oversight

State and Local Government Pension Plans: Economic Downturn Spurs Efforts to Address Costs and Sustainability

Published by the Government Accountability Office on 2012-03-02.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

             United States Government Accountability Office

GAO          Report to Congressional Requesters




March 2012
             STATE AND LOCAL
             GOVERNMENT
             PENSION PLANS
             Economic Downturn
             Spurs Efforts to
             Address Costs and
             Sustainability




GAO-12-322
                                               March 2012

                                               STATE AND LOCAL GOVERNMENT PENSION
                                               PLANS
                                               Economic Downturn Spurs Efforts to Address Costs
Highlights of GAO-12-322, a report to
                                               and Sustainability
congressional requesters




Why GAO Did This Study                         What GAO Found
Over 27 million employees and                  Despite the recent economic downturn, most large state and local government
beneficiaries are covered by state and         pension plans have assets sufficient to cover benefit payments to retirees for a
local government pension plans.                decade or more. However, pension plans still face challenges over the long term
However, the recent economic                   due to the gap between assets and liabilities. In the past, some plan sponsors
downturn and associated budget                 have not made adequate plan contributions or have granted unfunded benefit
challenges confronting state and local         increases, and many suffered from investment losses during the economic
governments pose some questions as             downturn. The resulting gap between asset values and projected liabilities has
to the sustainability of these plans, and      led to steady increases in the actuarially required contribution levels needed to
what changes, if any, state and local          help sustain pension plans at the same time state and local governments face
governments are making to strengthen           other fiscal pressures.
the financial condition of their pension
plans. GAO was asked to examine                Since 2008, the combination of fiscal pressures and increasing contribution
                                               requirements has spurred many states and localities to take action to strengthen
(1) recent trends in the financial
                                               the financial condition of their plans for the long term, often packaging multiple
condition of state and local government
                                               changes together. GAO’s tabulation of recent state legislative changes reported
pension plans and
                                               by NCSL and review of reforms in selected sites revealed the following:
(2) strategies state and local
governments are using to manage
                                               • Reducing benefits: 35 states have reduced pension benefits, mostly for future
pension costs and the impacts of these           employees due to legal provisions protecting benefits for current employees
strategies on plans, sponsors,                   and retirees. A few states, like Colorado, have reduced postretirement benefit
employees, and retirees.                         increases for all members and beneficiaries of their pension plans.
                                               • Increasing member contributions: Half of the states have increased member
To address these topics, GAO                     contributions, thereby shifting a larger share of pension costs to employees.
analyzed various measures of sector-
                                               • Switching to a hybrid approach: Georgia, Michigan, and Utah recently
wide financial condition based on
                                                 implemented hybrid approaches, which incorporate a defined contribution plan
national-level data on pension funding
from the U.S. Census Bureau and
                                                 component, shifting some investment risk to employees.
others, and reviewed information on            At the same time, some states and localities have also adjusted their funding
recent state legislative changes               practices to help manage pension contribution requirements in the short term by
affecting government pensions from             changing actuarial methods, deferring contributions, or issuing bonds, actions
annual reports prepared by the                 that may increase future pension costs. Going forward, growing budget
National Conference of State
                                               pressures will continue to challenge state and local governments’ abilities to
Legislatures (NCSL). GAO did not
                                               provide adequate contributions to help sustain their pension plans.
assess the soundness of individual
plans, but did obtain documents and            Notable Changes to State-Sponsored Pension Plans (January 2008 to June 2011)
conduct interviews with pension and
budget officials in eight states and
eight localities, selected to illustrate the
range of strategies being implemented
to meet current and future pension
funding requirement.
The Internal Revenue Service and
Social Security Administration provided
technical comments, which were
incorporated, as appropriate.


View GAO-12-322. For more information,
contact Barbara D. Bovbjerg at (202) 512-
7215 or bovbjergb@gao.gov, or Stanley J.
Czerwinski at (202) 512-6806 or
czerwinskis@gao.gov.
                                                                                          United States Government Accountability Office
Contents


Letter                                                                                       1
               Background                                                                    4
               Plans Have Sufficient Assets to Pay Near-Term Benefits, but
                 Growing Budget Pressures Will Challenge Their Sustainability                7
               States and Localities Have Made Changes to Reduce Costs and
                 Improve Plan Sustainability                                               18
               Concluding Observations                                                     33
               Agency Comments                                                             34

Appendix I     Profiles of Selected State and Local Government Pensions                    36



Appendix II    Actuarial Methods and Assumptions for Measuring Funded Status
               for Public Sector Defined Benefit Plans                                     45



Appendix III   GAO Contacts and Staff Acknowledgments                                      49



Tables
               Table 1: State and Local Plans Selected for Review                            3
               Table 2: Understanding the Financial Condition of a Public Defined
                        Benefit Plan                                                       10
               Table 3: Median Contribution Rates for Large Plans as a Percentage
                        of Payroll                                                         15


Figures
               Figure 1: State and Local Government Pension Contributions,
                        Fiscal Year 2009                                                     4
               Figure 2: Investment Returns for State and Local Government
                        Pension Plans, Fiscal Years 2005–2009                                9
               Figure 3: Historical Trends in the Financial Condition of State and
                        Local Government Pension Plans—Aggregate Ratio of
                        Market Assets to Total Expenditures, 1957–2009                     11
               Figure 4: Variability in Large Plans’ Ratios of Assets to Annual
                        Expenditures, Fiscal Year 2009                                     11




               Page i                                       GAO-12-322 State and Local Pensions
Figure 5: Aggregate Funding Ratio: Trend Data for Large State and
         Local Government Pension Plans, Fiscal Years 2001–2010                           14
Figure 6: Distribution of Percentage of ARC Paid for Large Plans,
         Fiscal Year 2010                                                                 16
Figure 7: Notable Changes to State-Sponsored Pension Plans,
         January 2008–June 2011                                                           19
Figure 8: Pension Obligation Bond Issuances Nationwide, January
         2006–June 2011                                                                   29




Abbreviations

ARC               annual required contribution
ASB               Actuarial Standards Board
CAFR              Comprehensive Annual Financial Report
COLA              cost-of-living adjustment
CPI-W             Consumer Price Index for Urban Wage Earners and
                  Clerical Workers
ERISA             Employee Retirement Income Security Act of 1974
GAAP              generally accepted accounting principles
GASB              Governmental Accounting Standards Board
NASBO             National Association of State Budget Officers
NCSL              National Conference of State Legislatures
POB               pension obligation bond


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Page ii                                              GAO-12-322 State and Local Pensions
United States Government Accountability Office
Washington, DC 20548




                                   March 2, 2012

                                   The Honorable Herb Kohl
                                   Chairman
                                   Special Committee on Aging
                                   United States Senate

                                   The Honorable Michael B. Enzi
                                   Ranking Member
                                   Committee on Health, Education,
                                   Labor, and Pensions
                                   United States Senate

                                   The recent economic downturn combined with continuing budget
                                   challenges has heightened concerns about the financial condition of state
                                   and local pension plans. Pension funding is a long-term endeavor, but
                                   states and local governments often have annual balanced budget
                                   requirements that can pit government contributions to pension plans
                                   against other pressing funding needs. Although state and local retiree
                                   benefits are not subject, for the most part, to federal laws governing
                                   private sector retiree benefits, the federal government has an interest in
                                   ensuring that all Americans have a secure retirement. This includes the
                                   over 27 million people covered by state and local government pension
                                   plans. 1 The federal government also has an interest in the challenging
                                   fiscal situation facing the state and local sectors because fiscal health
                                   presents a national challenge shared by all levels of government. In light
                                   of these concerns, you asked us to examine

                                   1. recent trends in the financial condition of state and local government
                                      pension plans and

                                   2. strategies state and local governments are using to manage pension
                                      costs and the impacts of these strategies on plans, sponsors,
                                      employees, and retirees.




                                   1
                                    This total is based on the U.S. Census Bureau’s 2009 Survey of State and Local Public-
                                   Employee Retirement Systems and includes active members, inactive members, and
                                   beneficiaries.




                                   Page 1                                              GAO-12-322 State and Local Pensions
To describe trends in the financial condition of state and local pension
funds, we analyzed various measures of sector-wide financial condition
based on existing national-level data on pension funding. We analyzed
data from the U.S. Census Bureau’s surveys of state and local retirement
systems and from the Public Plans Database developed by the Boston
College Center for Retirement Research, which includes financial data on
126 large state and local defined benefit plans covering more than 85
percent of total state and local government pension assets and members.
To better understand the context for these trends, we reviewed existing
literature on state and local government pension plans and interviewed
national experts on state and local government pension issues.

To identify the prevalence of various strategies state and local
governments are using to manage pension costs, we analyzed national-
level data on state legislative changes and use of bonds to finance their
plans. Specifically, to identify legislative changes, we analyzed annual
reports prepared by the National Conference of State Legislatures
(NCSL) summarizing selected state pension and retirement legislation
enacted from January 1, 2008, through June 30, 2011. 2 We limited our
analysis of these NCSL reports to changes affecting broad categories of
employees, such as state employees, teachers, public safety personnel,
and local employees who are members of state-administered plans. In
some limited instances, to better understand a legislative change, we
reviewed supplemental documents such as pension plan documents and
summaries of the legislation prepared by plans, state legislative counsel,
or state agencies. We did not conduct an independent legal analysis to
verify the accuracy of the information pertaining to recently enacted
legislation contained in the NCSL reports. To identify bonds issued for the
purpose of financing public pension plans, we analyzed multiple sources
of bond data, including Mergent BondViewer and the Electronic Municipal
Market Access system. 3 We supplemented these national-level data by
interviewing state and local pension and budget officials, and reviewing
financial and actuarial reports, from a small judgmental sample of plans
from eight states, and one locality within each of these states, that had


2
 Ronald K. Snell, NCSL, Pensions and Retirement Plan Enactments, annual reports for
2008-2010 and 2011 report as of June 30, 2011. For additional information about the state
legislative changes described in this report, refer to the NCSL reports.
3
 Mergent BondViewer is an online database of bond data. The Electronic Municipal
Market Access system, maintained by the Municipal Securities Rulemaking Board, is an
online database of municipal disclosures and data on the municipal securities market




Page 2                                              GAO-12-322 State and Local Pensions
                                           implemented pension modifications since 2008 (see table 1). This
                                           judgmental sample was selected to provide examples of plans
                                           experiencing a range of financial conditions and types of strategies
                                           adopted by their sponsors. We based this selection on our analysis of
                                           NCSL annual reports on pension legislation and suggestions from our
                                           interviews with pension experts. We did not assess the financial
                                           soundness of individual plans.

Table 1: State and Local Plans Selected for Review

State          State plan                                              Locality                  Local plan
California     •   California State Teachers’ Retirement System        Sonoma County             Sonoma County Employees’ Retirement
               •   California Public Employees’ Retirement                                       Association
                   System
Colorado       •   Colorado Public Employees’ Retirement               City of Denver            Denver Employees Retirement Plan
                   Association
Georgia        •   Employees’ Retirement System of Georgia             Cobb County               Cobb County Employees’ Retirement
                                                                                                 System Pension Plan
Illinois       •   State Employees’ Retirement System of Illinois      City of Chicago           Policemen’s Annuity and Benefit Fund of
               •   Teachers’ Retirement System of the State of                                   Chicago
                   Illinois
Missouri       •   Missouri State Employees’ Retirement System City of Springfield               Police Officers’ and Firefighters’
               •   Missouri Department of Transportation and                                     Retirement Fund
                   Highway Patrol Employees’ Retirement System
Pennsylvania   •   Pennsylvania Public School Employees’               City of Philadelphia      City of Philadelphia Municipal Pension
                   Retirement System                                                             Plan
               •   Pennsylvania State Employees’ Retirement
                   System
Utah           •   Utah Retirement Systems                             City of Bountiful         Public Safety Retirement System (City of
                                                                                                 Bountiful)- part of the Utah Retirement
                                                                                                 Systems
Virginia       •   Virginia Retirement System                          City of Norfolk           Employees’ Retirement System of the City
                                                                                                 of Norfolk
                                           Source: GAO.


                                           Note: See appendix I for more detailed profiles of each state, locality, and plan.

                                           We conducted this performance audit from December 2010 to March
                                           2012 in accordance with generally accepted government auditing
                                           standards. Those standards require that we plan and perform the audit to
                                           obtain sufficient, appropriate evidence to provide a reasonable basis for
                                           our findings and conclusions based on our audit objectives. We believe
                                           that the evidence obtained provides a reasonable basis for our findings
                                           and conclusions based on our audit objectives.




                                           Page 3                                                        GAO-12-322 State and Local Pensions
             There are over 3,400 state and local pension systems in the United
Background   States, according to the most recent Census Bureau Survey of State and
             Local Public-Employee Retirement Systems. 4 Most large plans are state
             plans, and more state and local employees are covered by state-
             administered plans than by locally-administered plans (about 24 million
             members and beneficiaries compared with about 3 million). However,
             there are more local government employees than state government
             employees (about 14 million compared with about 5 million), and while
             local governments sometimes participate in plans administered by states,
             the local governments generally retain responsibility for contributing the
             employer’s share of funding to the plans for their employees. As a result,
             local governments contribute more to pension plans each state fiscal
             year, overall, than do state governments (see fig. 1). 5

             Figure 1: State and Local Government Pension Contributions, Fiscal Year 2009




             Pension plans are generally characterized as either defined benefit or
             defined contribution plans. Unlike in the private sector, defined benefit



             4
              U.S. Census, 2009 Survey of State and Local Public-Employee Retirement Systems
             (Washington, D.C. 2011).
             5
              Throughout this report, the term “fiscal year” refers to state fiscal year (as opposed to
             federal fiscal year). State fiscal years vary, but most run from July 1 to June 30, according
             to the Census Bureau.




