Before the economic downturn started in 2008, pension
plans sponsored by state and local governments had done a
pretty good job of setting aside money to “pre-fund” benefits
that will be owed to current and future retirees. But since
the unprecedented 2008-2009 drop in the stock market,
many pensions have found themselves facing a funding gap.
A funding gap occurs when the benefits owed to current
and future retirees exceeds the amount of money the plan
has socked away to meet these obligations. This fact sheet
provides some basic information about pension funding
gaps, which are also referred to as “unfunded liabilities.”
What are they? How much of a problem are they? What’s
the solution for filling the gap?
A funding gap occurs when there
is a mismatch between a plan’s
obligations and its assets.
A pension plan’s obligations are
the dollar value of the benefits that
have been promised by the plan, and
earned by employees and retirees.
AA pension plan’s assets consist of
financial holdings—cash, stocks,
bonds, and other securities—that
have been accumulated by the plan over the years. Pension
plans are pre-funded, which means that regular contributions
for each worker are made into a retirement fund during the
Pension Funding Gaps
Although it is generally
preferable for a pension
plan to be “fully funded,” it
is not unusual for funding
gaps to emerge, especially
during economic downturns.
Putting the gap in context is
the key…
• A funding gap (or “unfunded
liability”) occurs when the
benefits owed to current
and future retirees exceeds
the amount of money the
plan has socked away to
meet these obligations.
• Funding gaps do need to be
filled—but they can be filled
gradually, over time.
• For most states, filling
funding gaps is manageable.
In fact, in response to the
financial crisis, states have
already made significant
pension reforms, and
forecasts show that in most
cases, these reforms will
fully fill the funding gaps
over time.
• Closing down a pension plan
to newly hired employees
will not eliminate a funding
gap. Rather, it may be even
harder to close the gap,
once a plan is “frozen.”
Understanding Pension Funding Gaps
THE UNITED STATES OF AMERICA
ONE
L1180916G
L1180916G
THE UNITED STATES OF AMERICA
ONE
L1180916G
L1180916G
THE UNITED STATES OF AMERICA
ONE
L1180916G
L1180916G
THE UNITED STATES OF AMERICA
ONE
L1180916G
L1180916G
THE UNITED STATES OF AMERICA
ONE
L1180916G
L1180916G
THE UNITED STATES OF AMERICA
ONE
L1180916G
L1180916G
THE UNITED STATES OF AMERICA
ONE
L1180916G
L1180916G
THE UNITED STATES OF AMERICA
ONE
L1180916G
L1180916G
THE UNITED STATES OF AMERICA
ONE
L1180916G
L1180916G
THE UNITED STATES OF AMERICA
ONE
L1180916G
L1180916G
Funding Ga
p
Obligations Assets
NRTA PENSION
EDUCATION TOOLKIT
Another point to remember is that a funding gap does not need to be closed in a single year, but the
payments can be spread out (or “amortized”) over many years, according to governmental accounting
standards.
2
In this way, many observers liken an unfunded liability to a mortgage, which is paid off over
time.
Sharp, unexpected downturns in financial markets can create funding gaps. That’s because when the
stock market drops, the value of the assets held by the plan drops, as well. The economic downturn
of 2008 and 2009 included unprecedented losses in the stock market. Because public pension funds
are invested in the market, these plans—like all investors—saw substantial losses in their assets.
According to the National Association of State Retirement Administrators, the aggregate funding
levels of the nation’s largest public pension plans fell from 86.7% in 2007 to 73.5% in 2012.
3
Funding gaps can also develop when contributions coming into the plan are insufficient to cover
promised benefits. The amount necessary to be contributed to the pension fund each year is generally
determined through an actuarial analysis. The plan actuary determines the cost associated with new
benefits earned in that year (normal cost) plus any additional amount that might be required to
make up for shortfalls that have developed in the past. This amount is called the “Annual Required
Contribution” or ARC, and this is what the plan sponsor should pay in order to maintain a healthy
plan.
