Many studies have documented the pervasive underfunding of public sector pension plans in the United States in recent years.  The deterioration of the funded status of public pension plans has coincided with severe fiscal crises that state and local governments experienced in the 2000s. This has led to a suspicion that state and local governments have decreased employer pension contributions as a back-door means of running fiscal deficits.  Although state and local governments are generally prohibited from running operational deficits, deliberate underfunding of public employee pension plans might be used as a means of buffering state or local government finances from fiscal or economic shocks.  In this paper, we investigate the extent to which this phenomenon has occurred. 

We estimate both static and dynamic panel data regressions using the Boston College Center for Retirement Research’s Public Plans Database, which provides data for 2001 through 2010. We find that contrary to popular belief, plan sponsors do not reduce their contributions in response to negative fiscal or economic shocks. In contrast, plan sponsors’ contributions to their pension plans increase in response to growth in their unfunded liabilities.   

We document that the public pension underfunding crisis during the 2000s developed largely as a consequence of portfolio returns that fell short of expectations.  Public pension plans’ asset portfolios have a relatively high share of equities and other risky assets, leaving the plans’ funded status vulnerable to asset price fluctuations.  Asset prices indeed dropped substantially during the dot-com bust and the financial crisis.  Although plan sponsors increased their contributions in response to the growth of unfunded liabilities, they did not do so by enough to fully counteract the effect of the sub-par portfolio returns.  This finding holds across the spectrum of plans ranked in terms of funded status in 2010. 

We find that the lowest quartile of plans ranked by their 2010 funded ratio on average experienced lower portfolio returns between 2001 and 2010 than did better funded public pension plans. However, they did not hold a higher share of equities and other risky assets in their portfolios, suggesting that they may suffer from lower-quality investment management.  Sponsors of the lowest-quartile plans on average made larger contributions relative to payroll than did better funded plans, and their contributions also grew faster over the sample period.