             Page 4                                                 GAO-12-322 State and Local Pensions
plans provide primary pension benefits for most state and local
government workers. About 78 percent of state and local employees
participated in defined benefit plans in 2011, compared with only 18
percent of private sector employees. 6 In a defined benefit plan, the
amount of the benefit payment is determined by a formula (in the public
sector, the formula is typically based on the retiree’s years of service and
final average salary, and is most often provided as a lifetime annuity).
However, unlike private sector employees with defined benefit plans,
state and local government employees generally contribute to their
defined benefit plans. A few states offer defined contribution or other
types of retirement plans as the primary retirement plan. 7 In a defined
contribution plan, the key determinants of the benefit amount are the
member’s and employer’s contribution rates, and the rate of return
achieved on the investments in an individual’s account over time.
Alternatively, some states have adopted hybrid approaches that combine
components of both defined benefit and defined contribution plans.

Also unlike in the private sector, many state and local employees are not
covered by Social Security. About 6.4 million, or over one-fourth, of state
and local government employees are not eligible to receive Social
Security benefits based on their government earnings and do not pay
Social Security taxes on earnings from their government occupations. 8 As
a result, employer-provided pension benefits for non-covered employees
are generally higher than for employees covered by Social Security, and
employee and employer contributions are higher as well.




6
 U.S. Department of Labor, Bureau of Labor Statistics, National Compensation Survey:
Employee Benefits in the United States, March 2011 (Washington, D.C.: 2011).
7
 As we have previously reported, all states also offer a voluntary, supplemental defined
contribution option in addition to their primary defined benefit plan. 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).
8
 42 U.S.C. § 410(a)(7). Historically, Social Security did not require coverage of
government employment. In 1950, Congress enacted legislation allowing voluntary
coverage to state and local government employees not covered by public pension plans,
and in 1955, extended voluntary coverage to those already covered by plans as well.
Social Security Act Amendments of 1950, Pub. L. No. 809, § 106, 64 Stat. 477 (1950),
codified at 42 U.S.C. § 218(a) &(d); Social Security Amendments of 1956, Pub. L. No.
880, § 211 (e), 70 Stat. 807 (1956), codified at 42 U.S.C. § 218(d)(6).




Page 5                                               GAO-12-322 State and Local Pensions
The federal government has not imposed the same funding and reporting
requirements on state and local pensions as it has on private sector
pension plans. 9 State and local government pension plans are not
covered by most of the substantive requirements under the Employee
Retirement Income Security Act of 1974 (ERISA)—requirements which
apply to most private employer benefit plans. Nor are they insured by the
Pension Benefit Guaranty Corporation as private plans are. Federal law
generally does not require state and local governments to prefund or
report on the funded status of pension plans. However, in order for
participants to receive preferential tax treatment (that is, for employee
contributions and investment earnings to be tax-deferred), state and local
pensions must comply with certain requirements of the Internal Revenue
Code. 10

State and local governments also follow different standards than the
private sector for accounting and financial reporting. The Governmental
Accounting Standards Board (GASB), an independent organization, has
been recognized by governments, the accounting industry, and the capital
markets as the official source of generally accepted accounting principles
(GAAP) for U.S. state and local governments. GASB’s standards are not
federal laws or regulations and GASB does not have enforcement
authority. However, compliance with its standards is enforced through
laws of some individual states and the audit process, whereby auditors
render opinions on the fair presentation of state and local governments’



9
 To further clarify the difference between government and private sector pension plans,
the Internal Revenue Service issued an advance notice of proposed rulemaking in
November 2011 relating to the definition of the term “governmental plan.” The guidance
under consideration is intended to establish coordinated criteria for determining whether a
plan is a governmental plan and address current uncertainty regarding entities with
organizational, regulatory, and contractual connections with states or political subdivisions
of states. Determination of Governmental Plan Status, 76 Fed. Reg. 69,172 (Nov. 8,
2011), to be codified at 26 C.F.R. § 1.414(d)-1.
10
  Contributions to qualified pension plans that meet certain requirements—whether
defined benefit or defined contribution—are generally not counted as taxable income to
employees when the contributions are made. However, when pension benefits are paid,
amounts not previously taxed are subject to federal and perhaps state tax. This also
applies to the interest income such contributions generate. As an alternative, some state
and local qualified pension plans provide an option for designated Roth contributions to
Roth accounts, and such contributions to Roth accounts are made after taxation. The
interest income earned on such contributions is generally not subject to tax upon
distribution, provided that the requirements and restrictions applicable to such accounts
under the Internal Revenue Code have been satisfied.




Page 6                                                 GAO-12-322 State and Local Pensions
                        financial statements in conformity with GAAP. GASB’s standards require
                        reporting financial information on pensions, such as the annual pension
                        cost, contributions actually made to the plan, and the ratio of assets to
                        liabilities. In addition, actuarial standards of practice are promulgated by
                        the Actuarial Standards Board. These standards are designed to provide
                        practicing actuaries with a basis for assuring that their work will conform
                        to appropriate practices and to assure the public that actuaries are
                        professionally accountable (see app. II for information on recently
                        proposed changes to GASB and Actuarial Standards Board standards).

                        Some municipal bond analysts have reported concerns about state and
                        local governments’ creditworthiness in light of the recent economic
                        downturn and continuing pension obligations. In 2008 and 2010,
                        respectively, the Securities and Exchange Commission took enforcement
                        actions against the city of San Diego and the state of New Jersey for
                        misrepresenting the financial condition of their pension funds in
                        information provided to investors. 11


                        Although pension plans suffered significant investment losses from the
Plans Have Sufficient   recent economic downturn, which was the most serious since the Great
Assets to Pay Near-     Depression, most state and local government plans currently have assets
                        sufficient to cover their benefit commitments for a decade or more.
Term Benefits, but      Nevertheless, most plans have experienced a growing gap between
Growing Budget          actuarial assets and liabilities over the past decade, meaning that higher
Pressures Will          contributions from government sponsors are needed to maintain funds on
                        an actuarially based path toward sustainability. In spite of budget
Challenge Their         pressures through the recession, most plans continued to receive
Sustainability          prerecession contribution levels on an actuarial basis from their sponsors,
                        with most plans contributing their full actuarial level. However, there were
                        some notable exceptions, and these plans continued to receive lower
                        contribution payments. State and local governments experienced
                        declining revenues and growing expenses on other fronts, and growing
                        budget pressures will continue to challenge their ability to provide
                        adequate contributions to help sustain their pension funds.



                        11
                          GAO is conducting work under Section 976 of the Dodd-Frank Wall Street Reform and
                        Consumer Protection Act, enacted in 2010, to study the information that state and local
                        governments provide investors in municipal securities, including the advantages and
                        disadvantages of providing additional financial information. The report is scheduled for
                        issuance in summer 2012.




                        Page 7                                               GAO-12-322 State and Local Pensions
Despite Investment Losses,   The recent economic downturn resulted in state and local pension plans
Most Plans Hold Sufficient   suffering significant investment losses. Positive investment returns are an
Assets to Pay Benefit        important source of funds for pension plans, and have historically
                             generated more than half of state and local pension fund increases.
Obligations for the Near     However, rather than adding to plans’ assets, investments lost more than
Future                       $672 billion during fiscal years 2008 and 2009, based upon Census
                             Bureau figures for the sector (see fig. 2). Since 2009, improvements in
                             investment earnings have helped plans recover some of these losses, as
                             evidenced by more recent Census Bureau data on large plans. 12 More
                             importantly, however, public pension plans have built up assets over
                             many years through prefunding (that is, employer and member
                             contributions) and through the accumulation of associated investment
                             returns. 13




                             12
                               Based on Census quarterly data on 100 large retirement systems, investment returns
                             have been mostly positive since the second quarter of 2009. See Census, Finances of
                             Selected State and Local Government Employee Retirement Systems.
                             13
                               A prefunded plan means a plan has set aside funds for pension obligations made for
                             current employees as opposed to pay-as-you go plan, which does not set aside funds to
                             pay for future obligations to current employees.




                             Page 8                                             GAO-12-322 State and Local Pensions
Figure 2: Investment Returns for State and Local Government Pension Plans, Fiscal
Years 2005–2009




Assessing the financial condition across all plans using actuarially
determined figures (such as a plan’s funded ratio) is challenging, in part,
because of the various methods and assumptions used by these plans
(see app. II). One alternative measure of financial condition across
pension plans, although not optimal when assessing the financial health
of a single plan, is the ratio of fund assets to annual expenditures. 14 Fund
assets represent the dollar amount a plan has built up, while annual
expenditures ultimately determine how quickly assets are spent down. 15
Alternatively, when assessing the financial condition of an individual
defined benefit plan, various approaches are used, and looking at multiple
factors is especially useful in providing a more complete picture of a
plan’s financial condition. In addition to the level of funding (level of plan
assets relative to plan liabilities), assessments of a plan’s financial


14
  Expenditures include both annual benefit payments and any expenses paid out of plan
assets.
15
  However, using nonactuarial figures is a simplification because it does not consider the
unique demographic profile—especially, the relative proportions of retired and active
workers in the plan’s actuarial liability—and related data associated with each plan.




Page 9                                                GAO-12-322 State and Local Pensions
                                         viability by rating agencies and others may take into consideration the
                                         influence of the plan sponsor, the plan’s underlying methods and
                                         assumptions, and efforts to manage risk (see table 2).

Table 2: Understanding the Financial Condition of a Public Defined Benefit Plan

                                    Sample questions
Influence of plan sponsor           •   Has the government sponsor maintained its actuarial required contributions over
                                        time?
                                    •   What is the outlook for the government sponsor’s economy and budget (to afford
                                        future contributions)?
                                    •   Is the plan’s sponsor able to adjust the plan’s design (that is, benefit levels), if
                                        needed?
Underlying plan methods and         •   Are underlying actuarial assumptions reasonable, such as the plan’s discount rate or
assumptions                             assumptions for inflation and salary growth?
                                    •   Do the sponsor’s actuarial methods for determining the rapidity of prefunding
                                        (actuarial cost methods for assigning costs to time periods, amortization periods, and
                                        any asset smoothing methods) produce a responsible path toward funding the
                                        obligation?
                                    •   Who ultimately determines a plan’s methods and assumptions?
                                    •   Are those making these decisions doing so with sound professional judgment?
Managing risk                       •   Is a plan’s investment portfolio properly positioned to balance risk and returns?
                                    •   Has a risk evaluation, management, and reporting framework been identified to help
                                        manage plan risk?
                                    •   Has the risk analysis and asset allocation decision taken into account relevant risk
                                        factors, such as the size of the sponsor’s plans relative to the size of the plan
                                        sponsor’s tax base, budget, or other measure of economic resources?
                                    •   Do the plan’s benefit formulas or governance processes subject the plan sponsor to
                                        the risk of significant increases in benefit promises?
                                         Source: GAO analysis.


                                         As illustrated in figure 3, an analysis of historical Census Bureau data on
                                         state and local government pensions shows that the ratio of fund assets
                                         to annual expenditures fell during the stock market downturn related to
                                         the oil crisis of the early 1970s, but eventually recovered and reached its
                                         peak in 2000, driven by strong investment results throughout the 1990s.
                                         Since that peak, both the market downturn in the early 2000s and
                                         sustained economic weakness beginning in 2008 drove the ratio of
                                         sector-wide assets relative to expenditures lower. Overall, these data
                                         show that the aggregate ratio of fund assets to annual expenditures, as of
                                         2009, is lower, but in line with historical norms dating back to 1957.




                                         Page 10                                               GAO-12-322 State and Local Pensions
Figure 3: Historical Trends in the Financial Condition of State and Local Government Pension Plans—Aggregate Ratio of
Market Assets to Total Expenditures, 1957–2009




                                        At the same time, data on individual plans indicate that this measure can
                                        vary considerably across plans. As illustrated in figure 4, data on large
                                        plans for fiscal year 2009 show that their fund assets relative to annual
                                        expenditures varied widely, with ratios ranging from less than 5 to greater
                                        than 20.

                                        Figure 4: Variability in Large Plans’ Ratios of Assets to Annual Expenditures, Fiscal
                                        Year 2009




                                        Page 11                                           GAO-12-322 State and Local Pensions
                           From the early years of prefunding of pension plans, sector-wide plan
                           contributions outpaced plan expenditures, but by the early 1990s,
                           expenditures began outpacing contributions. 16 This trend was predictable.
                           As public plans matured, they began to have greater proportions of retirees
                           to active workers. As such, payments to retirees increased relative to plan
                           contributions and, as a result, in more recent years, sector-wide
                           expenditures have outpaced contributions. 17 Nevertheless, given the asset
                           levels of most state and local government plans and the pace of
                           expenditures relative to contributions, most plans can be expected to cover
                           their commitments for the near future with their existing assets. 18 For
                           example, even if these plans received no more contributions or investment
                           returns, most large plans would not exhaust their assets for a decade or
                           longer, since they hold assets at least 10 times their annual expenditures.


