Daily Tax Report: State

Recession Rocks State and Local Pensions, ‘Funding Gap’ Possible

June 25, 2020, 3:46 PM

The economic shutdown caused by the coronavirus will result in a steep drop in tax revenue for state and local governments, forcing them to make difficult decisions about how to fund the state pension systems their employees rely on for their retirement.

Pensions are largely funded from three sources: investment returns, employer mandated contributions on behalf of the workers, and employees who give a portion of their salaries. While funds have pared some losses on the investment front thanks to a bounce-back in the stock market, the ongoing recession will create problems for participating employers and the workers themselves.

The problem is so serious that states may suspend their contributions, “which would create a funding gap for state pension plans,” said Richard Johnson, a senior fellow and director of Program on Retirement Policy with the Urban Institute.

Should deficits continue, it would pressure public employers, such as state and local governments, as well as school districts, into more drastic measures for filling the gap in the future.

That could mean decreased funding for other priorities as they divert more of their incomes to pension plans as liabilities increase relative to assets. It could also portend future cuts in benefits to retirees or increases in contribution requirements for employers and workers.

Jonathan Hurtarte/Bloomberg Law

“The lack of revenues coming in from government means that all the cities in the state, everybody is really strapped for how they make their payments,” said James McNamee, president of the Illinois Public Pension Fund Association.

Making matters worse, governments find themselves losing revenue but also paying out more in unemployment benefits to help people who have lost their jobs.

“Coronavirus has hammered the total economy, it is not just the pension system,” former New Jersey Gov. Christine Todd Whitman (R) said. “The (N.J.) governor has to be looking everywhere for money because you do have a constitutional requirement to balance the budget.”

Unhealthy Pensions

There are about 5,400 public pension funds in the country; 297 are administered by the states and the rest are managed at the local level, according to the 2018 Census survey.

Among the least healthy pensions are Illinois, New Jersey, and Kentucky, whose plans are funded at 38%, 36%, and 34% respectively. The dire health status of these funds can be traced back to the governors who prioritized other needs such as health care and infrastructure instead of funding the pensions.

“The issue is lack of contributions by states, and in those states unfortunately the culture isn’t where the plan sponsors take their fiduciary responsibilities seriously,” said Hank Kim, executive director of the National Conference on Public Employee Retirement Systems.

In some cases, governors used the pension fund as a reserve account to address shortfalls in revenues. This was the case in New Jersey in the 1990s under Whitman, Kim said.

“Under the Whitman administration, the state decided to use the pension fund essentially as a piggy bank to fund tax cuts,” Kim said. “Subsequent to Whitman, both Republican and Democratic administrations and legislatures have decided to kick the can down the road, and not try to change the culture.”

Whitman said the tax cuts and pension system are separate issues.

“What we did with the pension system, we didn’t need to balance the budget,” she said. “We didn’t need to pay for tax cuts that way.”

Whitman increased the state’s long term debt by issuing $2.8 billion worth of pension bonds to help fill the deficit. She also reduced the required contribution from participating employers for a few years.

Her actions surrounding the pension system were done “to help the municipalities, and I didn’t see why taxpayers should have to continue paying into something for the future that was already well overfunded,” she added.

Payroll Declining

Kentucky’s problem was that the state overestimated returns from investments and the size of the payroll.

“The reverse was true, and that was that for years payroll was going down by about 2% per year,” said David Eager, executive director of the Kentucky Retirement System. “The expectation that we were going to get more and more money from employers through the payroll was false. We were getting less and less.”

The state reacted by lowering revenue expectations and passing legislation that required full payment by the legislature to the system.

The statute became necessary because prior legislatures gave about 40% instead of fully funding the pension fund in lieu of more immediate needs. In addition, a greater share of contributions from employees will be dedicated to pensions as opposed to other state priorities.

Despite these measures, Kentucky continues to wrestle with the fallout from coronavirus as legislators anticipate significant declines in tax revenue. This forced the state into an annual budget process instead of a biennial one.

