February 22, 2022

Unfunded Liabilities: How Three Public Pensions Found Themselves in Crisis

And how they are clawing their way out.

Reported by Anna Gordon

CIO-022222-Unfunded Liabilities_Taylor Dow-web

Art by Taylor Dow

In the past decade and half, public pensions across the country have struggled with large amounts of unfunded liabilities. In some cases, like in Puerto Rico and Detroit, pension debts became so unmanageable that the government supporting the pension went bankrupt. But there’s some good news: the Equable Institute estimates that the average funded ratio for statewide plans was 80.8% in 2021, an increase of 10 percentage points from 70.9% in 2020.

Part of this good news, undoubtedly, is due to 2021’s record stock market returns, spurred from the lows of the pandemic. While those kinds of record return numbers are unlikely to repeat in the years to come, there is still some reason to be optimistic, according to the report.

Meanwhile, 2021’s estimated unfunded liabilities also have significantly surpassed pre-pandemic levels from 2019. Back then, the average state public pension was still only 72.6% funded.

But nevertheless, the question remains. Just how did so many of these public pensions become so underfunded? And what are they doing to fix it? CIO Magazine looked into the history behind the Chicago Teachers’ Pension Fund, the Puerto Rico Employees’ Retirement System, and the Kentucky Public Pensions Authority. Sure enough, some common themes emerged.

Chicago Teachers’ Pension

The $13.1 billion Chicago Teachers’ Pension is among those funds that are struggling. The pension currently has a 47.48% funded ratio based on actuarial value of assets and a 53.24% funded ratio based on market value of assets.

The pension has been around since 1895, making it among the oldest funds in the country that are still around today. For the first 100 years of the pension’s existence, it was funded via a tax levy. In 1995, that changed, and Chicago Teacher’s would come to pay the price for decades to come.

The story begins when Chicago public schools faced a funding crisis in the 1990s. Politicians looked to the pension, then over 90% funded, to help support classroom needs.

“The mid-1990s fundamentally changed the structure of pension funding,” Carlton W. Lenoir Sr., executive director and interim CIO of the Chicago Teachers’ Pension Fund, wrote to CIO in an email. “CPS administrators in need of operating revenue supported legislation, enacted in 1995, which allowed the school district to use money earmarked for pensions (the tax levy) for operating costs.”

Officials called it a “pension holiday.” It diverted approximately $1.5 billion away from the pension and toward operation costs. Primarily, it helped increase teacher salaries. At first, it seemed innocuous enough. In 1999, the pension was still fully funded thanks to healthy investment returns making up for the missing funds.

But by the mid-2000s, the missed payments began to catch up with the fund. In 2003, the pension was 92% funded, then in 2004 it fell to 86%, and by 2006 it was only 78% funded. In less than a decade the fund had gone from fully funded to dealing with a deficit of more than $3 billion.

But what makes Chicago’s story exceptional is not what happened in this first decade of trouble. It’s the fact that even upon seeing these negative results in 2010, legislators decided to renew the “pension holiday” program.

“This crisis is arguably the best example of how Illinois politicians use and abuse pensions, turning what is meant to provide government workers with retirement security into a political slush fund,” states a scathing article from libertarian nonprofit think tank Illinois Policy.

It was after this renewal that Chicago Teacher’s Pension really began to find itself in a hole. By 2013, the fund was only 49.5% funded.

“CTPF lost $3.2 billion in revenue when CPS failed to make actuarially required contributions needed to sustain the fund from 1996 through 2005,” Lenoir wrote.

Lawmakers justified their decisions by saying the funds needed to be diverted to pay for classroom necessities. However, from 1997 to 2014, taxpayer revenues to Chicago Public Schools actually grew at more than 1.5 times the rate of inflation, according to Illinois Policy.

In 2016, legislators finally ended the pension holiday program and re-instituted the tax levy. But by then, the damage could not be undone so quickly. The pension’s funded rate has hovered around the 50% mark ever since.