Plans Face a Growing Gap   While state and local pension plans have sufficient assets to meet their
between Assets and         obligations in the near future, an examination of actuarially determined
Liabilities, Leading to    funded ratios among large plans shows a growing gap between their
Higher Contribution
Requirements               16
                             This trend is consistent with actuarial practices of pension plans that have increasing
                           proportions of retirees (that is, maturing plans).
                           17
                             Whether pension funds grow or diminish depends on whether positive investment
                           returns and contributions stay ahead of pension fund expenditures.
                           18
                             A study by the Center for Retirement Research at Boston College analyzing plan assets
                           relative to benefit payments and projecting these figures forward, assuming investment
                           return rates of 6 and 8 percent respectively, showed that most large plans have enough
                           prefunded resources to cover their benefit payments for at least 30 years, with a few
                           notable exceptions. Plans included in this study were chosen from the largest plans from
                           each state as well as a judgmental sample of locally administered plans. The study was
                           based upon 2009 data that did not reflect investment return gains over 2010 or recent
                           state and local government efforts to increase employee contributions and reduce benefits
                           for new employees, See Alicia H. Munnell, Jean-Pierre Aubry, Josh Hurwitz, and Laura
                           Quinby, Can State and Local Pensions Muddle Through?(March 2011). Also, just prior to
                           the economic crisis, we reported that most state and local government pension plans had
                           enough invested resources to keep up with benefits they were scheduled to pay for
                           several decades. See GAO, State and Local Government Retiree Benefits: Current
                           Funded Status of Pension and Health Benefits, GAO-08-223 (Washington, D.C.: Jan. 29,
                           2008). There have been other studies projecting the longevity of state and local pension
                           plans; notably a study by Joshua Rauh, see Joshua D. Rauh, Are State Public Pensions
                           Sustainable? Why the Federal Government Should Worry About State Pension Liabilities,
                           (May 15, 2010). The study projected some notably early fund exhaustion dates, including
                           some funds running out of money this decade. However, the study was based on the
                           assumption that benefits earned to date would only be financed out of current plan assets
                           and not from any future contributions. The projected exhaustion dates are thus not
                           realistic estimates of when the funds might actually run out of money.




                           Page 12                                               GAO-12-322 State and Local Pensions
assets and liabilities. 19 This ratio is important since, on a plan-by-plan
basis, a plan’s funded ratio shows the plan’s funding progress and is part
of the basis for determining contribution levels necessary for fund
sustainability. 20 As a result of recent market declines and other reasons—
such as sponsors’ failure to keep pace with their actuarially required
contributions and benefit increases during the early 2000s—funded ratios
have trended lower. Data compiled on large plans indicate that the funded
ratios for these plans, in aggregate, have fallen over the past decade from
over 100 percent in fiscal year 2001 to 75.6 percent in fiscal year 2010. 21
(See fig. 5.)




19
   The funded ratio is calculated by dividing plan actuarial assets by plan actuarial
liabilities. See appendix II for additional information on actuarial methods and measures.
20
  Current GASB standards include a measure known as the annual required contribution,
or ARC, which is not necessarily the same amount as the contribution actually made by
the employer to the plan. Conceptually, the ARC is an amount that would cover the
employer’s share of costs attributable to the current year of employee service (the “normal
cost”), plus an amount to eliminate the plan’s unfunded liability over an amortization
period, all determined in accordance with an actuarially sound funding method selected for
the plan (of which there are multiple choices). The accounting cost—that is, the cost for
the year recognized in the employer’s financial statements—is based on this ARC. In this
sense, the accounting is based on the stated funding method selected by the employer.
But the employer may or may not actually contribute the ARC in any given year, so that
the accounting cost may differ from the funding cost. See appendix II for information on
proposed changes to GASB standards.
21
  Analyzing the aggregate level of large plans minimizes the difficulties in making
comparisons across plans with actuarially based data, since these data include the same
group of plans over time. Most plans keep their key actuarial methods fairly steady over
time, with some significant exceptions. For example, any given plan will typically use a
similar cost method, smoothing, and amortization period over time.




Page 13                                               GAO-12-322 State and Local Pensions
                                   Figure 5: Aggregate Funding Ratio: Trend Data for Large State and Local
                                   Government Pension Plans, Fiscal Years 2001–2010




                                   Note: The number of large plans included in the analysis ranged from 119 to 126 plans.

Growing Gap between                Several factors have contributed to the growing gap between plans’
Actuarial Assets and Liabilities   actuarial assets and liabilities. For example, large pension funds generally
                                   assumed investment returns ranging from 6 to 9 percent throughout the
                                   2000s, including assuming returns of approximately 8 percent, on
                                   average, in 2009, despite the declines in the stock market during this
                                   time. 22 Pension portfolios maintain other assets beside equities; however,
                                   gains in these other asset classes did not make up the amounts lost by
                                   negative equity performance over this period. 23 It is important to note that
                                   the period from 2008 to 2009 was an extraordinary low period for returns
                                   on investments in the financial history of the United States.




                                   22
                                     Plans typically perform “experience studies” as one factor to guide them in making
                                   adjustments to their underlying actuarial assumptions such as adjusting expected
                                   employee salary levels or retiree life expectancies.
                                   23
                                    See National Association of State Retirement Administrators, Public Fund Survey
                                   Summary of Findings for FY2009, (November 2010).




                                   Page 14                                                    GAO-12-322 State and Local Pensions
                              Benefit increases were another important reason for the growing gap
                              between assets and liabilities over the past decade. These increases
                              were enacted early in the decade when the funded status of plans was
                              strong. For example, 11 states increased pension benefits in 2001
                              according to reports from the National Conference of State Legislatures. 24
                              Among the sites included in our review, Pennsylvania enacted legislation
                              in 2001 that increased the pension benefit multiplier from 2 to 2.5
                              percent—an increase of 25 percent. 25 This higher benefit formula applied
                              to both new and currently employed pension plan members (covering
                              state employees and local public school employees). This was also the
                              case in California and Colorado where pension benefit increases in the
                              late 1990s and early in the 2000s helped drive liabilities higher.

Actuarially Determined        Lower funded ratios generally mean higher annual contribution rates are
Contribution Rates Trending   necessary to help sustain pension plans. Thus, as funded ratios trended
Higher                        lower over the past decade, sponsor contribution rates trended higher.
                              For example, from 2002 to 2009, the median government sponsor
                              contribution rates among large plans rose as a percentage of payroll,
                              while employee contribution levels remained the same through this same
                              period (see table 3).

                              Table 3: Median Contribution Rates for Large Plans as a Percentage of Payroll

                                                                                                                      2002         2009
                               Plans not participating in Social Security                        Employer            10.3%        12.7%
                                                                                                 Employee                 8            8
                               Plans participating in Social Security                            Employer                 6          9.4
                                                                                                 Employee               5%           5%
                              Source: National Association of State Retirement Administrators.



                              In spite of budget pressures through the 2007-2009 recession, most
                              government sponsors of large plans continued to contribute about the
                              same percentage of their annual required contribution (ARC) levels



                              24
                                See Ronald Snell, NCSL, Pensions and Retirement Plan Enactments in 2001 State
                              Legislatures (2001).
                              25
                                Soon after Pennsylvania increased benefits, the state also changed its actuarial
                              methods to amortize gains more quickly than losses, effectively suppressing the employer
                              contribution rate over the subsequent 10-year period, according to plan officials.




                              Page 15                                                                 GAO-12-322 State and Local Pensions
determined to be needed to help sustain their fund assets. 26 From 2005
until 2009, just under two-thirds of large plan sponsors continued to pay
at least 90 percent of their ARC payments. 27 However, the gap in dollars
between what large plans would have received, in aggregate, if they
received their full ARC payments is significant. For example, in 2009,
large plans sponsors contributed approximately $63.9 billion in aggregate,
$10.7 billion less than if they had made their full ARC payments.

In addition, the distribution of plan sponsor contribution levels in 2010,
illustrated in figure 6, shows that about half the sponsors of large plans
contributed their full 100 percent or more of ARC payments, while others
contributed much less.

Figure 6: Distribution of Percentage of ARC Paid for Large Plans, Fiscal Year 2010




26
  A government sponsor may provide a lower percentage of the ARC from one year to the
next, yet its contribution, in dollars, may be higher than the previous year’s amount. This is
significant from a budgeting perspective because of the year-to-year increase.
27
  This level had fallen since 2001, when 9 of every 10 large plan sponsors were paying at
least 90 percent of their ARCs.




Page 16                                                GAO-12-322 State and Local Pensions
                          Going forward, among the eight selected states and eight selected local
                          jurisdictions we reviewed, several officials told us that they expected
                          significant increases in their employer contribution rates as a percentage
                          of payroll. For instance, officials from the Employees’ Retirement System
                          of Georgia expect their contribution rates to nearly double over the next 5
                          years (from 10.5 to 20 percent of payroll) to help maintain a sustainable
                          path for their defined benefit plans. Officials from the Utah Retirement
                          Systems expect rates to increase from approximately 13 to 20 percent of
                          payroll.


Plans Are Vulnerable to   Fiscal pressures on state and local governments’ budgets add to the
Pressures on State and    challenges faced by plan sponsors and their ability to make adequate
Local Budgets             contributions to their pension plans. The economic downturn and slow
                          recovery led to budget shortfalls in the state and local sectors because of
                          declining tax revenues and increased spending on economic safety net
                          programs such as health care and social services. According to survey
                          data from the National Association of State Budget Officers (NASBO),
                          from fiscal years 2009 through 2011, states reported solving nearly $230
                          billion in gaps between projected spending and revenue levels. 28 Local
                          governments have also struggled with their budgets. For example, the
                          National League of Cities reported that if all city budgets were totaled
                          together, they would likely face a combined estimated shortfall of
                          anywhere from $56 billion to $83 billion from 2010 to 2012. 29

                          As a result, higher pension contributions have been needed at the same
                          time state and local governments have faced added pressures to balance
                          their budgets. Even in normal economic times, state and local
                          governments seek consistency in program spending areas, meaning that
                          large year-to-year increases in pension contribution levels can strain


                          28
                            NASBO, Fiscal Survey of States: Spring 2011 (Washington, D.C.: 2011). In addition,
                          NASBO notes that one of the clearest signs of fiscal stress is the need for states to make
                          midyear budget cuts to help balance their budgets. Survey responses indicate that 43
                          states made such reductions in fiscal year 2009, and 39 states did so in fiscal year 2010.
                          29
                             As an indication of extreme fiscal stress among local governments, a small number have
                          filed for bankruptcy: 4 filed in 2008, 10 in 2009, 6 in 2010, and 4 as of June 2011. Since
                          1937, when the municipal bankruptcy code was instituted, there have been 624 filings as
                          of June 30, 2011, according to an expert’s analysis of municipal bankruptcy filings. See
                          James E. Spiotto, “The Myth and Reality of State and Local Governments Debt Financing
                          in the U.S.A. in Times of Financial Emergency,” (July 25, 2011). Available on the U.S.
                          Securities and Exchange Commission website.




                          Page 17                                               GAO-12-322 State and Local Pensions
                        budgets. Since some of these governments are subject to balanced
                        budget requirements, annual pension contributions, which averaged
                        around 4 percent of state and local budgets in fiscal year 2008, must
                        compete with other pressing needs, even though pension costs are
                        obligations that governments must eventually pay. 30

                        Although tax revenues are slowly recovering to pre-2008 levels, going
                        forward, long-term budget issues will likely continue to stress state and
                        local governments and their ability to fund their pension programs. GAO
                        has reported that state and local governments face fiscal challenges that
                        will grow over time, and with current policies in place, the sector’s fiscal
                        health is projected to decline steadily through 2060. 31 The primary factor
                        driving this decline is the projected growth in health-related costs. For
                        example, GAO simulations show that the sector’s health-related costs will
                        be about 3.7 percent of gross domestic product in 2010, but grow to 8.3
                        percent by 2060. 32 These fiscal pressures, combined with growing
                        pension contribution rates, have spurred many states and localities to
                        take action to reduce pension costs and improve the future sustainability
                        of their plans.


                        States and localities have implemented various changes to their pension
States and Localities   systems since the 2008 economic downturn—changes that, according to
Have Made Changes       officials, were intended to help manage costs and improve plan
to Reduce Costs and
Improve Plan            30
                          Provisions in state constitutions, statutes, or recognized legal protections under common
Sustainability          law often protect pensions from being eliminated or diminished for current or retired
                        members. In a few rare exceptions, some jurisdictions have avoided paying promised
                        benefits. This can happen in cases of government bankruptcy or when legislative changes
                        to reduce benefits are made retroactively and survive any legal challenges.
                        31
                          GAO, State and Local Governments' Fiscal Outlook: April 2011 Update, GAO-11-495SP
                        (Washington, D.C.: Apr. 6, 2011).
                        32
                          To provide more flexibility in addressing the growing cost of government employee’
                        retiree health care, state and local jurisdictions have begun to prefund these costs. With
                        prefunding, governments can reduce the unfunded liability reported in their financial
                        statements, take advantage of the compounding effects of investment returns on plan
                        assets, and provide greater benefit stability for employees and retirees. In addition, by
                        setting aside funds for this purpose in advance, government contributions can be reduced
                        when fiscal pressures are great. However, prefunding retiree health benefits requires
                        higher contributions in the short term than pay-as-you-go financing requires. For further
                        discussion of this topic, see GAO, State and Local Government Retiree Health Benefits:
                        Liabilities Are Largely Unfunded, but Some Governments Are Taking Action, GAO-10-61,
                        (Washington, D.C.: Nov. 30, 2009).




                        Page 18                                              GAO-12-322 State and Local Pensions
                                       sustainability long term (see fig. 7). Based on our tabulation of state
                                       legislative changes reported annually by NCSL, we found that the
                                       majority of states have modified their existing defined benefit systems to
                                       reduce member benefits, lowering future liabilities. Half of states have
                                       increased required member (that is, employee) contributions, shifting
                                       costs to employees. Only a few states have adopted primary plans with
                                       defined contribution components, which reduce plan sponsors’
                                       investment risk by shifting it to employees. Some states and localities
                                       have also taken action to lower pension contributions in the short term by
                                       changing actuarial methods, and a few have issued pension bonds to
                                       finance their contributions or to lower their costs by reducing the gap
                                       between plan assets and liabilities. In general, we found that states and
                                       localities often package several of these different pension changes
                                       together. These packaged changes can have varying effects on employer
                                       contributions, plan sustainability, and employees’ retirement security. 33

Figure 7: Notable Changes to State-Sponsored Pension Plans, January 2008–June 2011




                                       33
                                         See appendix I for a summary of the recent pension changes implemented in the eight
                                       states and eight localities we reviewed.




