The multiplying risks of public employee pensions to state and local government budgets

Reuters

Detroit city workers and retirees carry signs protesting against cuts in their city pensions during a protest against the city's municipal bankruptcy filing, outside the Federal courthouse in Detroit, Michigan October 23, 2013.

Article Highlights

  • Pension risks to government budgets have multiplied by a factor of 10 over last 4 decades.

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  • Pension assets have nearly tripled to 143 percent of government outlays.

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  • More modest benefits and increased risk sharing could reduce pensions' risks to government budgets.

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State and local government pensions tout their ability to couple generous, guaranteed benefits for public employees with low and stable contributions from taxpayers. In reality, the risks that public pensions pose to taxpayers and government budgets have multiplied by a factor of 10 over the past four decades. While elected officials—including a number of Democratic mayors—are pushing for reforms, even they may not be aware of how much pension risk government budgets are truly bearing.

State and local governments contribute to public employee pension plans on the expectation that they will receive high and steady returns on the plans’ investments. Public plans generally assume annual returns of around 8 percent and calculate their required contributions on the assumption that they will receive these returns going forward.[1]

But pension investments are risky. If actual returns fall short of the assumed rate, the sponsor must make larger catch-up contributions in future years. These catch-up contributions—referred to as amortization payments, as they pay off unfunded liabilities generated when investment returns fall short—increase pensions’ burden on government budgets. This is particularly true because investment returns tend to be correlated with the state of the economy. This means that a plan often will need to increase its pension contributions in bad economic times, precisely when tax revenues are lowest and the call on tax revenues for other purposes are greatest.

If contributions rise too high, governments may even skip making them. This alleviates the immediate budgetary burden but obviously only worsens the problem for the future. This is especially problematic because the future payments must also include interest at the 8 percent rate that plans assume for their investments. Public plans have seen both higher required contributions and skipped payments over the past decade.

What many elected officials do not understand is how much these risks have grown.

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About the Author

 

Andrew G.
Biggs
  • Andrew G. Biggs is a resident scholar at the American Enterprise Institute (AEI), where he studies Social Security reform, state and local government pensions, and public sector pay and benefits.

    Before joining AEI, Biggs was the principal deputy commissioner of the Social Security Administration (SSA), where he oversaw SSA’s policy research efforts. In 2005, as an associate director of the White House National Economic Council, he worked on Social Security reform. In 2001, he joined the staff of the President's Commission to Strengthen Social Security. Biggs has been interviewed on radio and television as an expert on retirement issues and on public vs. private sector compensation. He has published widely in academic publications as well as in daily newspapers such as The New York Times, The Wall Street Journal, and The Washington Post. He has also testified before Congress on numerous occasions. In 2013, the Society of Actuaries appointed Biggs co-vice chair of a blue ribbon panel tasked with analyzing the causes of underfunding in public pension plans and how governments can securely fund plans in the future.

    Biggs holds a bachelor’s degree from Queen's University Belfast in Northern Ireland, master’s degrees from Cambridge University and the University of London, and a Ph.D. from the London School of Economics.

  • Phone: 202-862-5841
    Email: andrew.biggs@aei.org
  • Assistant Info

    Name: Kelly Funderburk
    Phone: 202-862-5920
    Email: kelly.funderburk@aei.org

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