Can States Afford Rising Public Pension Debts?

Andrew Biggs, a resident scholar at the American Enterprise Institute and contributor to Forbes, wrote a comment examining whether states can afford rising public pension debts:
Most observers are aware of the rising cost of state and local government employee retirement plans, driven by benefit increases, overoptimistic investment return assumptions and failures by governments to make full contributions as required. But in a recent study, the National Conferences of Public Employee Retirement Systems (NCPERS) cites federal government data to argue that public sector pensions remain easily financially sustainable by state and local governments.

In fact, though, those same federal data show that public pension debt is rising significantly faster than the growth rate of the economy, with pension liabilities doubling as a percentage of GDP over the past three decades. Worse, state and local government pensions are failing even to fully fund the new benefits earned by employees each year, much less rebuilding their troubled finances. All of this points to difficult decisions ahead, not to a future in which, as the NCPERS study concludes, “the data clearly demonstrate that public-sectors employers’ economic capacity to handle that debt is also increasing.”

The NCPERS study rightly states that “policy makers need to examine the trends in the ratio between pension debt and GDP to get a realistic picture about sustainability of public pensions.” What is more questionable is NCPERS’ conclusion: “Our analysis … shows that this ratio has been stable and is likely to be stable over the next 30 years with minimal adjustments.”

Indeed, the same data NCPERS relies on appear to show a very different story — that public pension liabilities, funded or unfunded, have increased dramatically over the years.

NCPERS uses data from the Federal Reserve’s Financial Accounts of the United States publication. The Fed’s pension data in turn are drawn from the federal Bureau of Economic Analysis (BEA), which prepare these data as part of the National Income and Product Accounts.

The Fed/BEA pension data show that immediately following World War Two, total state and local government liabilities were equal to only seven percent of gross domestic product (GDP). Pension liabilities grew to around twenty percent of GDP by 1970, remaining at more or less that level through the late 1980s. But beginning in 1989 pension debt began a long and dramatically higher upward path, with total pension liabilities reaching 41% of GDP in 2019.

The unfunded share of state and local pension liabilities has increased as well. Up through the 1970s many public sector pensions were funded on a pay-as-you-go basis, meaning that benefits were paid directly via tax revenues with no attempt at prefunding. In 1947, for instance, unfunded state and local pension liabilities equaled 5.8% of GDP at a time when total pension liabilities were just 7.1%. Over time, state and local governments moved to prefund their pension benefits, such that pension assets grew considerably. By itself, that’s a good move.

But all of this pension prefunding – and then some – was offset by increases in the cost of public pension benefits. In fact, unfunded public pension liabilities today are higher than in the years when state and local governments made little effort to fund pensions at all. For instance, even in public pensions’ best-funded year of 1999, total unfunded liabilities were nearly as large as in 1947, when pension funding was almost nonexistent. This merely illustrates the degree to which state and local government pension systems have grown.

So, given all that, how does the NCPERS study conclude that public pension liabilities are both modest and sustainable? It’s a little hard to follow their calculations, and a number of mathematical steps NCPERS takes don’t affect the trends very much.

But one does: NCPERS’ standard for sustainability is “how much more money should have been contributed into pension funds to keep the ratio stable,” which NCPERS defines as “at or below the average during the 16-year period (2002–2017).”

So what NCPERS does is take a subset of the much longer period over which pension liabilities have skyrocketed and then, by looking at the average increase in pension debt over that subset, effectively cut even that amount in half. The soft bigotry of low expectations.

Specifically, from 2002 to 2017 unfunded pension liabilities rose from 13.2% of GDP to 20.6%, an increase of 7.4% of GDP. The average increase during that period would be roughly half that amount, or 3.7% of GDP. But that’s a pretty modest goal when, over the past 30 years, unfunded state and local pension liabilities increased by 10.6% of GDP, nearly three times as much. In effect, NCPERS asks how much it would costs to stabilize pension debt as of the beginning of Barack Obama’s second term, when pension debt began its long upward climb back when George Bush – the first one – entered office.

