The sustainability of public sector pension plans is an issue of great fiscal concern for state and local governments in the United States. According to government reports, state public sector pension plans confront a total unfunded liability of $842 billion. Underfunding of this magnitude presents a serious fiscal problem for individual governments and will require a growing amount of budgetary resources to fund benefit promises to retired workers.
As large as this figure is, it understates the true magnitude of plan underfunding. Current government accounting conventions do not recognize the full value of public pension promises. When valuing plans on a fair-market basis—the method that economists recommend and that most countries use—the unfunded liability of US state pensions is actually $4.6 trillion.
Two states, Illinois and New Jersey, stand out as especially weak performers, lacking the assets necessary to fully fund plan liabilities. Absent continued reform, by some estimates both Illinois and New Jersey are on track to run out of assets to pay benefits for current retirees by the end of the decade.
Delaware is on the other end of the plan funding performance spectrum. It is cited as a state that operates a well-funded, well-managed defined benefit retirement system. According to the state’s pension valuation reports, Delaware’s nine plans are, on average, funded at 81.4 percent, with an unfunded liability of $1.03 billion. This estimate is based on the assumption that Delaware’s pension investments, on average, will return 7.5 percent annually.
However, when valuing Delaware’s pension plans on a fair-market basis—that is, as a government-guaranteed benefit based on a 2.03 percent US Treasury bond yield—the average funding ratio for Delaware’s plans drops to 40 percent and the unfunded liability rises to $11 billion. This amount is several times larger than Delaware’s total outstanding general obligation debt, reported at $1.62 billion in FY 2013, and the state’s current budget of $3.58 billion.
Delaware confronts a significant funding gap in its pension system. However, unlike other states, Delaware is also well-placed to reinforce its current defined benefit system and to pursue reforms that ensure the state does not end up with insurmountable obligations.
The good news is that Delaware has a long history of making full annual contributions to its pension system. Unfortunately, since these contributions are calculated based on the expected rate of return on plan assets, the annual payments fall short of the amount needed to truly fully fund the plan. To be fully funded, Delaware must increase its annual contribution to the pension system based on a market valuation of plan liabilities.
This paper analyzes Delaware’s pension system on a fair-market or government- guaranteed basis, with reference to the average US Treasury rate on 10- and 20-year bonds in June 2012. A discussion of the discrepancy between current government accounting conventions and the fair-market value approach and the implications for plan management follows.
This paper also considers how the new guidance from the Government Accounting Standards Board (GASB) for valuing plan liabilities, known as GASB 67, affects the plan’s investment strategy. One outcome of GASB 67 is that public sector pension plans may be encouraged to take on more investment risk in order to realize higher expected asset returns and to give the plan the appearance of full funding.
Since 2002, Delaware’s asset portfolio is increasingly made up of alternative investments such as venture capital funds, hedge funds, and real estate. While investing in alternatives is not necessarily problematic, unless the pension portfolio is balanced to hedge the risk inherent in the liability, this asset strategy may introduce more risk into Delaware’s pension system.
The paper concludes with recommendations for how Delaware can stabilize its current defined benefit plan through accounting reform.