The Growing Gap in Pension Funding

Government retirement programs may not be as safe as you think. Here's what you can do to protect your future.

All pension funds have their ups and downs according to the market, but public employee pension funds are dangerously underfunded. (Photo: Getty Images)All pension funds have their ups and downs according to the market, but public employee pension funds are dangerously underfunded. (Photo: Getty Images)

Public pensions across America are largely underfunded. A 2016 study by The Pew Charitable Trusts found that cumulatively, state pension funds across the U.S. faced a $1.4 trillion deficit. That was a $295 billion increase from 2015, and the 15th annual increase in pension debt since 2000. This problem is growing, and it puts the retirement incomes of public servants at risk.

Let's take a look at the problem, explain why it's happening, and discuss what you can do to protect your retirement income.

The Problem

In 2016, total liabilities of state pensions were $4 trillion, while they only had $2.6 trillion in assets to make good on their promises. Five states—Colorado, Connecticut, Illinois, Kentucky, and New Jersey—were less than 50% funded. Kentucky and New Jersey were in the worst situation, with only 31% funding. Only four states: New York, South Dakota, Tennessee, and Wisconsin, were at least 90% funded, with Wisconsin leading the pack at 99% funding.

Why Is This Happening?

There are two main causes for the growing pension funding gap: poor rates of return on investments and state governments failing to set aside enough money to fund the pension as planned.

Poor rates of return have caused the total asset value of public pensions to nosedive. In 2016, the median assumption for annual investment returns was 7.5%, but the median actual return was only about 1%. Even though state pension plans have lowered their assumed rates of return (in 1992 it was over 8% annually), they haven't been able to make up the difference.

Despite large declines in the expected rates of return for bonds over the last 20 years, pension plans' assumed investment rate of return has remained relatively constant. From 1992 to 2012, the median pension fund's assumed rate of return decreased from 8% to 7.75%. Compare that to the yield on 30-year Treasury bonds, which fell from 7.67% to 2.92% over the same period. Public pensions now assume they'll beat the 30-year bond by 4.83%, compared with the expectation 20 years ago of outpacing bonds by only 0.33%.

Historically, because of strict regulations, public pension funds invested primarily in "safe" fixed-income investments, like bonds. In 1952, 96% of public pension assets were invested in fixed income or cash. In the 1980s and 1990s, regulations loosened and allowed more high-risk investments, like stocks. Pension plans began reallocating their portfolios away from fixed income and into stocks.

By 1992, only 47% of pension assets were invested in fixed-income or cash. And by 2012, that proportion fell to 27%. Huge losses during the market downturns of 2000–2002 and 2008 affected public pension funds just like everyone else. These losses were a major contributor to the sharp decline in the funded status of pension plans nationwide.

Now let's look at the second reason, failure to set aside the money needed to fund the pensions.

A growing gap exists between the amount of money required to fund public pensions and the actual amount contributed by government employers in recent years. Even if every state pension plan had met its assumptions in 2016, the total funding gap would still increase because contribution policies don't require sufficient contributions to meet the growing costs (new benefits being paid out and interest on pension debt).

States just haven't set aside enough money. In 2016, only 27 states contributed enough money for their funding gaps to decrease, if their actuarial assumptions were met…and they weren't. Maintaining high expected annual rates of return (above 7%) reduces the annual payments into the plan from government budgets. When investment returns fall short of expectations, the government sponsors must increase contributions to make up for the shortfall. This doesn't usually happen, though, because poor market performance often coincides with broader economic problems, a time when governments can least afford to put more into pension funding.

So why are some states like Wisconsin doing so much better than others? There's no secret sauce. States that make their annual actuarial contributions, manage risk, and avoid unfunded benefit increases have well-funded pension programs. It's about policy choices. Sadly, most states aren't acting fiscally prudent in this area, and as individuals, it's nothing we can directly control.

Saving additional funds, making wise investments, and paying down debt before you leave the job will help you have a happy retirement. (Photo: Getty Images)Saving additional funds, making wise investments, and paying down debt before you leave the job will help you have a happy retirement. (Photo: Getty Images)

What Can You Do?

Since this issue affects your financial future and is no doubt important to you, let's focus on what you can control. Besides choosing to work in a state with well-funded pension plans, you can set yourself up for additional income in retirement.

In coming years, the name of the game in retirement will be multiple streams of income. Your retirement plan should be diverse enough to include not just your public pension, but other sources of regular income as well. Social security will play a part, but again, it's not the only thing to hang your hat on, and just like pensions, it's not what it used to be.

The way it stands, you're going to have to make up the gap. All indications are that public pensions will shift the burden onto employees to contribute more toward their own retirement, in order to make up the difference.

You'd be smart to explore options to save additional money out of your paycheck, pre-tax. Or in some cases, you may choose to save money after-tax in a Roth account, which allows you to earn tax-free gains and take withdrawals in retirement, tax-free.

Does your employer offer a 457 plan? Check with Human Resources or whoever handles employee benefits. Many employers offer a match on your contributions to your 457.

If your employer doesn't offer additional retirement savings plans, you can start either a traditional or a Roth IRA. Or if you have a side business, you may qualify for a Simplified Employee Pension (SEP) IRA. Your financial advisor and your tax professional can help you determine which type of investment account makes the most sense for your situation.

If you don't like market risk and would rather accumulate wealth with "safe" assets, it might make sense to research life insurance and annuities. The rates of return you'll find in those vehicles will beat CDs and bonds, plus they come with contractual guarantees. For more information, see "Life Insurance as a Savings Vehicle" (POLICE, July 2017).

As I mentioned in my article "Stop Living Check-to-Check" (POLICE, June 2017), it might be time to knock out some long-standing debts to recover income. Or if you don't have one already, it might be time to start a business. If you're not the entrepreneurial type, you might explore jobs that you would enjoy in retirement to supplement your income.

This problem of underfunded public pensions has grown dramatically in recent years and bears important implications for the security of public retirement systems. When it comes to your own financial future, don't just watch things play out from the sidelines—get in the game.

Did you get value from this? Do you have questions? You can email me: and I will personally respond. It's my mission to help my law enforcement family master their money and enjoy life more.

A 15-year veteran of law enforcement from the Kansas City area, Adam Doran is now a full-time financial advisor.

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