Public Pension Systems: Avoiding the Hard Choices?

At the Bottom Line we often complain about government officials avoiding hard fiscal choices because of the political difficulty involved. At the state level, one of the biggest hard choices involves the funding of public pensions.

As states struggle to close budget deficits – which often existed before the recession but are far worse now – some governors and state legislatures are suggesting that states not contribute (or under-contribute) to already-underfunded state pension plans. Although such actions may buy fiscal time for the states, they are bad news for the pensions.

Most pension funds already took large hits as the financial crisis reduced the value of equities in those funds. This confluence of events – the decline in funding occurring alongside declining state and local tax revenues and increasing demand for government services – has created a tough situation for many states to fulfill their pension obligations. With budgets so strapped, it is near impossible for states to imagine making up for market losses in their funds, which would likely have to come from tax revenues.

General practice for public sector pensions has been that they should maintain a level of assets equal to 80% of their liabilities. According to a recent study by the Center for State and Local Government Excellence and the Center for Retirement Research, prior to the financial collapse in 2008, only 54% of state and local complied with this practice. By last year, that number had dropped to 33%. And funding levels are expected to decline further for many of these funds, as losses from 2008 continue to be phased in under accounting practices that allow them to spread out market declines. The report states:

“While funding ratios for 2009 were the lowest they have been in 15 years, reported numbers are likely to decline further over 2010-2013 as gains in the years leading up to 2007 are phased out and losses from the market collapse phased in.”

There is an additional problem as well, highlighted in a Washington Post weekend editorial and a recent report out of Stanford. It turns out that putting off payments to pension funds, as many states are currently doing, will be even more detrimental and difficult to make up for than is currently evident. This is due to the fact that some state governments, in the way they calculate their unfunded liabilities, use assumptions that do not put into perspective what the true shortfall will be. As the Stanford report found for example, the unfunded liabilities of California’s pension funds are likely off by almost half a trillion dollars. And it is the same reason why, as Andrew Biggs stated a few weeks ago in a Wall Street Journal op-ed, that he believes pension plans for state government employees are underfunded by around $3 trillion – a far greater sum than the one a Pew Charitable Trusts report recently came up with, of $450 billion.

In calculating California’s true unfunded liability, the Stanford researchers used a more realistic rate of return of 4.14 percent – much lower than the 5.3 percent annual rate of return that U.S. stocks drew in the last century. The result was a significantly higher estimated unfunded liability, which will be harder for California - and other cash-strapped states in the same situation - to fulfill down the road. It could also post problems for the federal government, which could very well have to bailout states facing detrimental deficit levels. As the Post says,

“It's no mystery why states got into this fix. Politicians want to court public employee unions with generous promises without having to ask taxpayers for more money. Pretending that investment income will solve the equation helps them avoid hard choices -- though it gives fund managers a strong perverse incentive to take excessive risks in hopes of meeting unrealistic targets.”