                                       Page 19                                            GAO-12-322 State and Local Pensions
Majority of States Have   Since the economic downturn in 2008, 35 states have modified at least
Reduced Benefits since    one state-sponsored defined benefit system to reduce member benefits
2008, Reducing Future     and lower future pension liabilities, according to our analysis of NCSL
                          annual reports on recent pension legislation. 34 States and localities have
Liabilities
                          used various strategies to reduce benefits for plan participants, such as
                          adjusting the benefit formula, raising eligibility requirements, and limiting
                          postretirement benefit increases:

                          •    Adjusting pension benefit formula. Since 2008, 24 states have
                               adjusted the defined benefit formulas to reduce benefits by expanding
                               the time period for calculating final average salary or lowering the
                               percentage of final average salary multiplied by years of service for
                               determining benefits. 35 For example, California recently lowered the
                               benefit multiplier for new state safety employees, many of whom are
                               not covered by Social Security, from 2.5 to 2 percent. In addition, two
                               localities we reviewed made similar changes. For example, Denver,
                               Colorado, increased the period used for calculating final average
                               salary from 3 to 5 years for new members of the Denver Employees
                               Retirement Plan.

                          •    Raising eligibility requirements. Since 2008, 29 states have
                               increased retirement age or vesting requirements for plan
                               participants. 36 For example, Missouri raised the normal retirement age
                               for general employees from 62 to 67 and lengthened the vesting
                               period from 5 to 10 years for new members of the State Employees’
                               Retirement System and the Missouri Department of Transportation
                               and Highway Patrol Employees’ Retirement System. In addition, two
                               localities we reviewed made similar changes. For example, the normal
                               retirement age for new members of the Policemen’s Annuity and
                               Benefit Fund of Chicago was raised from 50 to 55 years.

                          •    Limiting postretirement benefits. Since 2008, 18 states have
                               reduced or eliminated annual postretirement cost-of-living
                               adjustments (COLA). Some states have even applied these changes


                          34
                            This analysis is based on our review of annual NCSL reports for the years 2008-2010
                          and a 2011 report that covered changes adopted by June of that year.
                          35
                            Expanding the time period for calculating final average salaries generally reduces
                          pension benefits by averaging in lower employee salaries.
                          36
                            The vesting period is the employees’ required years of service before they earn the right
                          to future pension benefits.




                          Page 20                                               GAO-12-322 State and Local Pensions
     to current retirees. In the case of Colorado, the state recently reduced
     postretirement COLAs for future, current, and retired members.
     According to plan documents, most plan members, who are not
     covered by Social Security, had previously been guaranteed an
     annual postretirement COLA of 3.5 percent, but the recent legislation
     eliminated the COLA for 2010 and capped future COLAs at 2
     percent. 37
The majority of these benefit changes have been limited to new
employees, slowing the future growth of pension liabilities, but usually not
significantly reducing systems’ existing unfunded liabilities, which are
based on the benefits promised to current employees and retirees. 38 As
we have reported previously, provisions in state constitutions, statutes, or
recognized legal protections under common law often protect pensions
from being eliminated or diminished for current or retired members. 39
Thus, some state and local governments change benefits by creating a
new tier or plan that applies to new employees hired only after the date of
the change, and sometimes also to newer employees who are not yet
vested. It takes time for these new employees with less expensive
pension benefits to become a significant portion of the workforce,
delaying for a decade or more any significant reductions in plan
liabilities. 40 Over the long term, however, these benefit reductions can


37
  Prior to the 2010 legislation, the amount of postretirement COLAs depended on when
employees joined the system, according to plan documents. The COLA amount was 3.5
percent for members who joined on or before June 30, 2005, and the lower of 3 percent or
the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) for
members who joined on or after July 1, 2005. The 2010 legislation lowered the COLA for
all future, current, and retired members. For members who joined before January 1, 2007,
the COLA was reduced to 2 percent unless the plan has a negative investment return
year, in which case the COLA will be the lesser of 2 percent or the CPI-W for the next
three years. A separate reserve fund was created for members who joined on or after
January 1, 2007. For these members, the COLA will be the lesser of 2 percent or the CPI-
W as long as payments do not exceed 10 percent of the COLA reserve fund. The
legislation also allows for the maximum COLA to be increased when the plan’s overall
funded status is at or above 103 percent and lowered if it subsequently drops below 90
percent.
38
  As discussed later, Illinois took the more unusual step of taking advance credit for
benefit reductions that apply only to new employees.
39
  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).
40
  Employers with higher rates of employee turnover will recognize savings from pension
benefit reductions sooner than those employers with less employee turnover.




Page 21                                                GAO-12-322 State and Local Pensions
                          reduce pension liabilities and consequently lower actuarially required
                          sponsor contributions. From the employee perspective, these changes
                          can mean that those in the new tier or plan will realize lower future
                          benefits than their coworkers who continue to participate in the old plan.
                          This could affect employee recruitment and retention over the long term,
                          but some pension officials we spoke with expected any short-term
                          impacts to be minimal.

                          Among the pension plans included in our review, we found that six states
                          and two localities had reduced the benefits in some of their largest
                          defined benefit plans. For example, in 2011, Denver, Colorado, reduced
                          retirement benefits for new members of the Denver Employees
                          Retirement Plan hired after July 1, 2011. Denver reversed previous
                          benefit enhancements enacted over prior decades by increasing the
                          period used for calculating final average salary (the basis for benefit
                          calculations) and raising the minimum retirement age from 55 to 60,
                          among other changes. Over the next 30 years, these changes are
                          expected to reduce the city’s pension contributions by 1.65 percent of
                          payroll. According to plan documents, the changes enacted are expected
                          to reduce pension benefits for new employees and will require some
                          members to work longer to receive full pension benefits. Nevertheless,
                          city officials do not expect any of the recent changes to significantly affect
                          employee recruitment and retention.


Half the States Have      Twenty-five states have taken action since 2008 to increase member
Raised Member             contributions, shifting pension costs to employees, according to NCSL
Contributions, Shifting   reports. States generally have more leeway to adjust member contribution
                          rates as compared with pension benefits for existing members. As a
Costs to Plan Members     result, more states have increased contributions for some active
                          employees rather than limiting the increases to future employees. Some
                          states are also requiring members to contribute to their pensions for the
                          first time. Among the states we reviewed, Virginia and Missouri recently
                          required some new plan members to contribute to the retirement plan (5
                          percent in Virginia and 4 percent in Missouri), whereas members did not
                          previously contribute.

                          Increases in member contributions reduce the actuarially required
                          amounts plan sponsors need to contribute to their pension systems. As a
                          result, these changes often do not affect the amount of revenue flowing
                          into pension systems, but rather represent a shifting of pension cost from
                          employers to plan members. Member contributions are a relatively stable
                          source of pension revenue, since they are less susceptible to market


                          Page 22                                       GAO-12-322 State and Local Pensions
                         conditions than investment returns, and less susceptible to budgetary and
                         political pressures than employer contributions. However, member
                         contributions are susceptible to declines in the size of the workforce and
                         are often refunded to employees if they separate from their employer
                         before becoming eligible to receive benefits.

                         Among the jurisdictions included in our review, we found that four states
                         and one locality had increased the member contributions in some of their
                         largest defined benefit plans. For example, in the case of Norfolk,
                         Virginia, the city began requiring new members to contribute 5 percent to
                         the Employees’ Retirement System in 2010, whereas current members
                         do not contribute. As a result of this change, the city’s employer
                         contributions will decline as more contributing members join the system.
                         City officials said that new employees had already contributed over
                         $140,000 to the system in the first year. This increase in member
                         contributions will reduce employee compensation and could affect
                         recruitment and retention, particularly since the change will be
                         immediately reflected in lower paychecks. However, city officials did not
                         expect the changes to have a significant impact on employee recruitment
                         and retention, since the Virginia Retirement System had recently
                         implemented similar changes for state employees.


Three States Recently    Although a majority of states have continued to use traditional defined
Adopted Hybrid           benefit plans as their primary pension system, our analysis of NCSL
Approaches, Reducing     annual reports on recent pension legislation found that, since 2008, three
                         states—Georgia, Michigan, 41 and Utah—have implemented hybrid
Risk for Plan Sponsors   approaches as primary plans for large groups of employees, 42 shifting




                         41
                           Michigan has operated a defined contribution plan for general employees since 1997,
                         but adopted a new hybrid system for public school employees in 2010.
                         42
                           Prior to 2008, three states, Alaska, Indiana, and Oregon, and the District of Columbia
                         had already adopted defined contribution or hybrid approaches as their primary plans for
                         general public employees. Indiana has operated a hybrid system since 1997, but adopted
                         a defined contribution option for new employees in 2011. In addition, Nebraska maintains
                         a cash balance defined benefit plan as its primary plan. Although still providing defined
                         benefit plans as their primary plans for general state employees, some states also offer
                         defined contribution plans or hybrid approaches as optional alternatives to their primary
                         plans. These states include Colorado, Florida, Montana, Ohio, South Carolina, and
                         Washington.




                         Page 23                                              GAO-12-322 State and Local Pensions
some investment risk to new employees. 43 Two of the eight localities we
reviewed have also switched to hybrid approaches since 2008: Cobb
County, Georgia, and Bountiful, Utah (which participates in Utah’s state-
administered retirement system). Unlike in a defined benefit plan, which
provides benefits based on a set formula, 44 in a defined contribution
component of a hybrid approach, the key determinants of the benefit
amount are the employee’s and employer’s contribution rates, and the
rate of return achieved on the amounts contributed to an individual’s
account over time.

Defined contribution and hybrid approaches reduce the impact of market
volatility on plan funding and employer contributions, but are riskier for
plan members. Whereas under a defined benefit system, employer
contributions generally rise and fall depending in part on investment
returns, plan sponsors of a defined contribution system contribute a set
amount regardless of investment returns. This reduces the risk facing the
pension system as well as the state or locality sponsoring the plan.
However, switching to a defined contribution plan can involve additional
short-term costs for plan sponsors, since contributions from new
employees go toward their own private accounts rather than paying off
existing unfunded liabilities of the defined benefit plan once it is closed to
new employees. From the member’s perspective, building up retirement
savings in defined contribution plans rests on factors that are, to some
degree, outside of the control of the individual worker. Most notable
among these is the market return on plan assets, which, among other
factors, determines future retirement benefits. On the one hand, this
exposure to market risk increases members’ financial uncertainty, since
retirement benefits rise and fall based on investment returns. On the other
hand, defined contribution plans are often viewed as more portable than
defined benefit plans, as employees own their accounts individually and
can generally take their balances with them—including both member and



43
  In this report we use the term “hybrid approach” to refer to public pension systems that
combine defined benefit and defined contribution components. In the private sector, a
hybrid plan most often refers to a cash balance plan, which is legally a defined benefit
plan that expresses benefits as a hypothetical individual account balance that is based on
pay credits (percentage of salary or compensation) and interest credits. For additional
information on private sector cash balance plans, see GAO, Private Pensions: Information
on Cash Balance Pension Plans, GAO-06-42 (Washington, D.C.: Nov. 3, 2005).
44
  In a public sector defined benefit plan, the amount of the benefit is determined by a
formula typically based on the retiree’s years of service and final average salary.




Page 24                                               GAO-12-322 State and Local Pensions
employer contributions—when they leave government employment, as
long as they are vested. In contrast, employees in defined benefit plans
can generally take their member contributions, if any, with them if they
leave government employment, but not the employer’s contributions. 45

In the case of Georgia, the state replaced its defined benefit plan with a
hybrid approach for all new employees hired after January 1, 2009. This
new hybrid approach is composed of a smaller defined benefit relative to
the previous plan (1 percent of highest average salary multiplied by years
of service compared with 2 percent previously) and automatic enrollment
in the state’s 401(k) plan with the state matching up to 3 percent of the
employee’s contributions. 46 Plan officials said it is difficult to calculate how
much the state will save as a result of the change, but it is expected to be
financially advantageous for the state in the long run. In 2011, employer
contributions for the defined benefit portion of the hybrid approach were
6.54 percent of payroll, compared with 10.41 percent for employees
covered under the old plan. However, since the changes are limited to
new employees, it will take time for the state to realize significant savings
from the change. According to plan officials, one of the motivating factors
behind the switch to the hybrid approach was the desire to attract new
employees to the state by providing them with more portable retirement
benefits that mirrored those in the private sector. However, as is common
with defined contribution plans in the private sector, some participants in
the hybrid approach may not be saving enough for a secure retirement.
As of December 31, 2011, 80 percent of employees participating in the



45
  Once an employee is vested, both defined contribution and defined benefit plans could
be regarded as “portable.” In the case of a defined benefit plan, the departing employee
takes with him or her the right to a future benefit, wherever he or she goes. However, the
benefit formulas of defined benefit plans are often weighted toward employees that retire
after many years of service with a single employer, so workers changing jobs may incur
future lifetime benefit losses. The perception of defined contribution plans as more
portable reflects the greater liquidity and employee discretion over the management of
these benefits, such as the ability to cash them out upon leaving employment, or to roll
them over into another plan or an individual retirement account. For additional information,
see GAO, Private Pensions: Alternative Approaches Could Address Retirement Risks
Faced by Workers but Pose Trade-offs, GAO-09-642 (Washington D.C.: July 24, 2009).
46
  A 401(k) plan is a type of defined contribution plan that permits employees to defer a
portion of their pay to a qualified tax-deferred plan. State and local government defined
contribution plans are typically 457(b) plans. The Tax Reform Act of 1986 prohibited state
and local governments from establishing any new 401(k) plans after May 6, 1986, but
existing plans were allowed to continue. Pub. L. No. 99-514, § 1116(b)(3), 100 Stat. 2085,
2455.




Page 25                                               GAO-12-322 State and Local Pensions
                              401(k) component of the hybrid approach were contributing only the
                              default 1 percent, according to plan officials. At this level, employees may
                              struggle to build adequate retirement savings. Plan officials said they
                              have tried to encourage members to contribute more to their 401(k) plans,
                              but these efforts have not been successful.


