The Day of Reckoning For State Pension Plans

by Josh Rauh, Northwestern University Kellogg School of Management  link>>>discussion

The pension plans sponsored by states and municipalities will place a substantial burden on state and local public finances in the near future. My recent work has estimated that the present value of already-promised state pension benefits is over $5 trillion when the benefit payments are discounted using Treasury yields, compared to a little over $2 trillion in pension fund assets. Most state constitutions offer special protections to pension benefits that state workers have already earned.

This analysis raises the question of how soon such a situation might lead to an all-out state and municipal fiscal crisis. One important day of reckoning is the day that the state pension funds run out of money. At that point, pension payments to retirees will have to come out of general revenues. This day of reckoning is in fact not as far away as some might imagine. For Illinois, it could be as soon as 2018.

For a paper I presented in January at a conference on America’s looming fiscal crisis, I calculated the year at which each state will run out pension fund money, under a number of stylized assumptions. I assumed, somewhat generously, that going forward states will contribute to their pension funds the present value of any newly accrued benefits. From the model of state pension fund payments I developed with Robert Novy-Marx (University of Chicago), I extracted our estimates of benefit payments that have already been promised to workers as of today. For simplicity, I pooled all the pension funds within each state. Finally, I conducted the analysis under a baseline assumption that states actually will earn 8% on their investments, as well as under alternative scenarios.

As the accompanying table shows, the day of reckoning is in fact not as far away as some might imagine. Under my projections, seven states run out of money before 2020, including Louisiana (2017), Illinois (2018), New Jersey (2018), and Connecticut (2018). Thirty more states are expected to run out of money during the 2020s.

The damage inflicted by this problem depends upon how large the benefits owed to workers actually are relative to the state’s revenues. In Illinois, obligations already promised to workers as of today will result in over $14.5 billion in pension payments in 2019, the year after the funds will run dry. Tax revenues for the state of Illinois were $31.9 billion in 2008, according to a recent U.S. Census Bureau table. Moving to a pay-as-you-go system would therefore be a catastrophic shock to the revenue needs of the state of Illinois, amounting to 46% of 2008 tax revenue. For Louisiana, the corresponding figure is a smaller but still worrisome 28%.

Some states whose funds might not run out of money until the mid 2020s face a very challenging situation when they eventually do. Ohio collected $26.4 billion in tax revenues 2008. If their pension funds run dry in 2023, they will face $19.1 billion of benefit payments owed in 2024 out of general revenues. That’s over 72% of 2008 tax revenues.

What then can states do to stave off this problem? Unfortunately, the only solutions that will work are solutions that are politically not viewed as desirable. Taxes could be raised to increase contributions to pension funds sooner rather than later. Alternatively, spending on some state programs could be cut. A recession is not the best time for either of these measures, but given the lag time with which any programs take effect, now would be a good time to at least implement a program that puts states back on a path to solvency.

As for the benefits themselves, the legal protections mentioned above limit the extent to which they can be cut without complete legal overhauls of state constitutions (see this list by the public pension advocate NCPERS, as well as a nice article by Jeff Brown and David Wilcox). States could test the constitutionality of reducing cost of living adjustments (COLAs) — as Colorado is attempting to do now under substantial resistance — and raising retirement ages for already-accrued pensions. Given that running these programs on an ongoing basis appears fiscally unsustainable, freezing the level of benefits at their current level is also a potentially important option. Employees would then get future retirement benefits in the form of tax-deferred savings vehicles such as the 403(b).

Teachers and public employee unions will doubtless complain that the expectation of accruing a large pension late in life provides a critical incentives for workers to choose and stay within the public sector. Education and public safety are clearly important societal priorities. The problem is that many US states and municipalities have not been paying for the public services they have been consuming, instead preferring to borrow from employees through underfunded pensions.

If we are going to keep providing generous pensions to state workers, taxes will have to rise dramatically in the near future to pay for them. Alternatively, public employee benefits could be limited to the extent possible under the law, and other spending could be cut. The most equitable solution is probably one in which both taxpayers and public employees share in the pain to some extent. One thing is for certain: to continue ignoring the problem until states run bankrupt is not in anyone’s interest.