The Revenue Demands of Public Employee Pension Promises

by Robert Novy-Marx, University of Rochester - Simon Graduate School of Business; National Bureau of Economic Research (NBER)

and Joshua D. Rauh, Stanford Graduate School of Business; National Bureau of Economic Research (NBER)

September 16, 2012

Editor’s Note: Table A-1 (pg. A-8) shows that $1436.40 per household per year is currently being paid into Hawaii government employees pensions—third highest in the nation. Table 4 (pg. 48) shows that an additional $1288 per household is needed to fully fund existing Hawaii government employee pensions.

Hawaii is also mentioned on Table 2 (pg. 45) and Table A-4 (pg. A-10) where the authors consider the impact of various pension reform scenarios.

Abstract:
We calculate increases in contributions required to achieve full funding of state and local pension systems in the U.S. over 30 years. Without policy changes, contributions would have to increase by 2.5 times, reaching 14.1% of the total own-revenue generated by state and local governments. This represents a tax increase of $1,385 per household per year, around half of which goes to pay down legacy liabilities while half funds the cost of new promises. We examine sensitivity to asset return assumptions, wage correlations, the treatment of workers not currently in Social Security, and endogenous geographical shifts in the tax base.

The condition of state and local government defined benefit (DB) pension systems in the U.S. has received national attention in debates over government budgets. The academic literature on this issue has primarily focused on three main questions. First, analyses of the strength of the legal claims of public pension beneficiaries have informed studies of the measurement of liabilities under appropriate discount rates (see Gold 2002; Novy-Marx and Rauh 2008, 2009, 2011a, 2011b; Brown and Wilcox 2009). These papers have largely focused on already-accrued liabilities. Second, several papers have considered the optimal level of funding for public employee pension plans (D’Arcy, et al 1999; Bohn 2011) in light of the political economy of public sector debt decisions (Persson and Tabellini 2000; Alesina and Perotti, 1995). Third, an extensive literature has considered the question of optimal asset allocation (Black 1989; Bodie 1990; Lucas and Zeldes 2006, 2009; Pennacchi and Rastad 2011).1

Missing in the literature has been an analysis of the revenue demands of the pension promises to public employees when considering the plans on an ongoing basis. If states and local governments are to pay pensions under current policies, how much more revenue will need to be devoted to these systems, both to pay down legacy liabilities and fully fund service accruals? This paper provides calculations of the increases in contributions that would be required to achieve fully funded pension systems in 30 years, a standard amortization period. These contribution increases are calculated relative to a base of Gross State Product (GSP) growth applied to today’s contributions. Results are presented under a variety of possible assumptions about growth, asset returns, the treatment of future work by current employees, and the sensitivity of state and local growth to policy changes. We loosely call the latter effects “Tiebout effects” after Tiebout (1956).2

These results may be best understood in terms of per-household contribution increases that would have to start immediately and grow along with state economies. The average immediate increase is $1,385 per household per year. In twelve states, the necessary immediate increase is more than $1,500 per household per year, and in five states it is at least $2,000 per household per year. A key feature of this analysis is that it accounts for the cost of new DB (Defined Benefit) accruals, for both current and future workers, not just the cost of unfunded legacy liabilities. Decomposing the results into these two components reveals that 49% of the increased contributions would be required to pay only the present value of new service accruals.

Link: Full Text

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