The Economics of State and Local Pensions

Featured in print Bulletin on Aging & Health

The rising cost and unfunded liabilities of public pension systems and retiree health plans have become a matter of increasing public concern in recent years. Estimates of the amount by which public pension plans are underfunded range as high as $3 Trillion, raising concerns about the ability of state and local governments to make good on their promises to workers and retirees while continuing to provide the level of services expected by taxpayers.

In The Economics of State and Local Public Pensions (NBER Working Paper 16792), researchers Jeffrey Brown , Robert Clark , and Joshua Rauh provide an economics-based perspective on the financial aspects of state and local pension plans in the U.S., drawing on work by numerous researchers for an NBER research program on this topic.

The vast majority of public sector workers are covered by employer-sponsored defined benefit (DB) pension plans and by retiree health insurance plans. The situation is markedly different in the private sector, where only 15% of non-unionized workers have DB plans and over one-third have no access to any retirement plan; access to retiree health insurance in the private sector is also rare. Public sector pensions tend to have higher benefits and lower retirement ages than private sector plans.

Compared to defined contribution (DC) plans, which are automatically fully funded, whether DB plans are fully funded is a matter of how much money has been put into the plan, how the plan's investments have fared, and what future benefits are expected to be. While virtually everyone agrees that public pension plans are underfunded, there is a surprising amount of disagreement about the size of the liabilities.

The main issue is the choice of the appropriate rate to use to discount future benefits back to the present. Most economists and finance scholars believe that the appropriate rate is one that reflects the risk of the cash flows being discounted and that this rate is in the range of 4 percent. Many plan administrators, policy makers, and labor unions, by contrast, prefer to use the expected rate of return on plan assets and suggest a rate of 7 to 9 percent. Using the (inappropriately) higher discount rate, unfunded liabilities are estimated to be only $800 Billion, versus $3 Trillion using the lower rate.

Whether full funding is optimal is in fact a matter of some dispute. Some scholars argue that each generation of taxpayers should pay the full cost of the public services it receives and worry that governments may give employees overly generous pensions in lieu of current wages in order to transfer the burden of paying for services on to future generations. But others point out that full funding could lead politicians to raise benefits when funding levels are high, ignoring the fact that they may not be able to reduce them when levels are lower. Still others, more provocatively, have suggested that under certain conditions, governments should not fund plans at all and instead pay for all retiree benefits out of current tax revenues.

There is also debate on the question of how public pension plans should invest their assets. While some suggest that an all-bond portfolio is most appropriate and would insulate plans from fluctuations in interest rates and equity markets, others argue for a portfolio with some equity holdings since pension liabilities depend on wage growth, which may be correlated with equity returns.

Although it is not clear exactly how much of a public pension plan's portfolio should be invested in equities, it appears that many plans are taking on too much risk - the typical portfolio has only one-quarter of its assets in fixed income securities and the remainder in equities and similarly risky investments. Evidence suggests that managers of public plans take more risk if their plan has recently performed poorly, if managers use a higher discount rate to calculate liabilities, and if the plan has more plan participants represented on its Board of Trustees.

The recent economic crisis has worsened the funding situation of many public pension plans, as a result of their heavy investment in equities. Yet portfolio allocation is far from the only cause of the problem - a history of failing to make sufficient annual contributions and of increasing benefits during good times have also helped to create the unfunded liabilities.

To solve their funding problems, state and local governments must either dedicate new revenue to their pension systems or cut benefits. However, a number of states appear to be constitutionally constrained in their ability to reduce benefits by a "non-impairment" clause. Even in states without such a clause, courts have interpreted employment contracts as providing pension protection, at least for benefits accrued to date. Some states have responded by creating a two-tier system with lower benefits for new employees, a move that may hurt their ability to recruit high-quality workers. However, studies suggest that even significant cuts in benefits will be insufficient to close the funding gap, suggesting that taxpayers will ultimately bear the brunt of legacy pension costs.