And it’s hard to portray that increase as benign, even if no state pension plan has yet gone insolvent. For instance, on paper, education funding per student has increased significantly over the years. But a substantial part of that increased funding doesn’t come anywhere near the classroom but instead goes to pay off unfunded liabilities for teacher pension plans. We see the same effects elsewhere as rising pension costs squeeze resources available for other purposes.

But there’s worse: the Federal Reserve/Bureau of Economic Analysis data show that state and local pensions aren’t even treading water, much less making up for lost ground. In fact, state and local pensions aren’t even receiving sufficient contributions to cover the new benefits accruing to employees each year. Simply to stay even, total pension contributions would need to roughly double or the rate at which future benefits are earned would need to be cut in half. That’s not a modest difference.

So what might a sustainable pension funding policy look like? And would it be affordable? I’ll make two assumptions: first, that current generations of taxpayers won’t shift costs to future generations, but that current generations also won’t pay off current pension debts in order to benefit future generations. That means, first, that the cost of newly-accruing pension benefits should be fully-funded using the lower-risk interest rates assumed in the Fed/BEA data. But second, instead of seeking to pay off unfunded pension liabilities, which costs current generations and benefits future ones, governments will simply pay interest on unfunded pension debts.

Using 2018 data, the value of newly-accruing state/local pension liabilities was $167 billion, according to the BEA/Fed data. And the cost of simply servicing the 2018 unfunded pension debt of $4.5 trillion comes out to $178 billion, for a total cost of $345 billion. But do you know what actual state and local government contributions to public pensions were in 2018? Only $151 billion.

It’s hard to say precisely what pension sustainability means. But using reasonable assumptions, we currently seem to be far from it.

Biggs's article elicited this response on Twitter form NCPERS:

Take time to read the NCPERS study, In Tranquility or Turmoil, Public Pensions Keep Calm and Carry On, which is available here.

I'll jump straight to the conclusion:

The exclusive focus on rising public pension debt is analogous to looking at a single-entry
bookkeeping system, that is, looking at one side of the ledger. The Brookings study expands this approach by looking at both liabilities and the economic capacity of plan sponsors. While public pension debt is rising, the data clearly demonstrate that public-sectors employers’ economic capacity to handle that debt is also increasing. Our analysis shows that pension debt in the United States can be stabilized – and pensions can be sustained despite current losses due to the coronavirus pandemic – with minimal adjustments on an ongoing basis.

In a recent review and critique of the Brookings paper, Keith Brainard and Alex Brown of the National Association of State Retirement Administrators noted that the finding that pensions are sustainable in the context of employers’ economic capacity is encouraging. The authors caution, this hopeful outlook, however, does not mean that we should overlook the well-accepted principles and discipline of pension funding and risk management policies and practices.

It also does not mean that state and local governments should pursue a path – a path some are already on – that makes their revenue systems regressive and volatile and increases reliance on risky revenues schemes such as casinos, lotteries, and excise taxes. Pursuing such a path will undermine their ability to effectively make use of their economic capacity.

In short, public pension debt is sustainable in perpetuity if a stable ratio of debt to GDP is maintained. This can be achieved by monitoring this ratio on a regular basis and making minor adjustments along the way. In the meantime, policy makers must continue to follow good pension funding policies and discipline and align their revenue systems with their economies to best exploit the economic capacity of their states.

When policy makers have a clear understanding of the resources available to fund pensions and make the commitment to align economic and fiscal priorities appropriately, the result of public pension policy can indeed be happiness for taxpayers and workers alike.

Now, I have an issue with any claims that state "public pension debt is sustainable in perpetuity if a stable ratio of debt to GDP is maintained."

As I keep stating on this blog, all pensions -- public and private -- are all about matching assets with long dated liabilities.

It's not about who has outperformed on any given year, it's all about the funded status and making sure your pension never runs out of money to pay retirees and future beneficiaries.

Unfortunately, for a multitude of reasons Mr. Biggs points out in his article, the rising cost of state and local government employee retirement plans, driven by benefit increases, overoptimistic investment return assumptions and failures by governments to make full contributions as required, have made the situation in the US untenable in some states.

