The Five Trillion Dollar Hole
U.S. government officials don’t hesitate to lecture foreign governments who are running up big debts about the need to live within their means. Yet in some ways, the spending habits of U.S. states are far worse than many foreign governments. The state public pension programs of the 50 states are estimated to be underfunded by as much as $5 trillion, double the total government debt of Italy (widely considered to be a country whose finances are out of control). Here in the United States, millions of retired police officers, teachers, sanitation workers, judges and others will continue to depend on these state pension funds for years to come. And it only takes a brief look at the slow-motion train wreck happening in some states to see that we may be on the cusp of a dramatic shift in how taxpayers fund public sector workers’ retirements.
Actuaries spend a lot of time estimating what states will pay to retirees, who often collect them for their lifetimes. Making those estimates requires making a lot of assumptions about dozens of things, from how old workers might be when they retire and how long they’ll live once they do, to what the investment returns on the assets in the pension plan might be. (Get a quick tutorial here.) One of the most influential assumptions is the discount rate used to calculate the present value of future pension obligations. Assume a higher rate, and the present value of the pension obligations is suddenly much smaller; assume a lower rate, and the present value gets bigger.
That in turn affects two things: how much states need to put into the pot every year, and how big the pension plan assets are in relation to the plan’s actual obligations – that is, how “funded” its plans are.
That’s roughly the math that produced this mortifying list of the 10 most underfunded state pension plans in the United States, according to State Budget Solutions, which is a nonprofit, nonpartisan public policy organization in Glen Allen, Virginia. Take a look:
One thing that emerges from the list is that partisan politics doesn’t explain the tendency of state governments to promise more on pensions than they can afford. While states like California and Illinois have been led mostly by Democratic state governors, other states like Alaska and Nevada have been dominated by Republican governors for most of the last couple decades.
Having so little set aside now for such a large liability later is a recipe for disaster in anyone’s book. So how did some of these states get in such bad shape, and what are they doing to cope? Let’s take a look at a few.
Alaska: This state offers an example of the power of actuarial assumptions. In 2010, Mercer Inc., which was hired to estimate pension costs, agreed to a $500 million settlement with Alaska, which claimed Mercer flubbed calculations and gave the state a false sense of security that led to raises and other financial decisions it later regretted. This was in addition to Alaska’s very high expectations of 8% market returns. In June 2014, the governor decided to pull $3 billion out of the state’s budget reserve to try to reduce the gap of nearly $30 billion.
New Jersey: This state’s problem is a case of failing to make adequate contributions. As is the case for many states, often this happens because there are higher-priority demands on the state’s budget. In FY2014, for example, New Jersey put less than $700 million into its pension plan even though it should have put in $3.7 billion that year, according to the New Jersey Pension and Health Benefit Study Commission. Public-worker unions have sued over this. The cases are still pending.
Illinois: If holding back contributions, suing your actuary or telling retirees to pay more doesn’t work, states can always try cutting benefits. That’s what Illinois did in December 2013, when its legislature passed a bill reducing and suspending cost-of-living increases, raising retirement ages and limiting the salaries on which the pensions are based. The state’s pension contributions are eating up 20 percent of its general fund revenue, according to one report, and Illinois is on such shaky fiscal ground that it has the lowest credit rating in the union. Now the state is asking the Illinois supreme court to let it restrict employee pensions, arguing that it doesn’t have an obligation to protect retirement benefits.
California: California is perhaps the most perplexing of the underfunded states due to the sheer size and complexity of its pension systems, but a recent ruling there may provide another means for getting out from under crushing pension liabilities: bankruptcy. In October, a judge ruled that Stockton could sever its obligations to state pension fund manager CalPERS, basically rejecting the idea that governments must make pension contributions no matter what. Another part of California’s problem, according to State Budget Solutions, is how plan assets are invested. California Public Employees Retirement System and the state’s teacher pension fund earned just 1% to 1.8% in 2012, for example. Their assumed rates of return were between 7% and 8%.
For the millions of people now reaching retirement age and expecting to collect government pensions, these are the times that test men’s souls. Will benefits go down? Will taxes go up? Or will the states go on pretending that all is well and let the debt mountain get even bigger?