On Pension Reform, Make the States More European

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In the midst of massive economic interventions, Congress should push public-pension reform.

NRPLUS MEMBER ARTICLE A s spring turns to summer, temperatures are rising outdoors and on the Hill. Last week, Mitch McConnell noted that the Senate will assess in July whether another spending bill, which the House Democrats and Trump administration already want, is needed to prop up the economy. State and local governments are clamoring for their own slice of any new pie, in some cases citing the need to shore up their underfunded pensions. For lawmakers negotiating the next round of stimulus, here’s a suggestion: Save our seniors and make public pensions more European.

The widespread economic damage wrought by the coronavirus and the measures to contain it has not been limited to businesses and their employees: State and local governments are struggling too. Contrary to some claims, this is not merely a problem for profligate state governments: Ohio had a $200 million surplus in February and an $800 million deficit by May. Illinois’s Senate asked Congress for a $40 billion bailout, while Maryland’s Larry Hogan and New York’s Andrew Cuomo requested $500 billion on behalf of the National Governors Association.

While the House Democrats welcomed this request, Senate Republicans have been more circumspect. The House’s new stimulus plan would give states $500 billion and local governments another $375 billion over the $150 billion already provided in the CARES Act, but McConnell has instead proposed that states consider bankruptcy, since he does not want “to bail out state pensions by borrowing money from future generations.”

A danger to this approach is that it will encourage states to double down on some of their most irresponsible behavior: cutting contributions to their pension funds. Nearly every state is required to balance its budget, so they cannot borrow to ride out the revenue shortfall. If the money does not come in, they will have to cut expenses or raise taxes. Although many are warning about cuts to law enforcement, fire departments, and education, most states will use a loophole to reduce funding for their pension funds.

Regulations in the United States hold public pensions to laxer standards than their European counterparts or those in the American private sector, and, with relatively few states opting for the safer course of defined-contribution schemes, these rules are driving them toward insolvency. Public funds can use their investments’ assumed rates of return to predict their future assets instead of using the industry standard, which is to project that the fund will only make the returns of safe investments. This arcane detail creates ruinous incentives: The riskier the asset purchased, the higher the assumed rate of return, so state and local governments can cut pension contributions and the fund will still appear solvent if the fund managers make risky, high-interest investments. The Society of Actuaries warns that these funds “go against basic risk management principles.”

Unfortunately, pension managers are not very good at picking these kinds of investments. One analysis found that from 1990–2012, when the Dow average almost quintupled, American public pension funds — which should have had a higher rate of return because of their risky portfolios — made less from their investments than their peers who played it safe, and also less than market indexes. The funds that had more retirees to pay bet even bigger and did even worse. These funds are now $1.5 trillion in the hole according to the regulations’ funny numbers, but the Federal Reserve calculates their 2017 liabilities as $4 trillion larger than their assets.

High-tax state and local governments are doing their best to delay the reckoning as long as they can, but reality will catch up to them. When it does, it will be devastating: There are about 10 million retirees depending on these pensions, many of whom are not eligible for Social Security (this was changed, although not retrospectively, by a law enacted in 1991, which itself contains an exemption that left many employees reliant on their state and local governments), and another 15 million still on the job.

Once these funds are depleted, the localities that have made the worst decisions will have to cut their services and raise their taxes even more, forcing their citizens to pay more and get less. Warren Buffett already warns that “if I were relocating into some state that had a huge unfunded pension plan, I’m walking into liabilities.” Many will vote with their feet: As a taste of what’s to come, the Rockefeller Institute predicts that 100,000 people will leave New York after losing the state and local tax deduction. This could leave millions of seniors destitute and pull localities into the fiscal death spiral that ruined Detroit.

Many senators are understandably reluctant to increase the federal debt to prop up governments with bloated bureaucracies and extravagant benefits, but the pandemic offers them an opportunity to address a serious problem that will only get worse without action. Aid to state and local government should be conditioned on their pension funds’ accepting normal industry standards.

Progressives often compare the U.S. government unfavorably with those of other industrial democracies, wishing we were more European. On pension reform, let ‘em have it.

Mike Watson is the associate director of the Center for the Future of Liberal Society at the Hudson Institute.

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