Some States and Localities    To address rising actuarially required pension contribution levels and
Have Adjusted Pension         budget pressures, some states and localities have taken actions to limit
Funding Practices,            employer contributions in the short term or refinance their contributions. 47
                              These strategies included changing actuarial methods or issuing pension
Potentially Increasing
                              bonds to supplement other sources of financing for pension plans. Such
Future Costs                  strategies help plan sponsors manage their contributions in the near term,
                              but may increase their future costs. Fewer nationwide data are available
                              on the use of these strategies; however, we were able to document their
                              use across several of our selected pension plans. 48

Adjusting Actuarial Methods   Some state and local governments have limited or deferred their pension
                              contributions in the short term by making actuarial changes. It is difficult
                              to determine the recent prevalence of these changes nationwide;
                              however, five of the eight states and one of the localities we reviewed had
                              implemented actuarial changes to reduce their pension contributions
                              since 2008. 49 The changes included expanding amortization periods (the
                              number of years allotted to pay off unfunded liabilities) and adjusting
                              smoothing techniques (methods for reducing the effect of market volatility


                              47
                                State and local plan sponsors can also address their pension finance challenges by
                              adjusting their investment policy, particularly plan asset allocation, which is the third key
                              mechanism, besides benefit policy and funding policy, that plan sponsors have in
                              attempting to manage the amount, riskiness, and sustainability of their pension costs. A
                              less risky asset allocation can raise estimated costs but also make them less volatile; a
                              more risky allocation can lower estimated costs but at the price of greater risk. We have
                              previously reported that state and local plans have gradually changed their asset portfolios
                              over many years by increasing their allocations in higher-risk investments partly in pursuit
                              of higher returns. See GAO, State and Local Government Pension Plans: Governance
                              Practices and Long-Term Investment Strategies Have Evolved Gradually as Plans Take
                              On Increased Investment Risk, GAO-10-754, (Washington, D.C.: Aug. 24, 2010).
                              48
                                Since implementation of actuarial changes sometimes does not require a legislative
                              change, use of such strategies is not reflected in the NCSL annual reports of state
                              legislative changes. As a result, our analysis of such changes is based on reviews of our
                              selected states and localities rather than NCSL reports.
                              49
                                In the states we reviewed, actuarial changes were implemented either by state
                              legislation or by the pension plan boards.




                              Page 26                                               GAO-12-322 State and Local Pensions
                         on pension contributions by averaging asset values over multiple years). 50
                         For example, Utah reported that it increased the amortization for the
                         state’s retirement system from 20 years to 25 years to extend the length
                         of time for paying down unfunded pension liabilities. 51 Alternatively, Illinois
                         reported that it recently required all Illinois state retirement systems to
                         switch from a market valuation with no smoothing to a 5-year smoothing
                         method for calculating actuarial assets and employer contributions to
                         lessen the immediate impact of fiscal year 2009 investment losses on
                         contributions.

Capping or Postponing    Some state and local governments, while not formally changing their
Employer Contributions   underlying actuarial methods, have simply deferred or capped their
                         pension contributions. Two states and one locality we reviewed limited
                         contributions in the short term by capping increases in employer
                         contributions or by simply postponing otherwise scheduled contributions.
                         Capping increases in contributions allowed these states and this locality
                         to temporarily suppress the increases that would otherwise have been
                         required given 2008 investment losses and other factors. In the case of
                         the Pennsylvania, the state addressed an expected 19 percent increase
                         in actuarially required contributions to the State Employees’ Retirement
                         System by capping annual increases at 3 percent for 2012, 3.5 percent
                         for 2013, and 4.5 percent thereafter. Similarly, the Illinois Municipal
                         Retirement Fund allowed local plan sponsors to cap contribution
                         increases at 10 percent starting in 2010.

                         Although adjusting plan funding produced some short-term savings for
                         state and local budgets, it also increased the unfunded liabilities of the
                         pension system and will necessitate larger contributions in the future. In
                         the case of Philadelphia, the city used its authority under state law to
                         partially defer pension payments by $150 million in fiscal year 2010 and
                         $90 million in 2011. While these deferrals helped the city reduce its
                         contributions in the short term, state law requires that the money be



                         50
                           Other actuarial changes, such as reducing the assumed rate of investment returns, can
                         increase actuarially required pension contributions.
                         51
                           Utah moved from an open 20-year amortization period (meaning that the amortization
                         was frozen at 20 years) to a closed 25-year amortization period ( meaning that the
                         amortization period will decrease annually by one year). As a result, Utah is currently at a
                         23-year amortization period, and the period will continue to decrease annually unless its
                         board takes action to change the amortization policy.




                         Page 27                                                GAO-12-322 State and Local Pensions
                             repaid with interest by fiscal year 2014. The city has adopted a temporary
                             1 percent increase in the sales tax to help cover these future costs. 52

Issuing Pension Obligation   Issuing pension obligation bonds (POB) is another funding strategy,
Bonds                        although relatively few states and localities have used it, as it can expose
                             plan sponsors to additional market risk. POBs are taxable general
                             obligation bonds that provide a one-time cash infusion into the pension
                             system. They convert a current pension obligation into a long-term, fixed
                             obligation of the government issuing the bond. POBs are issued for
                             generally one of two purposes: either to provide temporary budget relief
                             by financing a plan sponsor’s actuarially required contribution for a single
                             year, or as part of a longer-term strategy for paying off a plan’s unfunded
                             liability. Using POBs to pay off all or a portion of a plan’s unfunded liability
                             potentially reduces future actuarially required pension contributions, but
                             requires plan sponsors to make annual debt service payments on the
                             POBs instead. 53

                             We analyzed data on state and local government bond issuances
                             nationwide and found that other than the states of Illinois and
                             Connecticut, and the Chicago Transit Authority, most state and local
                             governments have not issued sizable POBs over the past 6 years (see
                             fig. 8). This type of pension funding has been limited, with only 25 or
                             fewer POB issuances in each of the last 6 years. The total amount of
                             POBs issued in a single year has not exceeded more than 1 percent of
                             total assets in state and local pension plans.




                             52
                               Philadelphia was not the only locality we reviewed that used a temporary tax increase to
                             cover pension contributions. In 2009, Springfield, Missouri approved a 0.75 cent sales tax,
                             all of which will go toward funding the city’s Police Officers' and Firefighters' Retirement
                             Fund.
                             53
                               Issuing POBs can be a leveraging strategy, since funds are borrowed at a fixed interest
                             rate and then invested in the stock market in an attempt to achieve a higher rate of return
                             (arbitrage).




                             Page 28                                               GAO-12-322 State and Local Pensions
Figure 8: Pension Obligation Bond Issuances Nationwide, January 2006–June 2011




                                       These transactions involve significant risks for government entities
                                       because investment returns on the bond proceeds can be volatile and
                                       lower than the interest rate on the bonds. In these cases, POBs can leave
                                       plan sponsors worse off than they were before, juggling debt service
                                       payments on the POBs in addition to their annual pension contributions.
                                       In a recent brief, the Center for State and Local Government Excellence
                                       reported that by mid-2009, most POBs issued since 1992 were a net
                                       drain on government revenues. 54 In light of these concerns, officials in




                                       54
                                        Center for State and Local Government Excellence, Issue Brief: Pension Obligation
                                       Bonds: Financial Crisis Exposes Risks (Washington, D.C., January 2010).




                                       Page 29                                            GAO-12-322 State and Local Pensions
                              Pennsylvania noted that the state had enacted legislation in 2010
                              prohibiting the use of POBs. 55

                              Two of the pension systems included in our review—Illinois and Sonoma
                              County, California—have issued POBs since 2008. Illinois, which is
                              discussed at length below, has been the largest single issuer in recent
                              years, issuing over $7 billion in POBs since 2010. In the case of Sonoma
                              County, California, the county issued $289 million of POBs in 2010 with
                              maturities ranging up to 19 years. County officials explained that the
                              POBs were financially advantageous because they had an average
                              interest rate of just under 6 percent, which is lower than the 8 percent
                              expected return on the pension fund investments at the time the bonds
                              were issued. The difference between the POB interest rates and the
                              assumed rate of return is projected to save the county $93 million in
                              contributions over the life of the bonds. 56 However, results could vary
                              significantly. The POBs could increase the county’s future expenses if
                              actual investment returns fall below 6 percent. Over the prior 10-year
                              period ending in 2010, the retirement system’s average investment rate of
                              return was 4.1 percent, but returns over the prior 20-year period have
                              been significantly higher at 8.4 percent.


States and Localities Often   States and localities often packaged multiple pension changes together.
Combine Strategies            For example, our analysis of the NCSL reports revealed that 23 states
                              have both increased employee contributions and reduced member
                              benefits. Each change made, and the interplay among the changes,
                              contributes to various impacts on plan sponsors, pension sustainability,
                              and plan members. The following examples demonstrate some of the
                              ways states have packaged these changes, and the varying impacts that
                              are expected as a result.



                              55
                                The provisions of Pennsylvania’s pension reform legislation (Act 2010-120), enacted in
                              November 2010, are summarized in Commonwealth of Pennsylvania State Employees’
                              Retirement System, Comprehensive Annual Financial Report for the year ended
                              December 31, 2010 (Harrisburg, PA: May 2011). The report describes the act’s provisions
                              for reducing benefits for future plan members and for changing funding methods, and
                              notes that the act also prohibits the use of pension obligation bonds for funding liabilities.
                              24 Pa. C.S.A. § 8308 (2010).
                              56
                                The county pension system subsequently lowered its assumed rate of return to 7.75
                              percent. This action, along with any future actuarial changes, would affect the expected
                              savings from the POBs.




                              Page 30                                                GAO-12-322 State and Local Pensions
Reducing Benefits and          Missouri is an example of a state that packaged increases in member
Increasing Contributions for   contributions with reductions in benefits to narrow the gap between plan
New Members                    assets and liabilities. For new general members of the Missouri State
                               Employees Retirement System and the Missouri Department of
                               Transportation and Highway Patrol Employees’ Retirement System, the
                               state increased the normal retirement age from 62 to 67, expanded the
                               vesting period from 5 to 10 years, and required members to contribute 4
                               percent of pay to the pension system, although current members do not
                               contribute. These changes are expected to lower the state’s contributions
                               to the system over the long run by more than 5 percent of payroll, but the
                               initial savings are much smaller. In fiscal year 2012, the benefit and
                               contribution changes are expected to reduce the state’s contribution to its
                               largest plan by less than 1 percent of payroll, since there will be only a
                               small number of newly hired members in the system. However, by fiscal
                               year 2018, employees covered under the reduced benefit structure are
                               expected to account for over half of payroll, further reducing the state’s
                               annual contributions. Plan officials said these changes could pose issues
                               for recruitment and retention, although the influence of retirement plan
                               details will vary based on individual circumstances. They also noted that
                               the changes could affect employee morale, since new employees will
                               have to work longer to qualify for benefits and the required pension
                               contributions will reduce their compensation.

Combining Short-Term Funding   In the case of Pennsylvania, the state passed a package of pension
Adjustments with Longer-Term   changes in 2010 that offset a short-term funding cap with long-term
Benefit Reductions             benefit reductions to limit the impact on the plan’s funded status. For the
                               State Employees’ Retirement System, the most significant funding
                               change was a statutory cap on employer contribution rate increases. The
                               legislation addressed an expected 19 percent increase in actuarially
                               required contributions by capping any increases at 3 percent for fiscal
                               year 2011/2012, 3.5 percent for fiscal year 2012/2013, and 4.5 percent
                               thereafter. In the short term, the caps effectively reduced the state’s
                               expected contributions over the next 4 years by $2.5 billion. But in the
                               long term, the caps, along with other actuarial changes, are expected to
                               increase the state’s pension contributions to the system by $7 billion over
                               the next 32 years. To help offset the additional long-term costs,
                               Pennsylvania enacted pension legislation calling for various benefit
                               reductions for future employees. For example, the state reduced the
                               benefit multiplier for future employees from 2.5 to 2 percent (with an
                               option for members to maintain the 2.5 multiplier by paying a higher
                               member contribution rate); increased the normal retirement age from 60
                               to 65; and expanded the vesting period from 5 to 10 years. These benefit
                               reductions will reduce future liabilities and are expected to lower the


                               Page 31                                     GAO-12-322 State and Local Pensions
                               state’s pension costs by almost $8.5 billion over the next 32 years, for an
                               estimated net savings of $1.5 billion over the cost of the caps and other
                               funding adjustments. Both pension and budget officials said these
                               changes will help the state better manage rising pension contributions in
                               the short term, but the overall savings from the legislative package are
                               relatively modest over the long term. Meanwhile, the changes will require
                               new employees to work longer for lower benefits and will leave more
                               employees with no benefit at all. Plan officials said it is too early to tell if
                               this will affect employee recruitment and retention. 57

Managing Funding through       In the case of Illinois, the state combined use of POBs, actuarial changes,
POBs, Actuarial Changes, and   and benefit reductions to manage the state’s pension costs. The state
Benefit Reductions             issued $3.5 billion of POBs in 2010 and $3.7 billion in 2011 with
                               maturities up to 8 years and used the proceeds to fund the state’s annual
                               contributions to various pension systems. An Illinois budget official
                               explained that issuing the POBs helped the state avoid making additional
                               spending cuts to other portions of the state’s budget. Alternatively, given
                               the state’s budgetary challenges, some pension officials said that if the
                               state had not issued the POBs, it is more likely that it would have not paid
                               its full required pension contributions.

