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News Analysis: Massive State and Local Pension Debt Often Means Higher Taxes

Posted on September 20, 2016 by Koklanaris, Maria

South Carolina State Treasurer Curtis Loftis Jr. (R) has spent much of September telling people what few understand and none want to hear: The state is more than $20 billion in debt because it underfunded pension obligations to retirees, and that likely means new and higher taxes.

"We can't be afraid to go out front and say that the actions of the past are going to require future tax increases," Loftis said in an interview with Tax Analysts. "A lot of elected officials don't like to talk about it because they are afraid they are going to be branded the person who wants to raise taxes. There's nothing I like less than a tax increase. But I didn't make that decision" to underfund pensions.

Loftis, who has been warning about pension underfunding for several years, said that every year the state delays putting more money toward pensions will cost South Carolina another $1.5 billion. He said his state is far from alone.

"I don't think there's a pension fund in America that can earn its way out of its liabilities if it's been underfunded," Loftis said. "The taxpayer has got to know that we need to do something about this."

On the other side of the country, Joel Fox, an adjunct professor at Pepperdine University in Malibu, California, would agree with Loftis. Fox, who is also the former president of a taxpayer advocate group, was one of a dozen people interviewed by Tax Analysts for this article. He has a favorite quote he uses often: "If you're seeing taxes, think pensions."

That's because so many states and municipalities have put off or underfunded pension obligations. Meanwhile, their portfolios did not bring in the rates of return they were hoping for. Add in skyrocketing costs, and pension debt has mounted to levels that threaten state and municipal fiscal health.

In Pennsylvania, where Republican lawmakers and Gov. Tom Wolf (D) are battling over how the state should pay for and structure pensions, local school districts have indicated that they don't have time to wait for a legislative resolution. In a June 2016 report from the Pennsylvania Association of School Administrators and the Pennsylvania Association of School Business Officials, 85 percent of school districts said they were planning property tax increases for the current school year.

"How many of those cited pensions as a reason?" asked Steven Malanga, a pension expert with the Manhattan Institute for Policy Research Inc. "100 percent."

In an August 2016 report, Moody's analyst Dan White wrote that between "lower than expected tax collections" and "long-term structural issues" such as pension debt, states could be headed for trouble. For states and localities, "mandatory spending on items like Medicaid and pensions will make up more than 35 percent of total budgets this year. State and local governments are beginning to look a lot like the federal budget, and that is not a good thing," he wrote.

Part of the reason for so much spending is that states and municipalities made promises to their retirees that they struggle to keep, and the courts have shown little indication of allowing the jurisdictions to break them. For example, the Illinois Supreme Court in the last two years has ruled twice -- once against Chicago and once against the state of Illinois -- that the jurisdictions are under contracts that must be kept, regardless of their ability to pay.

Absent significant restructuring, which the courts seem disinclined to allow, there are ways out of the pension mess, but they are usually painful and involve more taxes, deep cuts to other services (known in fiscal circles as "crowding out"), or both. Chicago, for example, has increased property taxes and 911 fees to pay for pensions for teachers, police, firefighters, and laborers. Most recently on September 14, its aldermen passed a new tax on water and sewer usage to pay for municipal workers' pensions.

New Jersey, with pension debts of about $50 billion, illustrates how politically difficult it is to fix pensions. Bills for tax increases with designated revenue for pensions have failed. So did the New Jersey Public Worker Pension Plan Amendment, which would have put on the November 2016 ballot a measure to require the state to pay more money into pensions. Gov. Chris Christie (R) called the amendment a "road to ruin" that would have required double-digit increases in sales or property taxes. But Gordon MacInnes of New Jersey Policy Perspective, a group critical of Christie, said a storm is gathering for the governor's successor.

"We are now at a point where the assets of the pension fund are being liquidated to meet current retiree benefits," MacInnes said. "All you need is one more recession and you are wiped out. Then you are going to have to take tax receipts that are intended for schooling, and you're going to have warfare."

