It’s been a long recovery for U.S. states and cities, thanks in no small part to the trillions in retirement-benefit debt weighing down their balance sheets. As the Obama administration has noted in each of the last three editions of its “Economic Report of the President,” public pension obligations relative to revenue are at a 50-year high. Costs have been rising more rapidly than revenues, crowding out space in government budgets that should be going to services.
But the problem is not simply overly generous benefits. Pension-cost volatility is also a function of governments’ heavy reliance on the stock market to fund long-term benefit promises. To stabilize budgets, debate over pension reform will have to focus on how benefits are financed, as well as how much is promised in the first place.
Pension-funding policy is a child of the bull market. Over the last 30 years, the amount of government pension-fund assets held in cash and (conservative) fixed-income investments has dropped, from around 80 percent to 25 percent.
Government portfolios pushed into riskier, higher-yield investments, such as stocks and hedge funds, as a way to keep benefits robust while minimizing the cost to employees and taxpayers. For a while, the strategy worked. At the peak of the dotcom bubble, many state and local pension funds were overfunded: assets on hand exceeded the amount of benefits promised, according to official government accounting standards.
But reliance on risky investments is not cost-free. Overfunding led many governments, most notoriously California, to increase benefits under the mistaken assumption that the good times would last forever. And, as a result of America’s two recent stock market collapses, states’ and cities’ pension expenditures rose from 2.3 percent to 4 percent of general revenues during 2002-2013. That gap represents nearly $50 billion in annual revenues that, instead of bolstering public safety, education and infrastructure, must go to backfilling pension obligations.
In a recent paper, I calculate that state and local workforces — which, in contrast to private workforces, have yet to return to their pre-recession peak — would now be about 200,000 larger had pension spending not risen relative to revenues since 2008, and would be 500,000 larger if they had not risen relative to revenues since 2002.
Many states and cities have learned to make do with fewer employees; but this is not a victory for efficiency. Taxpayers’ burdens are still high and, because of pension debt, the costs are largely for past services rendered: today, we are paying more and getting proportionately less in terms of services.
Pension expenditures have kept escalating during recent years of growth, too. Though 2015 was a decent year by most economic indicators, such as job growth, public pension-plan investments must return 7 percent to 8 percent to merely keep pace with funding schedules. In 2015, they didn’t — returns were mediocre — so, in 2016, budgetary appropriations are going up. In other words, public pension-funding policy needs the economy to have a great year, not simply a good one.
Unions and other defenders of the status quo correctly point out that, since the subprime-mortgage crisis, virtually every state has reduced benefits. One of the more curious features of public-pension management is that taxpayers’ bills have kept going up even while pensions have become less generous. This is because the recent wave of reforms mostly addressed benefits not yet earned and, in many cases, for employees not yet hired. Yet states’ and cities’ most immediate challenge is how to fund promises already made, not determining benefits for teachers who will retire in 40 years.
That localities like Atlantic City and departments such as the Chicago Public Schools are on the verge of insolvency at a time of economic expansion suggests that Detroit will not be the last American city to go bankrupt. When the next downturn hits, solvent governments will also see their pension costs spike to recoup investment losses.
No one likes volatility: not households, corporations or governments. But it is especially vexing for states and cities — which we rely on to provide services in bad times as well as good — to see pension spending balloon as revenues contract; indeed, demand for some services, such as the public safety net, rises when the stock market falls.
To minimize volatility to government budgets, minimize their exposure to the stock market. This is one reason why conservatives warn against relying on the income tax. It is also why the public is poorly served by current state and local governments’ pension-funding policy.
