The National Association of State Retirement Administrators released an update to their publication “State and Local Government Spending on Public Employee Retirement Systems,” which concludes that “pensions on average do not comprise a significant portion of state and local spending.” Overall, state and local governments dedicated just 4.1% of their spending to pension contributions in 2013. The reality, though, is that if state and local governments were truly fully funding their pensions – that is, merely following the rules that the federal government requires for corporate pensions – their annual contributions would make up over 20% of total state and local government spending. Pension funding costs for state and local governments are seemingly low for one reason: They’re not fully funding their pensions.
NASRA’s reported cost for state and local pension funding of 4.1% of total government spending sounds affordable. Yet we can rebut that belief right off the bat: If pension contributions were affordable, every government would be able to make them. But they’re not. In 2013, only 41% of state and local pensions received their full contribution. Total contributions were equal to about 88% of what was required under GASB accounting rules. (I pulled these figures from my 2015 AEI study on public sector pension funding.) So right off the bat, to meet the full annual contributions calculated under Governmental Accounting Standards Board (GASB) rules, that 4.1% figure cited by NASRA should rise to 4.7%.
But it’s worse. Even “full funding” for state and local pensions based on GASB rules is far less than pretty much any other pension plan would be required to pay. If state and local plans operated under corporate pension funding rules, or the rules that are applied to public employee pensions in countries like Canada, the Netherlands or the United Kingdom, they’d be paying more. A lot more.
To illustrate, I’ll recalculate their state and local pension contributions using the rules the federal government requires private sector pensions to follow. Contribution rules for public and private pensions differ in two main respects: First, corporate pensions must use a lower interest rate to discount, or value, their benefit liabilities. State and local plans value their liabilities using an average discount rate of 7.7%, based on their increasingly-risky portfolios of bonds, stocks and “alternative investments.” Private pensions must value their liabilities using a corporate bond yield of about 3.8%, which reflects the fact that both pensions and bonds reflect a promise by the corporation to pay a given amount at a given future time.
Corporate pensions also must amortize, or repay, more quickly, usually in seven years versus the 30 years that’s common among state and local pensions. This increases costs in the short term, but ensures that an underfunded plan returns to full-funding more quickly. That’s something public sector plans are having a real problem with: They’re barely better funded today than during the depths of the Great Recession.
If state and local pension plans based their contributions on corporate pension rules, how much wold they have to pay? About four times as much. I found that, using corporate pension rules for valuing liabilities and amortizing unfunded liabilities, the average state and local pension contribution would rise from 24% of employee wages to 105%. That’s how big and expensive these plans are. As a percentage of budgets, pension contributions would rise from 4.1% to 20.4%. When you consider that 4.1% is as much as state and local governments can currently afford – again, even under lenient GASB accounting rules governments should be paying more – that’s pretty worrying.
State and local governments argue that they should operate under much more lenient funding rules because, supposedly unlike corporations, governments can’t go out of business. Obviously that’s no longer true. (Cough, Detroit. Puerto Rico. Chicago?) There's a reason corporate pensions have strict funding rules: because in the past, corporations didn't fully fund their pensions and then, when something bad happened, there wasn't enough money to pay retirees all their benefits. Does that sound familiar? So the “governments can’t go out of business” argument just doesn’t fly.
But even if state and local governments' claims were correct, that doesn’t justify government plans using loose assumptions. Public sector pensions operate under a principle of “intergenerational equity,” which means that the government should fully pay for employee’s pension benefits as they are accrued and not pass those costs on to future generations of taxpayers. But when a government low-balls its contributions by assuming high rates of return on risky investments and then amortizes investment losses over 30 years, it’s doing nothing other than making future taxpayers fund the pension benefits that current taxpayers should have paid for.
Economists almost unanimously believe that the accounting rules used by state and local pensions “understate their pension liabilities and the costs of providing pensions to public-sector workers.” So the reason pension contributions are seemingly low, at just 4.1% of state and local budgets, is quite simply that these governments aren’t fully funding their pensions.
State and local governments don’t want to fully fund their pensions, since doing so would further displace all the other things that state and local governments are there to do. In any case, state and local governments can’t fully fund their pensions: They aren’t even making the contributions required under GASB rules, which are a fraction of what true “full funding” of a pension plan would require. When a government should be devoting over one-fifth of its revenues to public employee pension funding but is actually contributing just one-twenty-fifth, that’s worrying.
