Risky Public Pension Plans Unsafe for Taxpayers, Bad for Business Growth

In new analysis published by the Competitive Enterprise Institute, economist Robert Sarvis ranks states based on the severity of their unfunded pension liabilities and explains how these pension programs could hurt taxpayers and devastate state economies.

According to Sarvis’s ranking, which averages the results of six different state pension studies, the states in the worst shape include New Mexico, Illinois, and Mississippi, when looking at the amount of pension underfunding compared to the size of the state’s economy. The rest of the top ten states that are struggling are Kentucky, Ohio, Hawaii, New Jersey, Alaska, Connecticut, and Montana.

In many cases, state pension shortfalls are worse than they appear because of dodgy accounting methods. To determine future levels of funding, state governments use discount rates to determine how much they need to contribute into their pension funds, with the balance to be made up with returns on investments by the pension funds.

The problem is that many states use discount rates based on overly optimistic investment return projections, usually in the 7 to 8 percent per year. While investments can make such rates of return, those need to be made year-on-year to keep up with liabilities, which grow without interruption. In many states, governments are under legal obligation to pay future benefits, thus implicitly causing them to take on debt. Using a high discount rate means that when pension investments go south, states—and therefore taxpayers—are stuck with the bill.

In addition to posing a risk to taxpayers, underfunded public pensions programs deter business growth because pension shortfalls often have to be covered by increased tax revenue, and businesses are less likely to invest in states with high tax rates. Furthermore, underfunded pensions can prod states into diverting resources from other public services, leading to inefficiency in the performance of those services. Despite these adverse effects of ignoring the pension underfunding problem, government employee unions consistently and fiercely oppose attempts to control pension costs. And the strong legal protections for public pensions enable these unions to sue anyone who attempts to scale back their members’ pensions.

States seeking job growth and business investment need to get their pension liabilities under control. This is not an easy task, and it will carry costs, but it will be far costlier to do nothing. When pursuing reforms, state lawmakers should be wary of the claims made by government unions, as their interests lie with spending more government money rather than shoring state finances. This is hardly fair to states’ taxpayers and nonunion workers, who don’t receive the same generous compensation to alleviate the cost of higher taxes.

Therefore, state legislators should move to defined contribution pension plans instead of defined benefits pension plans, which are far more risky. Also, given the fixed nature of pension liabilities, pension fund managers should use a risk-free rate, such as that for 15- to 20-year Treasury bonds, in the 3 to 4 percent range.