By the Editor
The coronavirus shutdowns have wreaked havoc across our economy. State and local governments have seen their finances badly damaged and are pleading for federal aid. Tax receipts are down significantly due to business closures and there are extra health care costs, so a case can be made for federal rescue funding.
But federal aid should not become a bailout for irresponsible fiscal practices that have been going on in some states for a long time. Doing so would only enable more bad behavior and would be grossly unfair to the states that have made tough budgeting decisions.
One of the most serious problems is underfunded public pensions. The issue varies by state. According to a recent report from the Hoover Institution, South Dakota reported that its public pensions are 100% funded while Illinois calculated its public pensions are less than 50% funded.
Many states regularly fail to set aside enough money each year to fund future pension benefits. Making matters worse, public pension plans use unrealistic assumptions about expected investment returns and the discount rate used to calculate the value of future liabilities in today’s dollars. Because these pensions are defined benefit plans paid over long periods of time, these assumptions can have a huge impact on correctly calculating the net present value of pension liabilities. Currently, public pension plans are using assumptions that are far too aggressive, badly understating their true pension liabilities.
Private pensions, on the other hand, are required to use more realistic assumptions to value their liabilities, putting those plans on sounder footing. According to a recent analysis by the American Legislative Exchange Council, if state pension plans had to use the same assumptions used by private defined benefit plans, public pensions in 32 states would be less than 80% funded, a level private plans must exceed to avoid being considered at risk of default.
The bottom line is that state and local governments with large unfunded pension liabilities have demonstrated they can’t be trusted to properly manage their defined benefit plans.
In return for federal aid, state and local pension funds should be required to transition to defined contribution plans for future pension benefits, with an option to leave pre-existing pension promises in place. Defined contribution plans eliminate the need to make assumptions about investment returns and discount rates because once a pension contribution is made, the plan sponsor has satisfied its obligations. The vast majority of private employees have already been transitioned to defined contribution plans for these reasons.
Local governments should be required to fully fund their annual pension obligations, eliminating the temptation to defer pension funding requirements to future taxpayers.
In some states, changes to public pensions are restricted by laws. There are even seven examples where such constraints are included in state constitutions. As a condition for receiving federal aid, states should be required to amend their laws to permit pension reforms. Making such amendments a prerequisite for aid would provide a helpful incentive for reform that would ultimately benefit the taxpayers in those states.
Finally, state and local pension plans should be required to enhance their disclosures. A lack of transparency has made it difficult for taxpayers to fully understand the scope of the problems in public pensions. In exchange for federal aid, states should agree to provide public disclosures regarding their pensions, including all assumptions used in calculating the unfunded liabilities and actual and projected individual pension payouts by quartile.
State and local governments might be tempted to backtrack on pension reforms. To guard against this risk, federal aid should be provided in the form of loans. These could be low-interest rate loans with very long maturities of 50 to 100 years, so there would not be meaningful cash flow requirements for a very long time. The loan structure should include covenants requiring continued adherence to these reforms. The federal government could also require some collateral to secure the loans, such as office buildings or parking lots, to further ensure compliance.
There should be no federal aid to states with unfunded public pension liabilities unless they agree to implement common-sense reforms, including transitioning to defined contribution plans and full disclosure of pension fund information.
Providing federal bailouts to profligate states without requiring reforms to prevent the same problems from occurring in the future would be a dangerous mistake, akin to enabling a junkie by providing addictive drugs. It would also be an insult to other states that have made sacrifices to live within their means. It’s time for some tough love.