Chuck DeVore of the Texas Public Policy Foundation is a former Republican vice chair of the California Assembly Revenue and Taxation Committee. He also sat on California's Joint Legislative Audit Committee. Writing in Forbes in July 2016, DeVore published his calculations of the "10 largest tax hikes needed to meet unfunded government pension obligations."

Illinois would need to raise taxes by 17.9 percent, DeVore calculated, followed by New Mexico at 17.3 percent. Rounding out the top 10 are California at 16.1 percent; Nevada at 16 percent; Kentucky at 15.9 percent; Mississippi at 15.6 percent; Oregon at 15.3 percent; Ohio at 14.1 percent; Alaska at 13.9 percent; and Alabama at 13.8 percent.

"You need to think about this if you're thinking about where to retire, or where to start a business, or where to move to," DeVore told Tax Analysts. "Because this is like a pending tax bill that hasn't necessarily been incorporated into the current tax structure of the state. People need to realize this. That is what I was trying to do."

In California, for example, DeVore, Fox, and other observers of the state's finances said unfunded pension obligations -- about $100 billion for the California Public Employees Retirement System (CalPERS) and about $73 billion for the California State Teachers' Retirement System (CalSTRS) -- should be the state issue voters are thinking about most when they go vote on November 8. On the ballot is Proposition 55, which would extend income tax increases on California's highest earners.

Those income tax increases are supposed to be phased out in 2018 under the terms of Proposition 30, the 2012 ballot measure that voters passed to create $6 billion in higher taxes. If Proposition 55 passes, the higher taxes will stay in place until 2030. Eighty-nine percent of the revenue raised is slated for K-12 education, but according to Fox, Malanga, and others, school budgets are made up of compensation. They said revenue from Prop. 30 went not to fund necessities and amenities for California's children, but rather to pay for retirement of the people who had taught their parents and grandparents. Prop. 55 will simply be an extension of that, they said.

David Crane, a professor at Stanford University, researches and writes often on state pensions. He is a former member of the CalSTRS board, but said he was removed because of his constant criticism and warnings that board members were shortchanging the system for political expedience. Revenue from Prop. 30, Crane has often written, was supposed to be for schools but went to pensions.

"If Prop. 55 is passed, I know it will happen again," Crane told Tax Analysts. "It happens whether or not 55 is passed. Cash is fungible, whether you crowd out services or grab taxes that might otherwise be used to pay for your infrastructure."

Ed Ring of the California Policy Center said trying to pay for pension debt with higher income taxes is ultimately a losing proposition for California. He said the state should foremost commit to restructuring its budget to put more money into its pension funds.

"The fact is when you raise taxes on wealthy people, you have to hope they make money," Ring said. "It's a very volatile way to raise money." Ring said California Gov. Jerry Brown (D) "talks about this all the time -- it's why they want to raise sales taxes, why they want to do away with Proposition 13 [which caps property taxes]. They want a smoother, more stable revenue stream."

California, with nearly 40 million residents, outranks the next largest state -- Texas -- by more than 10 million residents, according to January 1 data from the U.S. Census Bureau. Thus, its two massive retirement systems make up a significant portion of the nation's total pension debt, but it is difficult to tell by how much because calculations on the total U.S. pension debt vary widely.

Some analyses, like an August 2016 study by the Pew Charitable Trusts, look at a finite number of large pension systems, putting the figure at about $1 trillion. Others, such as the Pension Research Council of the Wharton School, University of Pennsylvania, say total pension debt would be closer to $3.5 trillion. Meanwhile, the U.S. Pension Tracker at Stanford University, adding in pension debt from localities, puts the number closer to $5 trillion.

Part of the divergence is that the university groups say that while pension debt is often based on states' calculations of expected returns on their portfolios, those estimated expected returns are far too high. Factoring in a too high rate of return makes unfunded liabilities, and thus debt, appear artificially lower. For example, CalPERS and CalSTRS had projected and accounted for a 7.5 percent rate of return on investment, but their actual results were much lower: CalPERS earned a 0.61 percent rate of return, while CalSTRS reported a 1.4 percent rate of return. Despite a robust stock market, 2015 was not a good year for pension portfolios.

