My colleague Maria Koklanaris recently wrote an excellent article on the pension debt held by state and local governments. It’s worth a read. Those in state and local government should be well aware of the level to which pension plans are underfunded. According to Koklanaris’s article, which was published in State Tax Today on September 20, there “isn’t a pension fund in America that can earn its way out of its liabilities.”
Most state and local governments provide some form of retirement income for their employees. Often, governments provide defined benefit plans, in which employees are guaranteed a specific pension payment upon retirement. Defined benefit plans are funded through dedicated trust funds, which are funded to cover future pension liabilities. Payments into those trust funds come from employers (the state or local government) and employees, and the amounts in the funds are invested.
The level of underfunding in state and local government pensions is significant.
When I first wrote about this in 2012, it was estimated that state and local government pensions were underfunded by approximately $1 trillion. And the picture was even worse if liabilities are valued using "low-risk" discount rates. Under that approach, state and local pension plans were estimated to be underfunded by $3 trillion. According to new numbers from the U.S. Pension Tracker at Stanford University, state and local government pensions are now underfunded by closer to $5 trillion. It’s a staggering figure, and it hasn’t improved in the last four years.
Many state and local governments also provide healthcare benefits to retired state and local government workers, as well as life insurance and other smaller benefits. Those programs often receive little funding because they are funded on a pay-as-you-go basis. The situation could be made worse if the federal government increases the eligibility age for Medicare. Liabilities for those programs would increase because state and local government healthcare benefits often provide coverage during the transition period between retirement from government service and eligibility for Medicare.
States must begin planning for the future. This is not a can to be kicked down the road. Given consistently tight budgets year after year, the always present potential for a decrease in federal funding (even if for programs that are not directly related to state pensions or healthcare), the existing underfunded programs, and the fact that most states must balance their budget each year (and must stop shifting funds to achieve a balanced budget), states have no ability to put off planning for the future. They must plan for more than one year at a time.
What does that mean? It means state and local officials will have difficult decisions to make. Do they raise taxes or lower expenses or both? The debts are coming due, so as much as politicians like to avoid being the one who raised taxes or reduced services, they will have to be honest with voters about the choices that were made and what it will take to eliminate the underfunding.
As Stanford University professor David Crane said in Koklanaris’s article, “When you’re in a hole, stop digging.”
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Editor's Note: On September 30, this article was corrected to show that the U.S. Pension Tracker estimates pension underfunding to be close to $5 trillion, not the Actuarial Standards Board. The author regrets the error.