                               Use of POBs will be costly to Illinois, since the state will face annual debt
                               service payments of about $1 billion over the next 9 years. However, the
                               state increased individual and corporate taxes in 2010 and state budget
                               officials told us the state plans to use the additional revenue to fund these
                               debt service payments as well as other budgetary priorities. Whether the
                               state’s statutorily required contributions are funded through POBs or
                               general revenue does not directly affect the financial condition of the
                               pension system. However, some pension officials were concerned that
                               the debt service payments on the POBs would reduce available funding
                               for future pension contributions.

                               Illinois has also lowered employer contributions to the state’s pension
                               systems in the short term by adjusting actuarial methods. In 2009, the
                               state required its pension systems to switch from a market value (no
                               smoothing) to a 5-year smoothing method for calculating actuarial assets


                               57
                                 The expanded vesting requirement, from 5 years to 10, would mean that more
                               employees would leave service with no benefit at all, except for a return of member
                               contributions. In the private sector, 5-year vesting has been the standard for defined
                               benefit plans since 1986.




                               Page 32                                               GAO-12-322 State and Local Pensions
               and employer contributions. Plan officials explained that the change was
               intended to reduce the state’s contributions and dampen the impact of
               fiscal year 2009 market losses for the short term. As a result of the
               change, the state’s actuarially calculated contribution to the State
               Employees’ Retirement System of Illinois was reduced by $100 million in
               the first year, according to plan officials. However, plan actuaries noted
               that this strategy only defers contributions when plan assets experience a
               loss, as they did in fiscal year 2009. Future contributions will be higher
               than they would have been previously once the fiscal year 2009 market
               losses are fully recognized.

               In addition to the use of POBs and actuarial changes, Illinois also reduced
               benefits for new employees and applied the future savings to reduce
               employer contributions in the short term. For example, the state raised
               new employees’ normal retirement age to 67, capped final average
               salaries used for pension purposes, and reduced annual COLAs. 58
               According to plan officials, these changes are expected to reduce the
               State Employees’ Retirement System’s future liabilities by a third. State
               budget officials said the projected total estimated savings for the state
               over the next 35 years will be about $220 billion. Since the changes apply
               only to new employees, the savings will slowly accrue over the next 35
               years. Nevertheless, the state took advanced credit for these future
               benefit reductions, further reducing contributions in the short term.
               According to plan actuaries, by taking this advance credit, the state also
               increased unfunded liabilities in the short term, adversely affecting its
               retirement systems.


               State and local governments continue to experience the lingering effects
Concluding     of investment losses and budget pressures in the wake of the recent
Observations   economic downturn. Although most large state and local government
               pension plans still maintain substantial assets, sufficient to cover their
               pension obligations for a decade or more, heightened concerns over the
               long-term sustainability of the plans has spurred many states and
               localities to implement a variety of reforms, including reductions in
               benefits and increases in member contributions.



               58
                 According to plan officials, capping salaries used for benefit calculations and for
               determining contributions decreases the anticipated amount of future payroll and
               employee contributions, which affects future state contributions.




               Page 33                                                GAO-12-322 State and Local Pensions
                  Despite these efforts, continued vigilance is needed to help ensure that
                  states and localities can continue to meet their pension obligations.
                  Several factors will ultimately affect the sustainability of state and local
                  pension plans over the long term. Important among them are whether
                  government sponsors maintain adequate contributions toward these
                  plans, and whether investment returns meet sponsors’ long-term
                  assumptions. Going forward, growing budget pressures will continue to
                  challenge state and local governments’ abilities to provide adequate
                  contributions to help sustain their pension plans and ensure a secure
                  retirement for current and future employees.


                  We provided officials from the Internal Revenue Service and the Social
Agency Comments   Security Administration with a draft of this report. They provided technical
                  comments that we incorporated, as appropriate. In addition, we provided
                  officials from the states and cities we reviewed with portions of the draft
                  report that addressed aspects of the pension funds in their jurisdictions.
                  We incorporated their technical comments, as appropriate, as well.


                  We are sending copies of this report to relevant congressional
                  committees, the Commissioners of the Internal Revenue Service and the
                  Social Security Administration, and other interested parties. In addition,
                  this report will be available at no charge on GAO’s website at
                  http://www.gao.gov.




                  Page 34                                       GAO-12-322 State and Local Pensions
If you have any questions concerning this report, please contact Barbara
D. Bovbjerg at (202) 512-7215 or Stanley J. Czerwinski at (202) 512-
6806. Contact points for our Office of Congressional Relations and Public
Affairs may be found on the last page of this report. GAO staff who made
major contributions to this report are listed in appendix III.




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




Stanley J. Czerwinski
Director, Strategic Issues




Page 35                                    GAO-12-322 State and Local Pensions
                                                            Appendix I

                                                            Profiles of Selected State and Local
                                                            Government Pensions


Overview of nationwide                                      Methodology
state and local retirement                                  We reviewed a small judgmental sample of plans from eight states, and
systems (FY 2009)                                           one locality within each of these states, that have implemented pension
Number of plans: 3,418                                      modifications since 2008. This judgmental sample was selected to
                                                            provide examples of plans experiencing a range of financial conditions
•     State plans: 222                                      and types of strategies adopted by their sponsors. The profiles on the
•     Local plans: 3,196                                    following pages are based on information from the U.S. Census Bureau,
                                                            Social Security Administration, pension plan documents (including
                                                            Comprehensive Annual Financial Reports (CAFR)), and interviews with
Active members: 14,829,943
                                                            state and local government officials. At each location, we interviewed
•     State plans: 13,112,318                               budget officials and pension plan administrators, and obtained
•     Local plans: 1,717,625                                documents describing recent changes to their plans. The descriptions of
                                                            recent pension reforms included here highlight notable changes given the
                                                            scope of our review; they are not intended to provide a comprehensive
Beneficiaries: 7,990,405                                    list of every change implemented by each state or locality. We did not
•     State plans: 6,751,285                                conduct an independent legal review of any state or local laws in
                                                            compiling this appendix.
•     Local plans: 1,239,120

                                                            State and Local Jurisdictions Selected for Review
Percentage of members covered
by Social Security: 73
                                                               •      California and Sonoma County

Assets (thousands):                                            •      Colorado and the City of Denver
       $2,465,959,589
•     State plans: $2,029,509,728                              •      Georgia and Cobb County
•     Local plans: $436,449,861
                                                               •      Illinois and the City of Chicago

Contributions (thousands)                                      •      Missouri and the City of Springfield
•     Employees: $39,511,586
                                                               •      Pennsylvania and the City of Philadelphia
•     State government: $35,509,035
•     Local government:$50,611,000                             •      Utah and the City of Bountiful

Source: GAO analysis of most recent Census
and Social Security data.
                                                               •      Virginia and the City of Norfolk
Note: Census categorizes plans as state or local based on
their level of administration, not sponsorship.




                                                            Page 36                                 GAO-12-322 State and Local Pensions
                                                            Appendix I

                                                            Profiles of Selected State and Local
                                                            Government Pensions
                                                            California and Sonoma County

Overview of California state                                Selected state-sponsored plans
and local retirement                                                                                                                                        California State
                                                                                                                 California Public Employees’          Teachers’ Retirement
systems (FY 2009)                                            Plan basics                                        Retirement System (CalPERS)                         System
Number of plans: 62                                          As of June 30, 2011
•     State plans: 5                                         Active members                                                                791,219                  429,600
                                                             Beneficiaries                                                                 536,234                  253,041
•     Local plans: 57
                                                             Members covered by Social                                                Varies by plan                     No
                                                             Security?
Active members: 1,767,618                                                                                                             $241,761,791
                                                             Net assets (thousands)                                                                            $155,345,815
•     State plans: 1,396,440                                 Contributions:         Employees                                           $3,600,089               $2,355,909
                                                                                                                                        $7,465,397
•     Local plans: 371,178                                     (thousands)          Employers                                                                   $3,503,615*

                                                            Source: GAO analysis of most recent plan CAFRs.

Beneficiaries: 1,017,122                                    *This also includes government contributions


•     State plans: 779,637                                  Benefit reductions: The state reduced benefits for new members of
•     Local plans: 237,485                                  CalPERS hired on or after January 15, 2011, including
                                                                   • raising the normal retirement age from 55 to 60 for general
                                                                      state employees and from age 50 to 55 for members of the
Percentage of members covered                                         state highway patrol,
by Social Security: 44
                                                                   • reducing the benefit multiplier from 2.5 to 2 percent for state
                                                                      safety employees, and
Assets (thousands): $470,140,330                                   • increasing the period for calculating final average salary from
•     State plans: $340,161,617                                       1 year to 3 years.
•     Local plans: $129,978,713                             Member contributions: In fiscal year 2010-2011, most CalPERS
                                                            member contributions increased by between 2 and 5 percent of
Contributions (thousands)                                   compensation, depending on the type of employee.
•     Employees: $18,217,580                                Funding changes: The CalPERS board temporarily adjusted the
                                                            actuarial smoothing methods for the system’s plans from 2009 to 2011 to
•     State government: $4,426,716                          reduce the effects of investment losses.
•     Local government:$10,785,868                          Selected locally-sponsored plan
                                                                                                                                     Sonoma County Employees’ Retirement
Source: GAO analysis of most recent Census
and Social Security data.
                                                             Plan basics                                                                                    Association
Note: Census categorizes plans as state or local based on    As of December 31, 2010
their level of administration, not sponsorship.
                                                             Active members                                                                                           3,780
                                                             Beneficiaries                                                                                            3,780
                                                             Members covered by Social Security?                                                                        Yes
                                                             Net assets (thousands)                                                                              $1,752,819
                                                             Contributions:            Employees                                                                    $37,322
                                                                    (thousands)         Employers                                                                 $337,761*
                                                            Source: GAO analysis of most recent financial report.
                                                            *This includes $289.3 million in pension obligation bond proceeds.



                                                            Funding changes: The county issued $289 million of pension obligation
                                                            bonds (POB) in September 2010 at an interest rate of 5.51 percent to
                                                            pay down the plan’s unfunded liability.
                                                            Page 37                                                              GAO-12-322 State and Local Pensions
                                                            Appendix I

                                                            Profiles of Selected State and Local
                                                            Government Pensions
                                                            Colorado and the City of Denver

Overview of Colorado state                                  Selected state-sponsored plans
and local retirement                                                                                                    Colorado Public Employees’ Retirement
                                                             Plan basics                                                                         Association
systems (2009)
                                                             As of December 31, 2010
Number of plans: 67
                                                             Active members                                                                          201,095
•     State plans: 2
                                                             Beneficiaries                                                                             94,017
•     Local plans: 65                                        Members covered by Social Security?                                                          No
                                                             Net assets (thousands)                                                               $38,405,701
Active members: 223,636                                      Contributions:        Employees                                                        $668,131
•     State plans: 201,524                                     (thousands)         Employers                                                        $908,330
                                                            Source: GAO analysis of most recent plan CAFRs.
•     Local plans: 22,112
                                                            Benefit reductions: In 2010, the state reduced postretirement cost-of-
Beneficiaries: 103,134                                      living adjustments (COLA) for future, current, and retired members. The
•     State plans: 87,174                                   COLA was set to zero for 2010, and future COLAs were set at 2 percent,
                                                            unless the plan has a negative investment return year, in which case the
•     Local plans: 15,960
                                                            COLA will be the lesser of 2 percent or the Consumer Price Index for
                                                            Urban Wage Earners and Clerical Workers (CPI-W) for the next 3 years.
Percentage of members covered                               Prior to the change, most plan members had been guaranteed an annual
by Social Security: 30                                      postretirement COLA of 3.5 percent.

Assets (thousands): $37,072,374                             Member contributions: For fiscal years 2011 and 2012, the state
                                                            temporarily increased member contributions by 2.5 percent of
•     State plans: $31,969,762                              compensation and reduced employer contributions by the same amount.
•     Local plans: $5,102,612
                                                            Selected locally-sponsored plan
                                                             Plan basics                                                   Denver Employees Retirement Plan
Contributions (thousands)
                                                             As of December 31, 2010
•     Employees: $658,087
                                                             Active members                                                                            8,403
•     State government: $313,999                             Beneficiaries                                                                             7,606

•     Local government: $1,121,023                           Members covered by Social Security?                                                        Yes
                                                             Net assets (thousands)                                                               $1,802,143
Source: GAO analysis of most recent Census
and Social Security data.
                                                             Contributions:            Employees                                                    $23,090
Note: Census categorizes plans as state or local based on          (thousands)         Employers                                                    $45,153
their level of administration, not sponsorship.
                                                            Source: GAO analysis of most recent financial report.



                                                            Benefit reductions: In 2011, the city adopted several benefit reductions
                                                            for new employees hired on or after July 1, 2011, including
                                                                  •      increasing the minimum retirement age from 55 to 60,
                                                                  •      increasing the age and service requirements needed to qualify for
                                                                         an unreduced early retirement, and
                                                                  •      increasing the period used for calculating final average salary
                                                                         from 3 to 5 years.