"The typical pension fund assumes kind of crazily that it is going to earn 7.5 percent year in and year out," said Donald Boyd, a pension funding expert at the Nelson A. Rockefeller Institute of Government. He said that wreaks havoc with state and local budgets.

Passing tax increases, said Boyd, "is not terribly remote. We have already had a lot of cuts in state budgets. These are very unpleasant choices, whether it is raising taxes again, or cutting teachers again."

Crane said pension boards that set their rates too high are contributing to "a rip-off of innocent people. I don't think people get how bad it is. The public employees didn't cause it, and they deserve the pensions they've been promised."

"You need a plan to play down debt," said David Draine of Pew. "And then for the future, don't offer benefits you can't handle. Don't take risks you can't assume. Don't overestimate. It's important that states constantly reexamine their assumptions."

Again, Crane and others said, the overestimation of return rates is linked to taxes, something politicians are aware of, as evidenced by Illinois Republican Gov. Bruce Rauner's reaction when the board of the Illinois Teachers' Retirement System (TRS) on August 26 voted to lower its rate of return from 7.5 percent to 7 percent. Crane said that was a responsible move, but the state will have to make up the difference of about $400 million a year.

The Rauner administration's reaction was not subtle in its displeasure. Michael Mahoney, Rauner's senior adviser for revenue and pensions, fired off a memo to others in the administration, warning that lowering the rate of return would further hamper the state's ability to provide services and would lead to "crippling" tax increases. After the TRS vote, a spokesman for the governor said that "with less than two hours notice, Illinois taxpayers, including our social service providers and small business owners, were just handed a bill for nearly a half-billion dollars."

The Chicago Tribune noted bemusement when covering the issue. "Rauner wanted TRS to delay the decision, an odd position for him to be in," the paper wrote. "Rauner has long criticized state and city government for kicking the can down the road on financial issues, and that's what he was advocating as he tried to delay the teacher pension decision."

Observers of Illinois politics and finances told Tax Analysts that the pension issue is another example of why Illinois -- which has been operating without a budget since Rauner took office in January 2015 -- is the most fiscally irresponsible state.

"Right now the percentage of state source revenue going to just the state pensions and their debt is about 25 percent . . . far in excess of any well-run state," said Laurence Msall of the Civic Federation. "It's unlikely that the state will be able to continue to cut enough services to accommodate the pension contribution, with just the existing revenue source. Especially when you recognize that we have about $6.5 billion in unpaid bills and more is coming, it is difficult to see how the state's budget crisis can be ended, and the state's finances stabilized, without additional revenue."

Amanda Kass of the Center for Municipal Finance, University of Chicago, said Illinois has been underfunding pensions for decades. But she said the state exacerbated the problem when it allowed its higher income tax rates to expire after Rauner took office, because lawmakers are well aware that they are required to pay for pensions no matter what.

"The state's pension contribution gets paid one way or another," Kass said. "The governor doesn't want to deal with the revenue issue in all this. They allowed the income tax rates to decrease, the pension amount is increasing, you have so many aspects of the budget being cut, you have delayed payments. It's a revenue issue."

Msall said Illinois has control over both state and local pensions. In recent days, Rauner has hinted that he will veto Chicago's new water and sewer tax because it comes in the absence of the pension reform he has long sought. However, he vetoed the Chicago property tax increases as well, and the General Assembly -- including some Republicans -- promptly overrode the veto.

Msall, Crane, and others gave Chicago Mayor Rahm Emanuel (D) credit for addressing the problem. "It isn't popular, because nobody likes to raise taxes. I don't like to raise taxes," Emanuel said at a news conference after the water tax vote. "But there's a cost to not doing what you need to do, both to the retirees and to the city of Chicago."

"When you're in a hole, stop digging," Crane said. "At least they stopped digging. These problems get harder to fix every day. Every day, it's more distress for innocent people down the road."