Pensions play a critical role in the ability of local governments to attract and retain the workforce needed to meet citizen demands. The costs associated with this employee benefit, however, can be substantial. In fact, a recent National League of Cities (NLC) survey revealed that over the past year the cost of pensions increased in more than 70 percent of cities. It is worth examining the trend over the past three decades to get a sense of how we got here.
Initially, many public sector pensions were established on a “pay-as-you-go” basis. The founding of the Government Accounting Standards Board (GASB) in 1984 led to the adoption of standards that require all cities to review their liabilities from an “actuarial perspective.” This requirement helps leaders think about the future costs of pension benefits as they make compensation decisions today.
In the 1990s, pension fund balances— or assets set aside to meet future benefit expenses—soared as financial markets boomed. Coming out of this boom period in fiscal year 2001, public sector pensions were funded over 100 percent, on average. As a result, many cities increased employee benefits and took contribution holidays.
As the 2001 recession began to take effect and yields on newly issued bonds declined, however, the assumed return on the bond component of plan portfolios began to decrease significantly. In order to address the large investment losses of the early 2000s in a declining interest rate environment, annual contributions were required to meet pension commitments. The actions taken in the 1990s, combined with general downward pressure on local budgets, exacerbated pension funding challenges and increased unfunded liabilities.
Pension funding took an even bigger hit as the Great Recession in 2008 materialized. The recession had an added component, beyond its depth and length, that previous recessions did not: a nearly decade-long period of exceptionally low interest rates. This feature of the recession resulted in lower expected returns and therefore higher pension funding requirements.
In response, many city officials instituted reforms, including lowering their investment-return assumptions and increasing contributions by governments and employees. While public pension funding ratios registered their first post-recession improvements in 2014, cities are still struggling to pay down their unfunded liabilities and alleviate the damage brought on by the Great Recession.
This article is an excerpt from NLC’s 2017 municipal action guide, Making Informed Changes to Public Sector Pension Plans. Download the guide to learn more about pension reforms made by cities and to fill out a city action worksheet to help you make informed decisions about your city’s pension plan.
About the authors: Christiana K. McFarland is NLC’s research director. Follow Christy on Twitter at @ckmcfarland.
Anita Yadavalli is program director for city fiscal policy in NLC’s Center for City Solutions.