions may be sufficient to pay
benefits for several years. Still, many governments have often contributed
less than the amount needed to improve or maintain funded ratios. Low
contributions raise concerns about the future funded status. For retiree
health benefits, studies estimate that the total unfunded actuarial
accrued liability for state and local governments lies between $600
billion and $1.6 trillion in present value terms. The unfunded liabilities
are large because governments typically have not set aside any funds for
the future payment of retiree health benefits as they have for pensions.

Percentage of State and Local Pension Plans with Funded Ratios above or
below 80 Percent

References

Visible links
  22. http://www.gao.gov/cgi-bin/getrpt?GAO-07-1156
  23. http://www.gao.gov/cgi-bin/getrpt?GAO-07-1080SP
  24. http://www.gao.gov/cgi-bin/getrpt?GAO-07-1156
  25. http://www.gao.gov/cgi-bin/getrpt?GAO-07-1156
  26. http://www.gao.gov/
  27. http://www.gao.gov/cgi-bin/getrpt?GAO-07-1156
  28. http://www.gao.gov/cgi-bin/getrpt?GAO-07-1080SP
  29. http://www.gao.gov/cgi-bin/getrpt?GAO-07-572
  30. http://www.gao.gov/cgi-bin/getrpt?GAO-07-355
  31. http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-99-45
  32. http://www.gao.gov/cgi-bin/getrpt?GAO/HEHS-96-38
  33. http://www.gao.gov/cgi-bin/getrpt?GAO/HEHS-96-56
  34. http://www.gao.gov/
  35. http://www.gao.gov/
  36. http://www.gao.gov/fraudnet/fraudnet.htm
  37. mailto:[email protected]
  38. mailto:[email protected]
  39. mailto:[email protected]
  40. http://www.gao.gov/cgi-bin/getrpt?GAO-08-223
  41. http://www.gao.gov/cgi-bin/getrpt?GAO-08-223
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