City Budgets Stressed

The market declines that happened in first quarter of 2020 have all but guaranteed that, at the least, employer-mandated contributions will increase in the near future.

“It is clear that we will have a negative year,” said Thomas DiNapoli, the New York State comptroller, who estimates the deficit will be no more than 5%. Regardless, market declines will mean “for the next go around of employer contributions, there is a pretty strong sense there will be an increase in the contribution rate,” DiNapoli said. “Hopefully not too high.”

That has the potential to wreak havoc on the budgets of municipalities such as Jamestown, a city with a population of 30,000 located just off the shores of Lake Chautauqua.

Jamestown paid about $56,000 to the state’s employees retirement system in 1999, and since then the recorded payments have whipsawed with spectacular increases sprinkled with modest percentage declines in some years.

Pension payments increased by almost 175% from 1999 to 2000 and again by 183% between 2002 and 2003. By 2005, Jamestown was contributing more than $700,000. Payments peaked in 2013 when the city paid about $1.2 million.

More recently, pension payments have stabilized through a combination of increased investment returns along with reduced benefits to new hires.

However, the coronavirus will place additional pressure on the city to meet the mandatory contribution increases.

Lower Sales Tax Intake

Jamestown officials are projecting a decrease a reduction in sales taxes between 20% and 30% in 2020, resulting in a loss anywhere from $1 million to $1.5 million for the year, according to estimates obtained from the state and Chautauqua County.

That results in a budget deficit between $2 million and $4.7 million.

“The city has been at its constitutional tax limit for the last three years so we have not even been able to raise revenue, so when the pension asks more from us, we can’t even raise the revenue to do that,” Jamestown Mayor Edward Sundquist said.

That will force city officials into tough decisions about sacrifices they will make to meet their share of the pension contribution.

Despite that, DiNapoli defends the mandated increases to employer contributions.

“Look at a state like Illinois, which is an easy one to point to, so much of their financial problems, their inability to borrow at certain times, is tied to the fact they have underfunded pensions,” DiNapoli said. “New York’s credit rating has gone up by the rating agencies in recent years because we have had a stronger economy, improved state budgets. The third part of that three-legged stool has been the fact that we have well-funded pensions in New York.”

Revenue Drop

Illinois has a dramatically underfunded pension system.

“Our revenues have dropped precipitously,” state Sen. Heather Steans (D) said. “It is unclear at this point how the economy is going to come about, what time frame and at what level. There is definitely a lot of unknowns out there.”

The state budget has allocated the full pension payment to the retirement fund, but without assistance from the federal government, the state will have to borrow money to meet its pension obligations as well as fund its other priorities.

Steans said the pension system is a high priority, but added it is too early to determine how the budget will be shaped because of other ballot measures meant to increase taxes to close the potential budget gap.

States and local governments are hoping to secure additional funding from H.R. 6800, the stimulus bill passed by the U.S. House May 15.

The legislation includes almost $900 billion in federal funding for states and cities, along with a second round of stimulus checks and an extension for expanded unemployment insurance. It passed largely along party lines, and thus far the Republican-controlled Senate has balked at the proposal.

The potential funding gaps are not immediate, and pension fund managers and state and city comptrollers have said the required employer contributions are fixed for the current year.

However, problems will begin in the subsequent years when states and municipalities begin to receive their sales tax revenue allocations and realize it is much less than the past, according to state and local officials. At the same time, they may be asked to increase the amount they contribute to the pension system.

“What you are going to see is governors looking at everything,” Whitman said of state actions in response to coronavirus. “It will be a little bit of cutting, a little bit of tax increases, a little bit of downsizing. It is going to be a little bit of all of that because I don’t think there is going to be a pot of gold that anybody can go to.”

To contact the reporter on this story: Ralph Chapoco in Washington at rchapoco@bloombergindustry.com

To contact the editors responsible for this story: John Dunbar at jdunbar@bloomberglaw.com; Cheryl Saenz at csaenz@bloombergtax.com

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