4
It is important that the full amount of the ARC be contributed to the pension trust each year. If not,
the plan can develop a funding gap. And if full payments are missed repeatedly, the gap will only
grow with each passing year. States and localities have generally done a respectable job with pre-
funding.
5
But there have been exceptions, and some governmental employers have failed to contribute
the full amount of their ARC each year. According to the National Association of State Retirement
Where Do Funding Gaps Come From?
$100 Billion Pension Plan
$10 Billion Funding Gap
=
90% Funded
NRTA Pension Educaon Toolkit | Pension Funding Gaps 2
course of that worker’s career. State and local pension plans are usually funded by employer contributions
and contributions from employees themselves. These contributions are invested to generate returns, or
investment earnings. Investment earnings can be continually reinvested into the pension fund, until such
time as the funds are needed to be paid out in the form of pension benefits.
When a pension plan’s obligations exceed its assets, the plan can be
described as having a funding gap or an “unfunded liability.” To illustrate,
imagine a pension plan that will eventually pay out $100 billion in
benefits, but only has $90 billion in assets on hand. The funding gap, or
unfunded liability, is $10 billion ($100 billion - $90 billion). That seems
like a lot of money. But is this pension plan really in trouble?
Sometimes it can be helpful to look at a pension’s funding status in
percentage terms. A plan’s “funding ratio” is calculated by dividing the
plan’s assets by its obligations. In this case, the plan’s $90 billion in assets
is divided by the $100 billion in obligations. This plan can be described
as 90% funded. In effect, for each dollar in future benefits to be paid,
the plan has 90 cents on hand. That sounds a lot more manageable than
a plan with a “$10 billion unfunded liability.” But both descriptions
accurately portray the same plan. Putting some perspective around these
numbers is critical to understanding just how much of a problem a funding gap poses.
Administrators, in 2012, more than six out of ten pension plans received the full ARC or something
close to it—even as employer contribution rates have had to rise in response to the financial crisis.
6
While achieving full funding of a pension plan may be ideal,
a funding gap may not be so problematic, depending on the
characteristics of the plan and plan sponsor (employer). For example,
if the plan is able to continue to pay promised benefits and the
plan sponsor can make its required contributions without causing
fiscal stress, then the funding gap can be closed gradually over time,
by making regular payments to the plan.
7
Actuaries describe this
process as “amortizing the unfunded liability.” This is similar to the
process of paying down a mortgage. As long as payments are being
made in full and on schedule, the plan will be on a course toward full
funding and the existence of a funding gap may not be considered
problematic at all.
It’s important to distinguish between plans whose funding gaps are the result of recent market
conditions and those where there has been a lack of funding discipline. Addressing the funding gap
should be more manageable for those plans where employers were disciplined about funding—the
downturn may be a temporary set-back, and restoring the plan to full funding may require only modest
adjustments to the plan. Plans whose sponsors were undisciplined about funding will have greater
challenges in recovering, and unfortunately, fewer tools at their disposal to address the issue. In fact,
many of these plans were experiencing problems even before the stock market downturn, due to the lack
of proper funding.
In addition, many state and local governments have been evaluating the need for, and even
implementing, adjustments to their pension systems to ensure that they will be on a strong footing for
the long-term. The actions taken by states to date have been quite substantive and varied, including
increased employee contributions and lower benefit levels. Boston College finds that for most states,
the reforms already implemented should fully offset the effects of the economic downturn, ensuring the
plans’ long term sustainability.
8
The only way to eliminate an unfunded liability is to pay it off. While it may be tempting to completely
close down a pension plan to new hires due to its unfunded liabilities, this action does nothing to close
the plan’s funding gap. This is because, whether a pension plan is open or closed, the obligation to
pay for benefits earned in the past will remain. Returning to the mortgage analogy, any balance on the
mortgage does not vanish simply because
you move out of your house—what is owed
remains owed.