It was in this context that Lenoir took over as executive director and interim CIO at Chicago Teacher’s Pension this past August. As for the biggest challenges Lenoir sees in overcoming the gap, he says it comes down to managing expectations.

“We have a funding plan, stable revenue sources, and excellent long-term returns, but this is a marathon, not a sprint,” he wrote. “Our funded ratio eroded due to a lack of contributions over two decades and will not be restored overnight.”

Lenoir said the Chicago Teachers’ Pension Fund is on a statutorily mandated plan to help it achieve 90% funding by 2059. According to the plan, the funded rate is anticipated to be below 60% for two decades before finally accelerating. This will be done by required Board of Education contributions steadily increasing after the year 2024. According to the law, these contributions must be sufficient enough to keep the pension on pace for its goal of 90% funding by 2059.

Puerto Rico Employees’ Retirement System

In Puerto Rico’s case, the pension plan’s collapse was much more drastic. A combination of decades of poor fiscal planning and bad luck left the plan at 1% funded with over $55 billion in unfunded liabilities in 2016.

In fact, the pension was so underfunded that it actually became a major contributor to the government’s decision to declare bankruptcy in 2017, according to Andrew Biggs, a senior fellow at American Enterprise Institute. Biggs was appointed to Puerto Rico’s financial control board by President Barack Obama to help oversee budget restructuring in 2016. He says the intense pressure on politicians in Puerto Rico to never make any decisions that were unpopular in the short-term ended up contributing to a culture of fiscal irresponsibility that was pervasive in public finances, especially in the pension system.

“The political incentives were such that politicians would often promise without thinking about paying,” Biggs said.

The big turning point for Puerto Rico’s pension was the Great Recession. The plan was underfunded long before that point, with consistent gaps between actuarially required contributions and actual contributions made.

However, during and after the Great Recession, this gap began to grow even wider. Puerto Rico made the mistake of trying to fix the pension’s crisis by issuing $3 billion in pension obligation bonds. The hope was that the investment returns accrued on the bond money would be greater than the interest that the pension fund would owe to bond holders.

Usually, pension funds make significantly more returns than a bond. However, Puerto Rico was issuing bonds at the beginning of the Great Recession. This move ended being disastrous, as the recession proved to be much longer and more severe than experts predicted, leading to mediocre investment returns.

In the end, Puerto Rico’s pension program collapsed and is in the process of being replaced with a defined contribution plan.

Kentucky Public Pensions Authority

Among pension funds on the US mainland, Kentucky’s public pensions have been declared by some to be the worst-funded programs in the country. The Kentucky Public Pensions Authority oversees five different retirement funds for different types of employees. All have below a 65% funded rate. The Kentucky Employees Retirement System Nonhazardous plan was the worst funded with a 16.8% funded ratio as of June 20.

But back in the year 2000, the state’s public pension plans were fully funded. Kentucky’s descent into poor funding seems to have a similar root cause to the Chicago Teachers’ Pension and Puerto Rico’s pension. Politicians, who were struggling to balance budgets in Kentucky, began shorting the pension to pay for other costs in the early 2000s. From 2003 to 2016, the Kentucky state government diverted $3.8 billion away from the pension system.

Then, of course, things became even worse in 2008 when the Great Recession hit, and investment returns were suddenly significantly less than expected.

These issues continue to plague the pension to this day. Despite a year of record-breaking returns, all five of Kentucky’s pension plans remain significantly underfunded.

But that doesn’t mean all hope is lost. There are currently multiple different efforts in the works to help get the pension fund back on track. A state Senate bill in 2013 introduced a hybrid plan for new public employees, which has elements of both a defined benefit plan and a defined contribution plan. Additionally, the bill also requires the state to pay the full actuarially required contribution to the pension each year.

In 2017, the pension also reduced its investment return assumptions for all five plans. And last year, the legislature closed a loophole that allowed some employers to use outsourced jobs to avoid paying pension benefits.