                                                            Page 38                                                 GAO-12-322 State and Local Pensions
                                                            Appendix I

                                                            Profiles of Selected State and Local
                                                            Government Pensions
                                                            Georgia and Cobb County

Overview of Georgia state                                   Selected state-sponsored plans
and local retirement                                                                                                         Employees’ Retirement System of
                                                             Plan basics                                                                             Georgia
systems (FY 2009)
                                                             As of June 30, 2011
Number of plans: 34
                                                             Active members                                                                           134,487
•     State plans: 9
                                                             Beneficiaries                                                                              55,929
•     Local plans: 25                                        Members covered by Social Security?                                          Most (varies by plan)
                                                             Net assets (thousands)                                                                15,479,714
Active members: 392,668                                      Contributions:        Employees                                                         $121,742
•     State plans: 365,274                                     (thousands)           Employers                                                        297,763
                                                            Source: GAO analysis of most recent plan CAFRs.
•     Local plans: 27,394
                                                            Hybrid approach: In 2008, the state adopted a hybrid approach for new
Beneficiaries: 155,462                                      employees hired after January 1, 2009, that combines defined benefit
•     State plans: 140,046                                  and defined contribution components.
                                                               • Defined benefit portion: The plan has a 10-year vesting period
•     Local plans: 15,416                                          with a benefit formula based on 1 percent of highest average
                                                                   salary multiplied by years of service.
                                                               • Defined contribution portion: Members receive a 1 percent
Percentage of members covered
                                                                   contribution match from state on the first 1 percent they contribute
by Social Security: 74
                                                                   to the 401(k) plan. The state then matches half of each additional
                                                                   percent contributed by members up to a total maximum state
Assets (thousands): $60,462,340                                    match of 3 percent (based on an employee contribution of 5
•     State plans: $54,830,465                                     percent). However, as of December 31, 2011, about 10 percent of
                                                                   new members have opted not to participate in this part of the
•     Local plans: $5,631,875                                      plan.
                                                            Selected locally-sponsored plan
Contributions (thousands)                                                                                           Cobb County Employees’ Retirement System
                                                             Plan basics                                                                         Pension Plan
•     Employees: $680,508
                                                             As of September 30, 2010
•     State government: $1,061,525
                                                             Active members                                                                              4,242*
•     Local government: $579,042                             Beneficiaries                                                                               1,490*
                                                             Members covered by Social Security?                                                            Yes
Source: GAO analysis of most recent Census
and Social Security data.                                    Net assets (thousands)                                                                     356,696
Note: Census categorizes plans as state or local based on
their level of administration, not sponsorship.              Contributions:            Employees                                                        $10,896
                                                                   (thousands)         Employers                                                        $27,068
                                                            Source: GAO analysis of most recent financial report.
                                                            *As of January 1, 2010

                                                            Hybrid approach: In 2009, the county adopted a hybrid approach for
                                                            new employees hired on or after January 1, 2010, and for nonvested
                                                            employees who elect to join the plan. Similar to the state’s new hybrid
                                                            plan, the defined benefit portion of the plan has a 10-year vesting period
                                                            with a benefit formula based on 1 percent of highest average salary
                                                            multiplied by years of service. The defined contribution component of the
                                                            plan is voluntary, but the county matches half of the member’s
                                                            contribution up to 2 percent.


                                                            Page 39                                                 GAO-12-322 State and Local Pensions
                                                            Appendix I

                                                            Profiles of Selected State and Local
                                                            Government Pensions
                                                            Illinois and the City of Chicago

Overview of Illinois state                                  Selected state-sponsored plans
and local retirement                                                                                                                                Teachers’ Retirement
                                                                                                                    State Employees’ Retirement     System of the State of
systems (FY 2009)                                                                                                              System of Illinois                  Illinois
Number of plans: 457                                         Plan basics                                                      As of June 30, 2010      As of June 30, 2011

•     State plans: 6                                         Active members                                                               64,143                   166,013
                                                             Beneficiaries                                                                58,392                   101,288
•     Local plans: 451
                                                             Members covered by Social Security?                                             Yes                        No
                                                             Net assets (thousands)                                                   $9,201,831              $37,471,267
Active members: 633,233
                                                             Contributions:        Employees                                            $246,173                 $909,577
•     State plans: 491,283                                     (thousands)          Employers                                        $1,095,546*               $2,326,029*
•     Local plans: 141,950                                  Source: GAO analysis of most recent plan CAFRs.
                                                            *Includes state appropriations

Beneficiaries: 404,194                                      Benefit reductions: In 2010, the state adopted several benefit changes
                                                            for new members of state plans effective January 1, 2011, including
•     State plans: 292,907
                                                                   • raising the normal retirement age from 62 to 67,
•     Local plans: 111,287
                                                                   • reducing COLAs to the lesser of 3 percent or half of the annual
                                                                      change in the CPI and made them noncompounding, and
Percentage of members covered
by Social Security: 55                                             • capping salaries used for benefit calculations and for determining
                                                                     contributions at $106,800 (indexed to the lesser of 3 percent or
Assets (thousands): $100,765,313
                                                                     half of the annual change in the CPI).

•     State plans: $67,472,265
                                                            Funding changes: The state issued $3.5 billion of POBs in 2010 and
                                                            $3.7 billion in 2011 to fund the state’s annual contributions to various
•     Local plans: $33,293,048                              pension systems. Previously, in 2009, the state required its pension
                                                            systems to switch from a market value (no smoothing) to a 5-year
Contributions (thousands)                                   smoothing method for calculating actuarial assets and contributions.
•     Employees: $2,497,390                                 Selected locally-sponsored plan
                                                                                                                                   Policemen’s Annuity and Benefit Fund
•     State government: $2,765,993                           Plan basics                                                                                    of Chicago
•     Local government: $3,150,048                           As of December 31, 2010
                                                             Active members                                                                                       12,737
Source: GAO analysis of most recent Census
and Social Security data.                                    Beneficiaries                                                                                        12,380
Note: Census categorizes plans as state or local based on
their level of administration, not sponsorship.
                                                             Members covered by Social Security?                                                                      No
                                                             Net assets (thousands)                                                                           $3,439,669
                                                             Contributions:            Employees                                                                $108,402
                                                                   (thousands)         Employers                                                                $183,835
                                                            Source: GAO analysis of most recent financial report.



                                                            Benefit reductions: In 2010, the state also adopted similar benefit
                                                            changes for local government employees, including the members of this
                                                            local policemen’s pension plan—except the normal retirement age for
                                                            policemen was raised from 50 to 55.
                                                            Funding changes: The state enacted legislation in 2010 requiring the
                                                            plan to move to an actuarially based funding method in 2015.

                                                            Page 40                                                        GAO-12-322 State and Local Pensions
                                                            Appendix I

                                                            Profiles of Selected State and Local
                                                            Government Pensions
                                                            Missouri and the City of Springfield

Overview of Missouri state                                  Selected state-sponsored plans
and local retirement                                                                                                                          Missouri Department of
                                                                                                                         Missouri State   Transportation and Highway
systems (2009)                                                                                                             Employees’              Patrol Employees’
Number of plans: 66                                          Plan basics                                            Retirement System             Retirement System
                                                             As of June 30, 2011
•     State plans: 10
                                                             Active members                                                     51,660                           8,160
•     Local plans: 56
                                                             Beneficiaries                                                      35,315                           7,792
                                                             Members covered by Social Security?                                   Yes                             Yes
Active members: 265,049
                                                             Net assets (thousands)                                         $7,866,917                      $1,555,681
•     State plans: 229,472                                   Contributions:        Employees                                      $660                             $45
•     Local plans: 35,577                                      (thousands)          Employers                                $ 291,121                        $150,022
                                                            Source: GAO analysis of most recent plan CAFRs.

Beneficiaries: 148,249
                                                            Benefit reductions: In 2010, the state adopted several benefit changes
•     State plans: 123,832                                  for new employees of both these plans, effective January 1, 2011,
•     Local plans: 24,417                                   including
                                                                  •      raising the normal retirement age from 62 to 67 for most
Percentage of members covered
                                                                         employees and
by Social Security: 73                                            •      increasing the vesting period from 5 to 10 years.
                                                            Member contributions: The state also adopted changes requiring new
Assets (thousands): $42,604,597
                                                            employees to contribute 4 percent of compensation (current members do
•     State plans: $36,489,230                              not contribute).
•     Local plans: $6,115,367                               Funding changes: The board of the State Employees’ Retirement
                                                            System temporarily adjusted its actuarial smoothing methods from fiscal
Contributions (thousands)                                   year 2009 to 2011 to reduce the effects of market volatility.
•     Employees: $780,248
                                                            Selected locally sponsored plan
•     State government: $486,439                                                                                        City of Springfield, Missouri Police Officers’
                                                             Plan basics                                                         and Fire Fighters’ Retirement Fund
•     Local government: $1,045,550
                                                             As of June 30, 2011
Source: GAO analysis of most recent Census                   Active members                                                                                       394
and Social Security data.
Note: Census categorizes plans as state or local based on
                                                             Beneficiaries                                                                                        497
their level of administration, not sponsorship.
                                                             Members covered by Social Security?                                                                   No
                                                             Net assets (thousands)                                                                         $191,168
                                                             Contributions:            Employees                                                               $2,991
                                                                   (thousands)         Employers                                                               $7,859
                                                            Source: GAO analysis of most recent financial report.



                                                            Funding changes: In 2009, the city approved a 0.75-cent sales tax, all
                                                            of which will go toward funding the city’s Police Officers' and Fire
                                                            Fighters' Retirement Fund System. The city subsequently closed this
                                                            plan to new members on January 31, 2010, so police and firefighters
                                                            hired after this date participate in the statewide Local Government
                                                            Employees Retirement System, which is less expensive for the city.

                                                            Page 41                                                   GAO-12-322 State and Local Pensions
                                                            Appendix I

                                                            Profiles of Selected State and Local
                                                            Government Pensions
                                                            Pennsylvania and the City of Philadelphia

Overview of Pennsylvania                                    Selected state-sponsored plans
state and local retirement                                                                                                                        Pennsylvania Public
                                                                                                                       Pennsylvania State          School Employees’
systems (FY 2009)                                                                                                   Employees’ Retirement          Retirement System
Number of plans: 1,425                                       Plan basics                                                  System (SERS)                     (PSERS)
                                                             As of Dec 31, 2010
•     State plans: 3
                                                             Active members                                                        109,255                      279,152
•     Local plans: 1422
                                                             Beneficiaries                                                         111,713                      194,622
                                                             Members covered by Social Security?                       Most (varies by plan)                        Yes
Active members: 519,496
                                                             Net assets (thousands)                                            $25,886,102                 $51,311,252
•     State plans: 392,889                                   Contributions:        Employees                                      $349,049                  $1,042,707
•     Local plans: 126,607                                     (thousands)         Employers                                      $273,083                    $747,753
                                                            Source: GAO analysis of most recent plan CAFRs.

Beneficiaries: 385,355
•     State plans: 285,831
                                                            Benefit reductions: In 2010, the state adopted several changes for new
                                                            employees of both these plans, effective January 1, 2011 for SERS and
•     Local plans: 99,524                                   July 1, 2011 for PSERS, including
                                                                  •      lowering the benefit multiplier from 2.5 percent to 2 percent (with
                                                                         an option to maintain the 2.5 percent multiplier if the member
Percentage of members covered                                            contributes at a higher rate),
by Social Security: 93
                                                                  •      increasing the vesting period from 5 to 10 years, and
Assets (thousands): $86,418,676                                   •      increasing the normal retirement age for general employees from
                                                                         60 to 65.
•     State plans: $68,671,589                              Funding changes: In 2010, the state also capped increases in employer
•     Local plans: $17,747,087                              contribution rates to both systems at 3 percent for fiscal year 2011/2012,
                                                            3.5 percent for fiscal year 2012/2013, and 4.5 percent thereafter. The
                                                            state also adjusted the actuarial methods for both systems, re-amortizing
Contributions (thousands)                                   State Employees’ Retirement System liabilities over 30 years and re-
•     Employees: $1,560,757                                 amortizing Public School Employees’ Retirement System liabilities over
                                                            24 years using a different actuarial method.
•     State government: $731,634
                                                            Selected locally-sponsored plan
•     Local government: $1,292,358                                                                                                    City of Philadelphia Municipal
                                                             Plan basics                                                                               Pension Plan
Source: GAO analysis of most recent Census                   As of June 30, 2010
and Social Security data.
Note: Census categorizes plans as state or local based on    Active members                                                                                    28,632*
their level of administration, not sponsorship.
                                                             Beneficiaries                                                                                     35,694*

                                                             Members covered by Social Security?                                           Yes (except police and fire)

                                                             Net assets (thousands)                                                                        $3,501,602
                                                             Contributions:            Employees                                                              $51,570
                                                                    (thousands)         Employers                                                            $312,556

                                                            Source: GAO analysis of most recent financial report.
                                                            *As of July 1, 2009

                                                            Funding changes: The city partially deferred its pension payments in
                                                            fiscal year 2010 and 2011 by $150 and $90 million respectively, but must
                                                            pay these amounts in addition to its future annual required amounts by
                                                            2014. The city also re-amortized its liabilities over 30 years.


                                                            Page 42                                                  GAO-12-322 State and Local Pensions
                                                            Appendix I

                                                            Profiles of Selected State and Local
                                                            Government Pensions
                                                            Utah and the City of Bountiful

Overview of Utah state and                                  Selected state-sponsored plans
local retirement systems
                                                                Plan basics                                                         Utah Retirement Systems
(FY 2009)
                                                                As of December 31, 2010
Number of plans: 7
                                                                Active members                                                                         104,467
•     State plans: 6
                                                                Beneficiaries                                                                           46,399
•     Local plans: 1                                            Members covered by Social Security?                                       Most (varies by plan)
                                                                Net assets (thousands)                                                            $19,756,106
Active members: 108,016                                         Contributions:     Employees                                                           $59,652
•     State plans: 106,261                                       (thousands)        Employers                                                        $682,600
                                                            Source: GAO analysis of most recent plan CAFRs.
•     Local plans: 1,755
                                                            Hybrid approach: In 2010, the state adopted a new retirement plan for
                                                            all government employees (except judges) hired on or after July 1, 2011,
Beneficiaries: 42,390                                       providing the option of joining a defined contribution plan or a hybrid
                                                            approach. The employer contribution rate is set at 10 percent of
•     State plans: 42,138                                   compensation for both options (12 percent for public safety employees).
•     Local plans: 252                                      For the defined contribution option, the employer contributes the full 10
                                                            percent to a 401(k), in addition to any voluntary employee contributions.
                                                            For the hybrid approach, members receive a defined benefit based on
                                                            1.5 percent of highest average salary multiplied by years of service. If the
Percentage of members covered                               actuarial calculated contribution rate for the defined benefit component is
by Social Security: 92                                      less than 10 percent, the employer deposits the difference into a 401(k)
                                                            plan. If the actuarial rate exceeds 10 percent, members are required to
Assets (thousands): $17,641,058                             make any additional contributions to the defined benefit component.
•     State plans: $17,568,156                              Funding changes: In 2009, the system’s board expanded the
                                                            amortization period for unfunded liabilities from an open 20 year period to
•     Local plans: $72,902                                  a closed 25 year period and adjusted the actuarial smoothing methods to
                                                            reduce the effects of market volatility.
Contributions (thousands)
                                                            Selected locally-sponsored plan
•     Employees: $36,471
                                                                                                                             Public Safety Retirement System
•     State government: $641,690                                Plan basics                                                                    (Bountiful City)
                                                                As of December 31, 2010
•     Local government: $7,680
                                                                Active members                                                                              36
Source: GAO analysis of most recent Census                      Beneficiaries                                                                    not available
and Social Security data.
Note: Census categorizes plans as state or local based on
                                                                Members covered by Social Security?                                                       Yes
their level of administration, not sponsorship.
                                                                Net assets (thousands)                                                                $14,998
                                                                Contributions:            Employees                                                        $-
                                                                   (thousands)            Employers                                                      $485
                                                            Source: GAO analysis of most recent financial report.
                                                            .

