SARVIS THE HIGH COST OF BIG LABOR Understanding Public Pension Debt UNDERSTANDING PUBLIC PENSION DEBT PENSION PUBLIC UNDERSTANDING A State-by-State Comparison The Competitive Enterprise Institute promotes the institutions of liberty and works to remove government-created barriers to economic freedom, innovation, and prosperity through timely analysis, effective advocacy, inclusive coalition- building, and strategic litigation. COMPETITIVE ENTERPRISE INSTITUTE 1899 L Street NW, 12th Floor Washington, DC 20036 202-331-1010 cei.org ROBERT SARVIS CEI THE HIGH COST OF BIG LABOR Understanding Public Pension Debt A State-by-State Comparison by Robert Sarvis The Competitive Enterprise Institute’s The High Cost of Big Labor series analyzes and compares the economic impact of labor policies on the states, including right to work and public sector collective bargaining laws. 2 Understanding Public Pension Debt Executive Summary TATE GOVERNMENT PENSION DEBT too high. This affects the valuation of liabilities burdens labor markets and worsens the and the level of governments’ contributions into Sbusiness climate. To get a clear picture of their pension funds. the extent of this effect around the nation, this Today, defined benefit plans are more prev- paper amalgamates several estimates of states’ alent in the public sector than in the private pension debts and ranks them from best to sector, where employers have moved toward worst. defined contribution plans, such as 401(k) ac- Today, many states face budget crunches due counts. In defined benefit plans, states are on to massive pension debts that have accumulated the hook for payouts regardless of their pen- over the past two decades, often in the billions sions’ funding level. Therefore, the discount of dollars. There are several reasons for this. rate used in the valuation of pension liabilities One reason is legal. In many states, pen- should be a low-risk rate, because of the fixed sion payments have stronger legal protections nature of pension liabilities. Ideally, this should than other kinds of debt. This has made reform as low as the rate of return on 10- to 20-year extremely difficult, as government employee Treasury bonds, which is in the 3 to 4 percent unions can sue to block any scaling back of gen- range. erous pension packages. However, in the U.S., most state and local Then there is the politics. For years, govern- governments use discount rates based on much ment employee unions have effectively opposed higher investment return projections, usually of efforts to control the costs of generous pension 7 to 8 percent a year. This usually leads to state benefits. Meanwhile, politicians who rely on and local governments making lower contribu- government unions for electoral support have tions, in the expectation of high investment re- been reluctant to pursue reform, as they find it turns making up for the gap. However, while much easier to pass the bill to future genera- such returns may be achievable at some times, tions than to anger their union allies. they need to be achievable year-on-year in order Another contributing factor has been math— for a pension fund to meet its payout obliga- or rather, bad math. For years, state govern- tions, which grow without interruption. There- ments have understated the underfunding of fore, failing to achieve such high returns can re- their pensions through the use of dubious ac- sult in pension underfunding that extends into counting methods. This involves using a dis- the future. Discount rates based on high return count rate—the interest rate used to determine projections also incentivize pension fund man- the present value of future cash flows—that is agers to seek higher returns. This encourages in- Competitive Enterprise Institute 3 vesting in riskier assets, which incur large losses to such a state—understand that the piper will for investors when they go south. have to be paid eventually. Without significant For years, this practice was validated by the reform, these debts will adversely affect their quasi-private Government Accounting Stan- business through higher taxes, fewer basic gov- dards Board (GASB). To improve accounting, ernment services, or both. GASB recently introduced new standards that Because locating or relocating a business is have pensions deemed underfunded—those an expensive proposition filled with upheaval, with a funding level of under 80 percent—use businesses are giving careful consideration to a lower discount rate. However, pension plans which jurisdictions they decide to call home. deemed to be above 80 percent funded will The rankings of state pension debt in this pa- still be able to use a high discount rate. Thus, per will help inform businesses of the quality of the new GASB standards do not go nearly far their options. They also should prompt GASB enough to end the dubious accounting practices to revisit its accounting standards and state law- that have exacerbated state pension underfund- makers and citizens to work to improve their ing by hiding its extent. states’ situation. Individuals and businesses in states with un- derfunded pensions—or considering a move —Aloysius Hogan 4 Understanding Public Pension Debt Introduction STATE GOVERNMENT’S FISCAL are severely underfunded, tax rates may need health affects the business climate and to be raised and government services curtailed Alabor markets within each state, as in order to meet future payment obligations. strained budgets or excess debt foretell possible Therefore, private businesses choosing where increased tax burdens and lower quality gov- to locate, and individuals choosing where to ernment services. The financial status of public live and work, are wise to consider not only the pension programs is an important factor deter- current policy climate of prospective states, but mining governments’ fiscal health, and may at- also the risk of policy changes made necessary test to the quality of a state’s fiscal administra- by looming budgetary concerns like the need to tion more broadly. If public pension programs increase funding of public pensions.1 Competitive Enterprise Institute 5 Economic Activity and Expectations of Future Changes in Public Policy AXES INFLUENCE THE ECONOMIC neighboring states, and its ultimate choice may decisions of individuals and businesses in be motivated in part by considerations of the a variety of ways. When tax levels rise, business climate, including tax and regulatory T 3 individuals and businesses increasingly act in issues. This is true of individuals as well. ways to reduce their tax burden, as some op- It is not just current tax burdens that mat- portunities for mutually profitable transactions ter. Moving a business or a household can be become unprofitable. Some businesses grow less costly, as can altering one’s business practices quickly, move elsewhere, or are not founded. or expenditures in light of policy changes. So Expenditures or investments are not made. New location and other business decisions, as well as jobs are not created. These effects reduce the ef- individuals’ residential choices, also depend on ficiency of markets and result in a loss of wealth expectations of future changes in tax burdens to both businesses and individuals. Moreover, and government-provided services. Govern- the loss of efficiency and wealth generally accel- ment debt can be a major driver of such expec- erates as tax rates go up. tations—the larger the debt, the more likely it is Many firms take into account tax burdens that significant policy changes will take place. when determining where and how to do busi- Given how difficult it is to reduce benefits to ness, and many individuals do likewise when politically influential constituencies, it is reason- choosing where to live, how hard to work, and able to assume that unfunded obligations for what things to buy. The evidence for this is com- future benefit payments to those constituencies pelling. Over the last 30 years, numerous stud- will be met, at least in part, by increased taxes ies using a variety of data sets and methodolo- and decreased government services. The larger gies have shown the relevance of tax burdens the debt, the larger the potential tax increases— to business decision-making and migration of and the greater the behavioral responses to people.2 them. This may be especially true where neighbor- But don’t the vast majority of states have ing states have substantially different regimes. constitutional balanced-budget requirements, A business looking to relocate to, or remain keeping the states from getting into debt prob- within, a given region may have a choice among lems? It is not that simple. 6 Understanding Public Pension Debt How Pension Plans Work OST STATE AND LOCAL SPEND- ing is funded by same-year revenue. Defined benefit public pension MTaxes, fees, federal grants, and other programs create legal obligations revenue sources have grown along with expen- to pay future benefits, and the ditures, keeping budgets in balance. And states way governments account for generally hold enough assets to offset explicit these future liabilities enables debt obligations. But defined benefit (DB) pub- them to implicitly take on debt by lic pension programs create legal obligations to underfunding pension programs pay future benefits, and the way governments account for these future liabilities enables them without appearing to do so. to implicitly take on debt by underfunding pen- sion programs without appearing to do so. A public pension program, at its simplest, employee is entitled to receive in retirement ac- entitles qualifying public employees to a stream cording to a formula. The funding of the plan, of income after they retire. Qualification re- including gains from investment of plan assets, quirements, retirement age, payout levels, and must be sufficient to meet the payment obliga- myriad other considerations all depend on the tions in future periods; otherwise, the plan is at specific plan details, but most public pension risk of becoming insolvent at some point in the plans generally have the same basic structure— future.