Furthermore, “freezing” a pension plan
and moving new hires to a new defined
contribution plan, like a 401(k) or 403(b) plan
can actually increase costs to the state. This is
Closing the Pension Plan to New Hires Won’t Eliminate the Funding Gap
Funding Gaps can be Addressed over time with a Disciplined Approach
Mortgage Paid
Mortgage Unpaid
NRTA Pension Educaon Toolkit | Pension Funding Gaps 3
DC Cost
DB Cost
Cost to Achieve a Target Benet in Retirement
46% Difference
NRTA Pension Educaon Toolkit | Pension Funding Gaps 4
because of the additional administrative costs associated with running a second retirement plan. Second,
traditional, group-based pensions (defined benefit plans) are associated with several economic efficiencies
that defined contribution plans cannot duplicate; forgoing these efficiencies drives up retirement plan
costs. Finally, appropriate funding stewardship may require plan sponsors to pay off the unfunded
liability faster once a plan is closed to new hires.
9
Accelerating pension contributions is generally
unhelpful for states and localities looking for ways to manage through a difficult budgetary environment.
Preventing funding gaps from occurring and closing gaps that do emerge is hard work, and requires
a disciplined approach to pension fund stewardship. The good news for employers, employees, and
taxpayers is that a well-managed group pension plan is the most economical way to achieve retirement
security.
The economic efficiencies embedded in group pension plans are substantial, and stem from the pooled,
professionally managed nature of these plans. A recent analysis of the cost to achieve a target retirement
benefit under a group pension structure, as compared with a defined contribution plan based on
individual accounts, found that a group pension can do the job at almost half the cost of the defined
contribution plan.
10
Time and again, states that have carefully studied the issue have concluded that, even in tough economic
times, continuing to provide retirement benefits via cost-effective group pension plans meets the joint
interests of fiscal responsibility for employers and taxpayers, and retirement security for employees. This
is why the vast majority of states have chosen to stay within the DB structure, even as they implement
pension reforms to ensure their long-term sustainability.
11
1
Naonal Instute on Rerement Security. 2010. Public Pension Resource Guide: Public Pension Basics. Washington, DC:
Naonal Instute on Rerement Security.
2
Governmental Accounng Standards Board. 2012. Summary of Statement No. 67: Financial Reporng for Public Pension Plans.
Norwalk, CT: GASB
3
Brainard, K. 2013. Public Fund Survey Summary of Findings for 2012. Naonal Associaon of State Rerement Administrators.
4
Naonal Instute on Rerement Security. 2010. Public Pension Resource Guide: Public Pension Basics. Washington, DC:
Naonal Instute on Rerement Security.
5
Naonal Instute on Rerement Security. 2010. Public Pension Resource Guide: Public Pension Basics. Washington, DC:
Naonal Instute on Rerement Security.
6
Brainard, K. 2013. Public Fund Survey Summary of Findings for 2012. Naonal Associaon of State Rerement Administrators.
7
Brainard, K. 2009. Public Fund Survey Summary of Findings for 2008. Naonal Associaon of State Rerement Administrators.
8
Munnell, A.H., J.P. Aubrey, A. Belbase, and J. Hurwitz. 2013. State and Local Pension Costs: Pre-Crisis, Post-Crisis, and Post-
Reform. Chestnut Hill, MA: Center for Rerement Research at Boston College.
9
Boivie, I., and Almeida, B. 2008. Look Before You Leap: The Unintended Consequences of Pension Freezes. Washington, DC:
Naonal Instute on Rerement Security.
10
Almeida, B., and Fornia, W. 2008. A Beer Bang for the Buck: The Economic Eciencies of DB Plans. Washington, DC: Naonal
Instute on Rerement Security.
11
Boivie, I., and C. Weller. 2012. The Great Recession: Pressures on Public Pensions, Employment Relaons and Reforms.
Washington, DC: Naonal Instute on Rerement Security.
