There’s No State Pension Crisis After All!

by Veronique de Rugy

At least that’s what this new piece from McClatchy claims. According to the report, pensions are not in crisis because right now, pension costs represent only a small share of state budgets:

Pension contributions from state and local employers aren’t blowing up budgets. They amount to just 2.9 percent of state spending, on average, according to the National Association of State Retirement Administrators. The Center for Retirement Research at Boston College puts the figure a bit higher at 3.8 percent.

My colleague Eileen Norcross, a state-pension expert, explained to me why this 3.8 percent number is misleading:

The 3.8 percent of budgets is the current average for all states under an 8 percent discount rate. In other words, it’s an aggregate number, and it says nothing about the deep underfunding that certain states such as Illinois and New Jersey. I’ve seen the internal reports from NJ – it’s not good and they know it. 

In fact, when you look at the source of the McClatchy article’s data, this paper by Alicia Munnell, it’s clear that the journalist has cherry-picked numbers to tell a tale.

Whereas public plans are substantially underfunded, in the aggregate they currently account for only 3.8 percent of state and local spending. Assuming 30-year amortization beginning in 2014, this share would rise to only 5 percent and, even assuming a 5 percent discount rate, to only 9.1 percent. Aggregate data  however hide substantial variation.

The key words ignored in the McClatchy piece are “substantially underfunded” and “substantial variation.”

Besides, the fact that states’ pension obligations are a small share of their budgets today is a relatively meaningless point, given the explosion in spending that’s coming now that bureaucratic baby boomers are starting to retire. As I note in my recent Reason column “The State Pension Time Bomb,” according to Joshua Rauh, professor of finance at Northwestern University, some states’ pension funds are scheduled to run out as soon as 2017. The below chart shows the ten states scheduled to run out of cash first:

Once the pension plans run out of money, the payments will have to come out of general funds, meaning taxpayers’ pockets. What does that mean concretely? In her testimony before Congress last month, Norcross explained:

By 2018 Illinois will run out of plan assets which will require that the state begin contributing $11 billion annually from revenues between 2019 and 2023. Currently, the state contributes $3.5 billion annually, and has often bonded its contributions. Using less generous assumptions, this scenario is much worse. Indeed, as Dr. Rauh notes this will present a “catastrophic shock” to Illinois’ current revenue needs.

The situation is not much better in New Jersey. Dr. Rauh estimates New Jersey will require $10 billion annually out of its revenues to pay for pension benefits it has already made beginning in 2020, which represents one-third of the state’s current budget. Other plans have a longer time horizon but face even more difficult scenarios. In 2031, Ohio will require 55 percent of its projected revenues, or roughly $13.8 billion annually to pay for existing liabilities.

Fifty-five percent? That’s quite different from the rosy 3.8 percent the McClatchy story is talking about. And those figures rely on very unrealistic assumptions about these plans’ rates of return.

The article also recycles a point we hear over and over again: that the only reason state pensions are underfunded is the recession.

Nor are state and local government pension funds broke. They’re underfunded, in large measure because — like the investments held in 401(k) plans by American private-sector employees — they sunk along with the entire stock market during the Great Recession of 2007-2009. And like 401(k) plans, the investments made by public-sector pension plans are increasingly on firmer footing as the rising tide on Wall Street lifts all boats.

Not so. #more#First, these numbers (which already look very bad) assume these plans will get average annual returns of 8 percent. Joshua Rauh, Andrew Biggs, Norcross, Doulgas Elliot of Brookings, and many others have hammered on how wrong and irresponsible this approach is.

Moreover, the problem started long before the recession began. A 2010 Pew study called “The Trillion Dollar Gap” finds that in 2000, slightly more than half of states had fully funded pension systems. (Check their exhibit 7.) By 2006, that number had shrunk to six states. By 2008, only four states (Florida, New York, Washington, and Wisconsin) could make that claim.

Let me repeat that. In 2000, only half of the 50 states’ pension plans were totally funded. There was no recession back then.

The bottom line: We can argue endlessly over when the pension plans will run out of cash, or what the value of their unfunded liabilities is. We can even debate the true meaning of being broke. But there is one issue where there is no room for debate: Once the pension plans run out of money, the payments will have to come out of general funds, meaning taxpayers’ pockets. That will happen very soon: The number of retirees is going up, the promises made have gotten more and more generous over time, and pension plans aren’t underfunded just because of the recession. States are already broke, so if they want to avert a pension crisis, they need to push through reforms as soon as possible.

By the way, this afternoon I will be on Bloomberg TV to do my weekly “Reality Check” segment with Carol Massar and Matt Miller — our focus will be state pensions.

Update: There was a tech bubble burst in 2000 but the country was coming out of  many years of strong economic growth. Yet some 50 percent of the states had already underfunded their plans. State lawmakers can’t be trusted to fund they plan properly because they have too many incentives to use the money elsewhere.