Unsustainable Debt

Many pensions for state and local public sector workers have amassed large levels of debt. The aggregate level of unfunded pension liabilities (the gap between future promised benefits and future revenues) across the US was $4.998 trillion USD in 2019, assuming a 3.25% discount rate. For perspective, that means the total pension debt in the US is slightly higher than Germany’s PPP-adjusted GDP as of 2021. As a proportion of the 2019 economy, the pension debt was 23.3% of GDP. COVID-19 exacerbated the financial instability faced by state and municipal pension funds. Thus, law makers must eliminate pension liabilities and make pension funds fully solvent.

How Did We Get Here?

State and local pension funds didn’t become indebted overnight. A confluence of factors came together to bring us to where we are now.

Low Interest Rates

Pension funds have operated off large discount rates assuming best case performance. This impacts the levels of public funding, employee contributions, and benefits. Since the Great Recession, interest rates have been much lower than the discount rates used by pension funds. This essentially amounts to lying on the balance sheets and masks the true amount of money necessary to fund pensions at promised benefit levels.

Short-term Thinking

Between the late 1970s up to the Dot-Com crash, interest rates were pretty high. Pension boards jumped on this and allowed pension funds to invest in riskier high-return investment portfolios to give public sector employees more benefits quickly. Many also mandated a minimum rate of return, often around 8%. This wasn’t problematic at the time, but the precipitous decline in interest rates since then has made the minimum guarantee costly. The most deleterious choice many pension funds made was to distribute the high investment returns as increased benefits instead of creating a rainy day buffer. Pension boards made these decisions because of their perverse incentives: board members are mostly political appointees, current workers, and former workers. Their tendency towards hyperbolic discounting jeopardizes the long-term solvency of the pension fund.

Extreme Generosity

Workers of all types deserve ample retirement benefits. State and local public sector pensions are often extraordinarily generous. The retirement age is usually 50-55 years old, and some workers receive 100% of their average salary or higher. Combined with relatively low employee contributions, it’s not affordable given current pension fund performance.

Why Does It Matter?

Many left-leaning policy observers scoff at proposals to deal with public pension debt, often claiming that it’s a scheme to stiff retirees. While some proposals can be unnecessarily harsh on beneficiaries, there are ways to reduce pension liabilities without harming seniors’ economic security. Pension debt affects everyone.

Beneficiaries

We owe it to beneficiaries present and future to ensure that they have a secure retirement. Making sure that there is a solvent pension fund to draw from is the highest priority in accomplishing this goal. There is no magic money wand once a pension fund is insolvent.

Taxpayers

Public pension debt is a terrible deal for taxpayers. Taxes can be great when they raise revenue for critical priorities like education, healthcare, and infrastructure that we all benefit from. In areas with high pension debt, however, a large amount of revenue goes to paying off pension debt. This money doesn’t go back to the community to benefit everyone. When debt payments aren’t coupled with structural reforms, it’s the equivalent of incinerating tax payers’ money. In states with high pension debt, such as Illinois or New Jersey, it crowds out spending on public investments and basic services. For Fiscal Year 2021, Illinois plans on spending 28.5% of its budget on public pensions. For Illinois, this means not just fewer services, but the worst credit rating of any state in the US. This severely limits Illinois’ ability to borrow and discourages business investment.

Businesses

The large tax hikes many states and municipalities intend on imposing to pay off their pension debts spooks businesses. The tax hikes also hurt businesses indirectly because people emigrate from states and municipalities with large pension debt to ones with better services, lower taxes, or both.

Permanently Solving The Problem

Addressing pension debt requires a serious approach that solves the trilemma of sustainability, adequate benefits, and affordability.

States should create opt-out defined contribution pension programs like OregonSaves for all workers, including public sector workers. The Federal government can do the same thing by expanding the Thrift Savings Plan (TSP) to all workers. If we want to attract workers to the public sector, we can raise their matching rate. Moving to a wholly public plan would reduce fees for everyone because of economies of scale and no money flowing to shareholders or expenditures to stave off competitors, such as advertising. The billions of dollars saved would stay with the individual account holders. The other benefit of a publicly ran defined contribution plan, especially if it is at the Federal level, is portability. You can have the same retirement plan no matter your job, encouraging people to work where they’re happiest.

Policy makers can migrate all public sector workers who aren’t retired into the plan through an opt-in that becomes the default for all public sector workers in 10 years. All public sector workers would have all their existing funds moved to their new account. This move also means all public sector workers would pay into Social Security, helping reduce its insolvency issues.

We Need To Deal With This Now

We’ve waited for too long to eliminate pension liabilities. As I’ve stated in previous posts, it’s crucial that social insurance programs are solvent. This bold plan gives all workers dignified retirement; it reduces costs and rent-seeking while giving everyone good benefits.