The latest PEW research states the following:

At $1.24 trillion, the 50-state pension funding gap—the difference between a state retirement system’s assets and its liabilities—improved slightly in 2018 primarily due to strong investment performance. However, after a decade of economic recovery, the aggregate pension funding gap remains historically high and could increase by up to $500 billion based on market returns through March 2020, including recent losses related to the COVID-19 pandemic. In addition, the disparity between well-funded and underfunded state retirement systems is greater than it has ever been.

As policymakers anticipate another recession and increased budget pressures, policies on pensions will play an important role in determining how well states are able to weather an economic downturn. In this brief, The Pew Charitable Trusts identifies and examines practices that can help public officials better prepare their retirement systems for a recession and help them manage through it, with particular attention to proven policies followed by the best-funded states. Specifically, Pew finds four pension management practices that contribute to strong fiscal position:

  • Following funding policies that target debt reduction.
  • Lowering investment return assumptions.
  • Adopting cost-sharing policies and plan designs.
  • Implementing pension stress testing.
This brief assesses the effectiveness of these practices using 50-state data from 230 state retirement systems covering teachers, public safety workers, and other state and local public employees. The findings are based on trends since before the Great Recession, as well as over the five-year period since 2014, when the Governmental Accounting Standards Board (GASB) implemented new reporting standards that allow for comparable analyses of funding and cash flow across state pension plans.
Take the time to read this brief here but here are some figures worth bearing in mind:

Remember, the average funded status is 71% and that was before the COVID crisis. Goldman Sachs estimates public pensions are now less than 60% funded on average.

As US long-term interest rates drop to record low levels and risk going negative, liabilities have exploded this year and even though stocks have snapped back, the funded status has surely deteriorated because the drop in rates has a disproportionate effect on liabilities.

Now, I happen to agree with the PEW recommendations, namely:
  • Following funding policies that target debt reduction.
  • Lowering investment return assumptions.
  • Adopting cost-sharing policies and plan designs.
  • Implementing pension stress testing.
The problem? When you lower your investment return assumptions, you are lowering your discount rate and that means you need to hike the contribution rate.

Public unions which represent public pension members are against any hike in the contribution rate as are many state governments which are strapped for cash.

The same goes for adopting cost-sharing policies. It makes perfect sense to adopt conditional inflation protection to temporarily suspend cost of living adjustments when public pensions are in a deficit but US public sector unions are dead set against it.

In Canada, some of the most successful public pensions -- OTPP, HOOPP and CAAT -- have all adopted a form of risk sharing, typically in the form of conditional inflation protection.

When times are tough, they will partially or fully remove inflation protection for a brief period and typically restore it retroactively when their plan is fully funded again.

This ensures intergenerational equity between active and retired members of the plan and it ensures that as more and more members retire, the risk of the plan is borne by active and retired members.

What else? Canadian pension plans use extremely low discount rates, on average 200 basis points lower than their US counterparts. This ensures their members and respective governments are contributing their fair share to fund these pensions.

And Canada's pension have world class governance which separates public pensions from the government, allowing them to set attractive compensation packages to manage more assets internally, lowering the cost of the plans.

So, maybe the answer to US public pension woes is to look up north and see what we are doing right.

In fact, Ingo Walter and Clive Lipshitz argue in The Hill that the US should look to Canada to reform its public pension system:

Observers of the diverse and often challenged American public pension system look north to Canada with a certain degree of admiration. Canadian public pension plans tend to be fully funded — some even have healthy surpluses. Most U.S. plans are in deficit, and several are unlikely to be sustainable. So what makes the Canadian system better? The inevitable response has to do with better governance. But it goes a lot deeper. It is the legal structure of Canadian public pension plans that enables strong governance.

Based on a new, comprehensive study of the largest Canadian and U.S. public pension systems – their design and performance – we found one feature of the Canadian model to be fundamental. If adopted in the U.S., it could reorient the relationship between employers and pension beneficiaries in the public sector, and even renew interest in defined benefit pensions for a significant group of private-sector employees. 

