By BOB MARTIN
There is a crisis growing in state, municipal, and local budgets; among all states, unfunded pension liabilities total $3.8 trillion (Rauh, 2017), while their reported outstanding debt is $1.1 trillion. Further, at the federal level, Medicaid, Medicare and Social Security’s unfunded liabilities total $127 trillion, coupled with $20 trillion in outstanding federal debt.
You can see the consequences of this kind of debt load by following Puerto Rico’s bankruptcy and the looming crisis in Illinois’ budget.
In a defined benefits program, unfunded liabilities are created when 1) politicians add beneficiaries who do not contribute their fair share to the fund, 2) the government does not make the required contributions to the fund, and/or 3) the government does not accurately estimate benefit costs.
The government is not guaranteeing benefits in defined contribution plans. They just promise to match part of the beneficiary’s contribution to a third party who manages the investments. Since someone else is managing the fund, the government cannot add a beneficiary to someone’s pension nor can they fail to make their contractual contribution or borrow from the fund.
The unfunded liabilities can only be paid for by some combination of faster economic growth, an increase in taxes, more borrowing, the sale of assets, or a dramatic cut in current spending. Unfortunately, lenders may refuse to lend and an increase in taxes will slow economic growth. It is not going to be easy to fix this problem.
Kentucky has the worst unfunded pension problem of all 50 states and it ranks third in pension liabilities as a percent of revenues. Finally, previous legislators bound the current legislature with guarantees that may prevent reform. I’m sure it seemed like a good idea at the time but in the end, it may wreck the state’s economy.
Suppose the state follows “best practices” with respect to their defined benefits pension programs; they may still have unfunded pension liabilities when they fail to properly anticipate the actual costs of the benefits they promised.
The problem is the state is guaranteeing a specific outcome for their employees’ retirement. They can make an educated guess about future costs, but no one knows for sure what those costs will be. The states always have an incentive to underestimate the cost since to do so means less money is withdrawn from state revenues for pensions. Hence, the states will systematically underestimate the cost and liabilities will be underfunded.
The same principles are involved in the unfunded liabilities faced by the federal government: the government makes promises in the form of entitlements and then does not properly fund those obligations. Since the obligations are unfunded, the debt gets passed on to future taxpayers and our children and grandchildren must pick up the tab.
Europe has similar unfunded pension liabilities and their obligations will be coming due at the same time as ours. What will happen as we try to refinance our unfunded liabilities?
Since the federal government has its own debt problems, it cannot act as “lender of last-resort” in this situation. Furthermore, the Fed’s balance sheet is a wreck and it will be of little help.
The governor and the legislature promise current retirees and those close to retirement will have their benefits preserved. It will be important for the state to start the transition to defined contributions retirement by enrolling new hires in defined contributions programs; however, they must make it clear to new hires that their contributions cannot be mixed with the existing retirement funds. The existing retirement funds must be brought up to date with new revenues.
Bob Martin is Emeritus Boles Professor of Economics at Centre College.