Understanding PERA’s Unfunded Liability

Colorado PERA provides lifetime retirement income to the state’s public employees and that poses a unique challenge: Estimating the cost of member benefits for many years into the future and ensuring the plan has enough money to pay them.

In discussions about how PERA is doing in that regard, the term “unfunded liability” often comes up.

It’s a term that isn’t always well understood, but examining a plan’s unfunded liability and the factors behind it can provide members and other stakeholders with a better sense of the plan’s financial footing and its future.

What is unfunded liability?

Unfunded actuarial accrued liability (UAAL)—or simply unfunded liability—is a common term used in funding for public pension plans. It refers to the gap between the amount of money a plan has in its trust funds and the value of current and future benefits members have earned to date.

In other words, UAAL is like a debt owed to members. The liability is the money the plan will eventually have to pay, and the portion that isn’t covered by current plan assets is considered “unfunded.”

Unfunded liability can be a helpful tool for measuring a pension plan’s financial health. While many plans carry some level of unfunded liability, UAAL that continues to grow can be a sign of underlying issues that may jeopardize the financial sustainability of the fund, such as inappropriate actuarial assumptions or insufficient contribution levels.

By the end of 2016, PERA’s unfunded liability had grown large enough that it prompted recommendations from the PERA Board of Trustees and responsive action from the Colorado General Assembly. Senate Bill 200, enacted in 2018, included various reforms designed to pay down PERA’s unfunded liability with the goal to fully fund the Defined Benefit Plan within 30 years, and PERA continues to make progress toward that goal.

The history of PERA’s unfunded liability

At the end of 2000, PERA was over 100% funded. That means the plan’s trust funds—which contain all the money that comes into the plan (including investment earnings) and from which the plan pays benefits—held more than what was needed to pay all earned benefits to date. By the end of 2016, the funded percentage had fallen below 60%, driving the Board’s recommendations and the bipartisan efforts of the General Assembly to pass Senate Bill 200 in 2018. By the end of 2024, PERA had improved its funding level to 69%, while also mitigating risk through the adoption of more appropriate economic and demographic assumptions over this eight-year period.

While various factors have contributed to the increase in PERA’s unfunded liability over the past two and a half decades, three of those factors have had the largest impact:

1. Assumption changes aimed at better reflecting reality: To ensure PERA’s projections are as accurate as possible, the Board regularly reviews and adjusts its actuarial assumptions—which include things like the expected lifespan of the retiree population and expected salary trends in public employment—through a process known as an actuarial experience study. Over the years, adjustments to assumptions resulting from these studies have gone both ways, with some changes reducing liabilities and other changes increasing liabilities. Certain adjustments, such as lowering the portfolio’s assumed rate of return and the adoption of generational mortality, are more impactful than other assumption changes and resulted in a net growth in PERA’s unfunded liability.
2. Plan experience worse than expected: Actuarial assumptions help pension plans like PERA make projections about the cost of benefits decades into the future. When reality differs significantly from expectation—for example, shifts in demographics and salaries for public employees—they affect the projections for how much money PERA will need to have on hand to pay retirement benefits.
3. Investment returns worse than expected: PERA’s investment portfolio has performed well relative to benchmarks over the long term, but investing in the markets exposes the portfolio to risks; like any investor, PERA is not immune to the effects of major market downturns. For example, the dot-com bubble in the early 2000s and the 2008 financial crisis led to unprecedented losses in financial markets. These major events resulted in negative investment returns far beyond general expectations.

When it comes to reducing PERA’s unfunded liability, the largest factor has been changes to plan provisions, such as the reforms included in Senate Bill 1 in 2010 and Senate Bill 200 in 2018. Those reforms include higher contributions from working members and their employers, an annual $225 million direct distribution from the State, lower annual increases for retirees, and increased age and service requirements for a full retirement benefit, all of which have helped put the plan on more solid financial footing.

PERA’s enhanced contribution structure, which better ensures sufficient funding to support current benefit accruals, is a key element to maintaining PERA’s sustainability. Strong investment returns on those contributions also make a difference. When the portfolio achieves a return that’s better than the assumed rate of return, that investment income increases the value of plan assets and reduces the unfunded liability. PERA’s assets have grown faster than liabilities over the past decade, and that trend is expected to continue.

Getting PERA to full funding

Unfunded liabilities don’t accrue overnight, and it can take many years to eliminate that debt. PERA’s goal is to reach full funding by 2048, and as of the date of our most recent Annual Comprehensive Financial Report, we remain on track to meet that goal.

The Automatic Adjustment Provision automatically adjusts, as necessary, member and employer contributions, retiree benefit increases, and the State’s annual $225 million direct distribution to PERA, based on funding progress. This mechanism helps ensure we don’t fall behind on the target of achieving full funding by 2048.

The PERA Board of Trustees also plays an important role. While Trustees can’t control factors such as inflation, public employee salaries, or the number of plan participants, the Board regularly monitors and adjusts the factors in its control, such as actuarial assumptions, the amount of risk in the investment portfolio, and plan costs.

Reducing the unfunded liability is a challenge, but it’s an important one to tackle. Through a combination of sensible policy updates, good plan governance, and fiduciary care, PERA is making progress toward full funding and a more secure future for Colorado’s retired public employees.

FURTHER READING:

• Actuarial Experience Study: Refining the Financial View of the Future
• Asset/Liability Study: A Guide to Building a Strategic Portfolio