Public pension funding improvements on display in West Virginia

After decades of underfunding, West Virginia dramatically closed its pension funding gap, according to a recent report from Pew Charitable Trust.

The state, which had the poorest funding ratio in the entire nation in 2000, reduced its debt burden by 90% over the decades, marking one of the most impressive turnarounds amid a national trend of similar improvement.

Pew’s report covered public pension programs across all 50 states from 2007 to 2021. 

It found that U.S. states collectively closed their pension funding gap to approximately $836 billion by 2021, leaving public pension plans 82% funded, the highest ratio since the 2008 recession.

“As recently as 2016, seven states still had gaps between outgoing benefit payments and incoming contributions that were large enough to cause insolvency if investments fell short of expectations and policymakers failed to react quickly,” Pew said. “By 2018, the number of plans at serious risk of insolvency had dropped to two, and in 2021, no state was below that dangerous threshold, a sign of the significant turnarounds.”

West Virginia had the worst-funded pension system in the nation at the turn of the century, said David Draine, principal investigator and methodologist for Pew’s research on public sector retirement systems.

“Many states, including West Virginia, Connecticut and Rhode Island, treated these things as a pay-as-you-go obligation for throughout the 80s and 90s,” he said. “Some of the states started recognizing that was long-term unsustainable and they were missing out on investment returns that were needed to make these benefits plausibly affordable.”

West Virginia put in place new funding policies and directed supplemental funds towards pensions designed to “over time get them back to full funding,” he said.

In 2009, the state passed Senate Bill 4007 which created the West Virginia Municipal Pensions Oversight Board to oversee the state’s 53 municipal police and firefighter retirement systems and work to educate plan trustees, prepare actuarial valuation reports, and review medical examinations of police and firefighters seeking disability pension benefits.

The bill also increased the state’s insurance premium tax by one percent, with the proceeds allocated to additional contributions to various pension funds in the state.

All of those things added up, Draine said, and changes decreased West Virginia’s unfunded liability from $5.2 billion in 2014 to less than $500 million in 2021.

Pew said in its report West Virginia’s situation shows “how consistently achieving positive amortization can actually fix past pension challenges.”

The state’s pension plans were historically underfunded, Pew said. “But thanks to funding policies designed to pay down debt, its funding gap has been steadily shrinking,” they said.

Other states, like Kentucky, Pennsylvania, and New Jersey, were fully funded in 2000 and often had surpluses that were used to pad current budgets. Combined with an inability to manage investment risks, unfunded benefits increased.

While the board reforms and policy changes across the nation helped state governments address pension issues, much of the scale of the change was driven by historic investment returns and improved cash flow.

By 2021, every state had achieved a cash flow ratio above −5%, with negative cash flow matched by $819 billion in investment returns thanks to “once-in-a-generation investment performance” that saw pension plans generate a 27% return, Pew said.

“Most states assume a 7% return from financial markets, which likewise would have more than offset the negative cash flow with $220 billion in expected gains,” they said.

Better cash flow for public pension programs was primarily associated with a significant increase in employer contributions, Pew said, which grew an average of 6.7% annually over the period surveyed.  

Other positive benefit reforms included limits to cost-of-living adjustments in many states that worked to improve cash flow by reducing growth in benefit payments.

Widespread positive amortization also played a key role in national improvement and from fiscal years 2014 through 2018, states missed the net amortization benchmark by an average of $18 billion annually, or 3% of payroll.

By 2019 “states were on the cusp of meeting the benchmark and under the threshold by just $400 million, or less than 0.1% of payroll,” according to Pew.

“This improvement helped stabilize pension debt and set the stage for the fiscal year 2020 when state pension plans received contributions sufficient to pay down $5 billion in pension debt,” Pew said.

Stress testing for pension risk has also become common as “a way of making sure that you’re always measuring and managing risk and making sure that the unexpected isn’t going to arrive in the form of a crisis,” Draine said.

Going forward, three key approaches can be seen in states that have taken steps to turn things around, including the introduction of effective risk management and building a contribution buffer to make up for shortfalls during bad economic times. 

Reducing the level of investment risk involved with pension portfolios was also important to success as projections of economic growth, bond yields, and investment performance indicate that future returns on pension portfolios are likely to be below both historic averages, Pew said.

“States have been adjusting to this new reality, with all 50 states having lowered their return assumptions since 2015,” Pew said. “From 1995 through 2021, state pension plans averaged 8% returns. By 2021, the average state pension plan was assuming that future returns will be about 7%.”

Pew said 25 states now conduct forward-looking assessments of investment risk on pension plans.

A rethinking of what pension benefits are on the employee end was also helpful and, instead of traditional defined benefits to public employees, a number of states have adjusted the shape of their plans.

Some, including South Dakota, Tennessee, and Wisconsin, have successfully instituted a hybrid model that combines a traditional benefit plan with a defined contribution plan similar to a 401K.

Others, like Colorado, Pennsylvania, Kentucky, and Rhode Island have “included variable benefit provisions and hybrid plan designs as part of their comprehensive reforms to manage and mitigate future risk,” Pew said.