Canadian public pension plans underwent a series of reforms starting in the late 1980s. Until then, many of them were not in good shape. In some cases, there was an unhealthy relationship between government pension sponsors and plan members. Sponsors were willing to grant benefit enhancements but did not match them with increases in pension contributions. So, both employers and employees became concerned about system solvency. Employers worried that they had made promises that would be difficult to honor. Employees worried that what seemed to be too good to be true actually was. Unions fretted that pension promises might be reneged when future governments realized they were simply not affordable.

Federal and provincial political leaders, for whom pension reform might have been fairly low on the priority list, were forced to reckon with design flaws in the pension system. Kicking the can down the road increasingly looked like a mug’s game.

First in Ontario and then in other provinces, negotiations between government and unions reached a compromise, whereby public pension plans would be restructured under so-called “joint sponsorship.” Rather than being unilateral promises from government employers to their employees, pensions would instead come under the joint control of both governments and unions.

Fundamentally, this was a shift from a paternalistic model to one in which employee representatives got a seat at the table alongside employers. Benefit and contribution levels would no longer be determined in a separate and distinct way. Unions cut back on unreasonable demands knowing they would be jointly on the hook for ensuring plan solvency if benefits were not matched by corresponding future increases in contributions. 

In Canada, the joint sponsorship model was key to ensuring greater public pension sustainability. How is it relevant to the U.S.? 

In both countries, there are few legal precedents for what happens when a public pension plan is unable to pay contractual pension benefits. By establishing a pension trust under joint sponsorship – independent of government – the responsibility for future funding is insulated from public finance. Market forces in public employment will help ensure that governments do not promise benefits they will be unable to pay, and that unions do not demand benefits future workers will be unlikely to receive. 

There are many other features of the Canadian model of sustainable public pensions that bear consideration, but joint sponsorship is at the heart of the model. The governance advantage that pervades the Canadian system emanates from this feature, as each pension constituency selects trustees to represent its interests.

Potentially, the basic features of joint sponsorship could also be used to benefit certain private sector pensions. In the United States, ERISA was enacted in 1974 primarily to protect private sector workers from egregious corporate activities such as raiding of pension funds. But it had the unintended consequence of encouraging companies to discontinue defined-benefit pension plans because the obligation to cover pension liability gaps became extremely costly. If pensions were established as trusts – independent of the sponsor – benefit and contribution levels may well move in tandem, with employee unions assuming joint responsibility for adequate pension funding. 

Retirement planning is complex for everyone. Defined-benefit plans have received bad press for decades, but if structured carefully they provide numerous benefits relative to self-directed savings. These include risk pooling, professional investment management, lower expenses and a more sensible approach to withdrawing pension assets during retirement (decumulation). The joint sponsorship model is worth considering in the public sector and perhaps even in the private sector as well.

Take the time to read Ingo Walter and Clive Lipshitz's study, Public Pension Reform and the 49th Parallel: Lessons from Canada for the U.S. which is available here.

I have long, long argued the US needs to adopt the Canadian model, but I've also stated there are powerful interest groups which don't want this to happen (basically private equity and hedge fund asset managers which gorge them on fees).

This is why I'm convinced US public pension bailouts are coming, it's only a matter of time.

In fact, with US unemployment at record levels and the GDP contracting at a record pace, there will be no choice but to bail them out if they can't make their obligations:

And remember what I keep telling you, pension bailouts are all about bailing out Wall Street which includes big banks and their big private equity and hedge fund clients that need perpetual funding.

It has nothing to do with bailing out pensioners but politicians will make it look that way.

Below, California State Senator John Moorlach explains the most consequential issues that his state's pension system currently faces. The promises that were made to participants in the pension system were made in a time of significant growth, but the time to deliver on these promises is coming at a point where pension fund managers are struggling to maintain high enough returns. California's pensions have increasingly become underfunded--and Senator Moorlach sees its story ending in bankruptcy.