                                                            Hybrid approach: The city contributes to several pension plans that are
                                                            administered by the Utah Retirement Systems, including the Public
                                                            Safety Retirement System. The changes adopted by the state’s system,
                                                            described above, apply to local government employees and employers
                                                            as well. Thus, new city employees hired on or after July 1, 2011, have
                                                            the same option of joining a defined contribution or a hybrid approach
                                                            plan, and the city’s required contributions to these plans are comparable.

                                                            Page 43                                                 GAO-12-322 State and Local Pensions
                                                            Map of Missouri                                                              Map of Missouri
                                                            Profiles of Selected State and Local
                                                            Government Pensions
                                                            Virginia and the City of Norfolk

                                                            Selected state-sponsored plans
                                                             Plan basics                                                          Virginia Retirement System
Overview of Virginia state                                   As of June 30, 2011
and local retirement                                         Active members                                                                           339,740
systems (FY 2009)                                            Beneficiaries                                                                            156,165
Number of plans: 18                                          Members covered by Social Security?                                                          Yes
•     State plans: 1                                         Net assets (thousands)                                                               $53,151,088
                                                             Contributions:        Employees                                                          $27,623
•     Local plans: 17
                                                               (thousands)          Employers                                                     $1,520,403*

Active members: 408,196                                     Source: GAO analysis of most recent plan CAFRs.

                                                            * Includes member contributions paid by employers
•     State plans: 346,929
•     Local plans: 61,267                                   Benefit reductions: In 2010, the state adopted several changes for new
                                                            employees hired on or after July 1, 2010, including
Beneficiaries: 176,737                                            •      increasing the period for calculating final average salary from 3 to
                                                                         5 years,
•     State plans: 141,746
                                                                  •      raising the normal retirement age for general employees from age
•     Local plans: 34,991                                                65 to the normal Social Security retirement age (age 67 for
                                                                         people born since 1960),
Percentage of members covered                                     •      increasing the age and service requirements needed to qualify for
                                                                         an unreduced retirement benefit, and
by Social Security: 94
                                                                  •      raising early retirement eligibility from age 50 to age 60.
Assets (thousands): $50,599,215                             Member contributions: The state also adopted changes requiring new
                                                            state employees hired on or after July 1, 2010 to contribute 5 percent of
•     State plans: $41,975,141                              compensation (current members’ contributions are paid by employers).
•     Local plans: $8,624,074                               In 2011, the state passed additional changes that as of July 1, 2011
                                                            require all state employees to pay the 5 percent member contribution, not
                                                            just new plan members.
Contributions (thousands)
•     Employees: $139,892                                   Selected locally-sponsored plan
                                                                                                                          Employees’ Retirement System of the
•     State government: $574,911                             Plan basics                                                                       City of Norfolk
•     Local government: $1,813,973                           As of June 30                                                                                2010
                                                             Active members                                                                               3,950
Source: GAO analysis of most recent Census
and Social Security data.                                    Beneficiaries                                                                                3,271
                                                             Members covered by Social Security?                                      Yes (except public safety)
Note: Census categorizes plans as state or local based on
their level of administration, not sponsorship.              Net assets (thousands)                                                                   $779,404
                                                             Contributions:            Employees                                                             $-
                                                                    (thousands)         Employers                                                      $35,515
                                                            Source: GAO analysis of most recent financial report.



                                                            Member contributions: In 2010, the city adopted changes requiring new
                                                            city employees hired on or after October 5, 2010, to contribute 5 percent
                                                            of compensation (current members do not contribute).


                                                            Page 44                                                 GAO-12-322 State and Local Pensions
Appendix II: Actuarial Methods and
                    Appendix II: Actuarial Methods and
                    Assumptions for Measuring Funded Status for
                    Public Sector Defined Benefit Plans


Assumptions for Measuring Funded Status
for Public Sector Defined Benefit Plans
                    Assessments of a plan’s funded status are complicated by the fact that
                    there are different ways to measure plan assets and plan liabilities for
                    different purposes, and the methods used can vary from plan to plan. 1
                    Plan assets could be valued at either market value or at a “smoothed”
                    value; smoothed values are often used with the goal of producing a
                    pattern of employer contributions to the plan that does not fluctuate as
                    much as the financial markets. Plan liabilities can be measured under a
                    variety of different “actuarial cost methods.” An actuarial cost method is a
                    means of assigning the costs of projected future benefits to time periods
                    in advance of those payments. It determines what portion of the cost of
                    an active worker’s future benefits is included in the plan’s liability (also
                    sometimes called the actuarial accrued liability or the accrued liability) at
                    any point in time. 2 Plan liabilities also vary with the actuarial assumptions
                    used. 3 One assumption in particular, the discount rate, has been a matter
                    of considerable controversy.


                    Over the past decade, there has been a growing controversy over how
The Discount Rate   the value of a plan’s liabilities should be determined, and in particular,
Controversy         over what discount rate should be used. The discount rate determines


                    1
                      Funded status is a comparison of plan assets to plan liabilities. One measure of funded
                    status is the “funded ratio,” which is calculated by dividing plan assets by plan liabilities.
                    Another measure of funded status is the difference between plan assets and plan
                    liabilities, that is, the dollar amount of surplus or deficit. For example, if assets are greater
                    than liabilities, the funded ratio is greater than 100 percent and the plan has a surplus
                    (overfunding) equal to the excess of assets over liabilities; if liabilities are greater than
                    assets, the funded ratio is less than 100 percent and the plan has a deficit (underfunding,
                    or unfunded liability) equal to the excess of liabilities over assets.
                    2
                      As examples, three such cost methods, as they would apply to common final-average-
                    salary benefit formulas, are 1. “unit credit”—The accrued liability is based on the worker’s
                    service to date and current average salary—2. “projected unit credit”—The accrued
                    liability is based on the worker’s service to date and projected average salary at
                    retirement—3. “entry age normal”—The worker’s service and salary are both projected to
                    retirement to estimate a projected benefit. The cost of this benefit is allocated over the
                    worker’s entire service (both past and projected future) as a level percentage of his or her
                    salary. The accrued liability is the value of these allocated costs accumulated up to the
                    point of the worker’s service to date.
                    3
                     Actuarial assumptions are needed to project the amount, likelihood, and timing of future
                    benefits and to determine their present value, and include both economic and
                    demographic assumptions. Economic assumptions typically include those for inflation,
                    future salary increases, and the discount rate. Demographic assumptions typically include
                    those for the likelihood of termination of employment, age of retirement, form of benefit
                    elected, and longevity.




                    Page 45                                                   GAO-12-322 State and Local Pensions
Appendix II: Actuarial Methods and
Assumptions for Measuring Funded Status for
Public Sector Defined Benefit Plans




some measure of “current value” (or “present value”) for pension benefits
that are not payable until various points in the future. The higher the
assumed discount rate, the lower the present value; conversely, the lower
the assumed discount rate, the higher the present value. Thus, for
example, a pension liability based on a 4 percent discount rate will be
higher than the same liability based on an 8 percent discount rate.
Because pension obligations extend far into the future, the discount rate
is applied over a long period of time. As a result, the effect of the discount
rate on pension liability measures can be substantial.

The discount rate controversy is an argument over two basic approaches
to setting a plan’s discount rate: (1) basing the discount rate on the
expected long-term return on plan assets (which, in recent years, often
would produce discount rates between 7 and 8 percent), or (2) basing the
discount rate on relevant interest rates in the bond market (which, in
recent years, often would produce discount rates around 4 percent). The
controversy is over which of these two approaches is the appropriate one
for measuring the present value of the obligations of public sector pension
plans. 4

(1) Basing the discount rate on the expected long-term return on
plan assets. In this approach, the higher expected market returns on
risky assets such as stocks is incorporated into the discount rate. As
such, the discount rate varies with the characteristics of the plan’s asset
allocation, so that adopting a riskier investment policy can increase the
discount rate and thereby lower liabilities and contributions.

•   Those advocating for this approach argue that this rate provides the
    best estimate of the likely cost to finance the plan’s pension
    obligation. They say that assuming a discount rate lower than a plan’s
    expected rate of return would lead to higher contributions and thus
    overcharge the current generation.

•   Those critical of this approach contend that using the expected rate of
    return takes credit for anticipated returns on risky investments before



4
 For some, the appropriate choice of discount rate will depend on the purpose for which
the resulting liability measure will be used. For example, some would argue that an
expected return on plan assets is the appropriate discount rate for funding purposes, while
a bond-like interest rate is the appropriate discount rate for accounting purposes. Others
might argue for one or the other for both purposes.




Page 46                                              GAO-12-322 State and Local Pensions
                    Appendix II: Actuarial Methods and
                    Assumptions for Measuring Funded Status for
                    Public Sector Defined Benefit Plans




                        such returns actually occur, and passes on the associated risk to
                        future generations. As such, using expected rates of return could
                        understate the cost of pension benefits and potentially lead to
                        excessive benefit promises. In addition, it may create an incentive to
                        adopt riskier investment policies.

                    (2) Basing the discount rate on relevant interest rates in the bond
                    market. In this approach, pension promises are viewed as “bond-like,”
                    and so are valued similarly to how the financial markets value fixed
                    income instruments of similar duration and credit quality.

                    •   Those advocating for this approach contend that the value of a plan’s
                        liability should be based on the characteristics of that liability, and not
                        on the characteristics of any assets put aside to finance the liability.
                        They say that while financial markets are volatile and not necessarily
                        always rational, there is no better, objective way to measure the value
                        of a pension promise than how the market currently values an
                        obligation with similar characteristics

                    •   Those critical of this approach hold that a “market” measure of plan
                        promises is not relevant and thus should not be used in an ongoing
                        pension plan. They contend that this approach would severely
                        overstate pension costs and could lead to distorted funding,
                        investment, and benefits policies.


                    Both the Governmental Accounting Standards Board (GASB) and the
Changes Currently   Actuarial Standards Board (ASB) have issued exposure drafts proposing
Being Proposed      comprehensive revisions to their standards regarding measuring and
                    reporting pension obligations. 5 Under current GASB accounting
                    standards, the discount rate must be the expected return on plan assets.
                    The GASB proposals, if enacted, would set the overall discount rate equal
                    to a composite of (1) the expected return on plan assets to the extent that
                    the plan is funded or projected to be funded, and (2) a high-quality
                    municipal bond rate to the extent that some plan benefits are not
                    expected to be funded in advance. In practice, this blended discount rate
                    is expected to be close to the current basis—that is, the expected return
                    on plan assets—for most plans. The GASB proposals would also require


                    5
                     GASB exposure draft of revisions to Statement 27 issued June 2011; ASB exposure
                    drafts of revisions to ASOP 4 and to ASOP 27 issued January 2012.




                    Page 47                                           GAO-12-322 State and Local Pensions
Appendix II: Actuarial Methods and
Assumptions for Measuring Funded Status for
Public Sector Defined Benefit Plans




the use of a single, uniform actuarial cost method; 6 and they would use
the current market value of plan assets, rather than a smoothed value, in
determining a plan’s deficit or surplus, which would be reported on the
government entity’s balance sheet.

Among other things, the ASB proposals, if enacted, would add additional
disclosure requirements regarding funded status, including a requirement
that whenever a funded status is disclosed using a smoothed value of
assets, the corresponding statistic based on the market value of assets
would also have to be disclosed; they would also require new disclosures
regarding the type of liability measure used and the rationale for and
reasonableness of the underlying actuarial assumptions. In addition, they
would clarify that either approach to the discount rate is acceptable, with
appropriate disclosure.




6
 The uniform actuarial cost method would be the “entry age normal” method, which is the
method already used by most public sector plans. See prior footnote for a further
description of actuarial cost methods.




Page 48                                             GAO-12-322 State and Local Pensions
Appendix III: GAO Contacts and Staff
                  Appendix III: GAO Contacts and Staff
                  Acknowledgments



Acknowledgments

                  Barbara D. Bovbjerg, (202) 512-7215 or bovbjergb@gao.gov, or Stanley
GAO Contact       J. Czerwinski, (202) 512-6806 or czerwinskis@gao.gov.


                   In addition to the contacts named above, Margie K. Shields, Assistant
Staff             Director; Thomas James, Assistant Director; William Colvin, Analyst-in-
Acknowledgments   Charge; Robert Yetvin; and Andrea Yohe made significant contributions
                  to this report. Susan Bernstein; James Bennett; Kathy Leslie; Frank
                  Todisco; Walter Vance; Roger Thomas; and Sheila McCoy also made
                  important contributions.




(131013)
                  Page 49                                    GAO-12-322 State and Local Pensions
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