A Public Pension Time-Bomb?

The Issue:

Underfunded pension liabilities have been an important element of most of the recent high-profile public sector defaults, and represent an important challenge for state and local finances. In Puerto Rico unfunded public pension liabilities are about $50 billion of the $123 billion public debt that will need to be restructured. In Detroit, the unfunded public pension liability was estimated to be approximately three times the size of the city’s general debt, and other post-employment benefits, such as post-employment health care for municipal employees, were larger than the pension liability. Pensions have also figured prominently in recent bankruptcies in the California cities of Stockton, San Bernardino, and Vallejo, in other places as well. Fully funding state and local pension commitments will, in many places, place significant strains on state and municipal finances. In order to fully fund pension liabilities, states and localities will need to undertake some combination of raising taxes and cutting spending on government services like schools, public safety, and infrastructure.

Fully funding state and local pension commitments will, in many places, place significant strains on state and municipal finances.

The Facts:

• Many of the workers employed by state and local governments participate in state sponsored defined benefit pension plans and these plans represent many public employees' sole source of post-retirement income. About one out of seven U.S. workers are employed by state and local government entities, serving as teachers, policemen, firemen, and in many other positions. Accordingly, state and local government spending makes up about one-eighth of the economy of the United States (see this article by University of Rochester economist Robert Novy-Marx for details.)
• A Defined Benefit (DB) pension plan promises workers a stream of post-retirement benefits that are determined by years of service, the wages or salary that the employee earned while working, and possibly other factors such as age at retirement. Employers contribute directly to these plans. A defined benefit pension plan can be thought of as creating a liability that is owed to today’s workers; these workers are accepting lower pay and benefits today in exchange for post-retirement compensation. These plans are distinguished from Defined Contribution plans, such as a 401(k) plan, in which employees directly contribute money to dedicated accounts (and their employers may add to those contributions) and then draw on these accounts after retirement.
• A retirement account in a Defined Contribution plan is “fully funded” in the sense that post-retirement benefits equal the value of the account, which is the money contributed and the returns earned. In contrast, although defined benefit pension plans typically have pension funds, the post-retirement benefits from a defined benefit plan will not, in general, be a function of money contributed to the fund and the performance of these assets. The benefits are instead a function of the defined benefit plan’s formula. This means that the employer will be responsible for making up any shortfall between promised benefits and the resources available in the pension fund.
• While the relative prevalence of Defined Benefit plans are declining as compared to Defined Contribution plans, Defined Benefit plans remain particularly important for employees in the state and local government sectors. An important distinction between private-sector and public-sector Defined Benefit pension plans is that private-sector plans enjoy federally-sponsored insurance coverage for a large part of their benefits. This coverage is provided by the Pension Benefit Guaranty Corporation (PBGC), which was created by the Employee Retirement Income Security Act of 1974. No similar insurance program exists for public-sector plans.
• Public-sector Defined Benefit pension plans appear to be underfunded by over $1 trillion, meaning that the value of the pension liabilities was more than $1 trillion greater than the value of plan assets, when these liabilities are valued following the accounting rules of the Governmental Accounting Standards Board (GASB). To provide some context for this amount, state and local borrowing in the municipal bond market is almost $4 trillion – so the unfunded liabilities of public sector pension plans are quite large.
• In fact, many economists believe this $1 trillion underfunding estimate is low relative to the true extent of the underfunding. Estimates of the size of the public pension liabilities depend critically on the rate of return they use for calculations. If they assume that there will be a very high rate of return, then they need a smaller amount of assets in order to meet future obligation. The $1 trillion estimate is based on discounting liabilities at relatively high discount rates because GASB rules allow discounting future payments using the expected return on plan assets. However, this is at odds with the standard approach to discounting future liabilities. The higher discount rate lowers the present value of future obligations since, for example, one needs less money today to pay out $1000 one year from now if the interest rate is 10% (in which case, the amount would be about $909 since $909 ×1.10 = $1000) than if it is 5% (since $952 ×1.05 = $1000). Very different values of the shortfall are obtained if other approaches to measure the value of the liabilities are used. For instance, one calculation shows that if one estimates the value of the future liabilities of U.S. public sector pension plans using a discount rate that is consistent with international accounting standards, then the measured shortfall of the liabilities is close to $5 trillion.
• Another concern raised by using the expected return on a plan, rather than the standard approach, is that this method sets up a perverse incentive. A municipality whose leaders prefer to report lower estimates of the reported pension liabilities will want to invest in assets that promise higher rates of return since this will lower the estimated present value of plan liabilities.  But higher returns typically come hand-in-hand with more risk, so investing in these high-yielding assets will raise the riskiness of the pool of assets that stand behind those liabilities.
• The ability to meet pension obligations facing states and localities varies greatly from one place to another. While the average state pension cost represents about 4 percent of state revenues, New Jersey, Illinois and Connecticut, face much higher costs at almost 15 percent of their own-source revenue. In contrast, Florida, Iowa and Nebraska have a cost burden much lower than average. A similarly varied picture emerges across different U.S. counties: four counties in California face the highest costs, in excess of 40 percent of their own-source revenue. And Chicago, Detroit, Miami, Houston, Baltimore, San Jose and Wichita are among the U.S. cities that face the highest pension costs relative to their revenues (for a detailed analysis see this policy brief by Alicia Munnell and Jean-Pierre Aubry.)
• The legal ability of state and local governments to cut defined pension benefits varies from state to state and plan to plan. In many states, pension benefits, once earned, enjoy constitutional protection. But accrued pension benefits have been cut in Detroit and Stockton through bankruptcy processes. It is not clear that it will be possible to cut pension benefits for the city of Chicago or for the state of Illinois, both of which are currently experiencing fiscal stress.