State pensions in America
Ruinous promises

States cannot pretend to be in good financial health unless they tackle pensions

LeadersJun 15th 2013 edition

JERRY BROWN, the veteran governor of California, is basking in glory. The golden state, once described as America’s Greece because of its fiscal woes, is reporting a $1.2 billion budget surplus (see article). But the euphoria is premature. California still has a mammoth long-term pension gap. If it used the same pension accounting standards as private companies must, its total debts would be a terrifying $1 trillion.

California is far from alone. Few fiscal problems are as grave, or as little understood, as underfunded state and municipal pensions. The funding gap for all state schemes is estimated at $4 trillion—25% of GDP.

Politicians long ago realised that if you offer public-sector workers bigger retirement benefits, they vote for you today and the bill does not arrive for years. Some states have allowed staff to “spike” their final-salary pensions by racking up lots of overtime in their last year on the job, vastly increasing their retirement payouts. Some retire with packages worth millions. The states granted these generous benefits on the basis of recklessly optimistic assumptions, such as that their pension funds’ assets would continue to generate the same bumper returns as during the equity bull market of the 1980s and 1990s.

It gets worse. To calculate the cost of pensions, one must use a discount rate on future liabilities. The higher the discount rate, the lower the liabilities appear to be. States and municipalities use the expected return on assets in their pension funds, which they guess to be 7.5%. But this is a strange approach. The liability will still exist even if the expected return is not achieved. If the stockmarket performs badly, taxpayers will have to make up the shortfall. Pensions are a bond-like liability, so the discount rate should be based on a bond yield. In any case, the states’ assumed investment return is far too high at a time when Treasury bonds yield a piffling 2%.

Rosy assumptions allow the states to put less money in the pension pot today. In the private sector, companies discount their liabilities in their accounts at a median rate of 4.7%. Falling bond yields have made defined-benefit pensions far costlier; many private companies have therefore closed their schemes to new members or shut them entirely. The states, by contrast, can pretend that their promises are affordable.

Stop digging

Not everyone is fooled. Moody’s, a ratings agency, is switching to a discount rate based on bond yields when calculating the states’ creditworthiness. Amazingly, even under their own rosy assumptions, state pension schemes are in trouble. In Illinois they are only 40% funded; in New Jersey, 53%. As people live longer, their pensions cost more. In California, the giant CalPERS fund is requiring taxpayers to chip in more from 2015 and the CalSTRS fund for teachers needs an extra $4.5 billion annually for the next 30 years—more than the surplus the state is now trumpeting. The governor of Illinois, Pat Quinn, has called a special legislative session for June 19th to discuss pensions, after two ratings agencies downgraded the state’s debt.

States need to wake up. The priority is to make taxpayers aware of the scale of the problem by accounting for it properly, rather than pretending the stockmarket fairy will magic it away. The second step is to do as much as legally possible to slow the growth of future benefits.

New employees should not be offered final-salary pensions. The accrued pensions of existing public-sector workers should be paid, but their benefits from now on should be renegotiated, for example by aligning pensionable ages with those for Social Security (if state courts allow it, which some, bizarrely, do not). And all the dodges, such as allowing employees to put in longer hours in their final year to increase the final-salary number, should go.

If costs are not cut, the eventual result will be a huge rise in taxes when the pension funds run out of money. The burden will fall on private-sector employees, who do not qualify for such a gilded retirement. They will not be happy.

This article appeared in the Leaders section of the print edition under the headline "Ruinous promises"

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