State Governments: Big (Empty) Promises

Many states continue to bamboozle their citizens by obfuscating the true depth of their debt that is occurring in the form of unfunded liabilities. Those liabilities are mainly state public pension plans, and they continue to routinely promise pie-in-the-sky returns, even after years of bleak economic growth and investment.

A group called State Budget Solutions analyzes the problem of underfunding each year. Its annual report “reveals that state public pension plans are underfunded by $4.7 trillion, up from $4.1 trillion in 2013. Overall, the combined plans’ funded status has dipped three percentage points to 36%. Split among all Americans, the unfunded liability is over $15,000 per person.”

Many people might think, “I don’t work for my state government, so it doesn’t affect me”. It most certainly does. We are facing a generation of Baby Boomers who are getting ready to retire, and expect to have the pension that has been promised to them. Those promises are the unfunded liabilities which must be paid out. Pension costs come from state budgets — you and me — and in order to cover the costs, adjustments must be made. Expect tax increases and/or reduced government services in the coming years because a greater portion of the state budget will need to be dedicated to meeting these obligations.

How did we get here? The most damning factor is that of generous promises.

Ultimately, negotiators — be it union heads, lawmakers, or other bureaucrats — have had a fiduciary responsibility not to pay more than fair compensation, thereby restricting compensation and benefits to amounts no greater than what those skills would command in the private sector. Unfortunately, there are really no such competitive inhibitions in the public sector and therefore the negotiation routine lacks the incentive for restraint. In most cases, the self-interest of the public sector negotiator is more directly aligned with the leader that can get him elected rather than the taxpayer whom he is representing.

Lofty and mythical promises have been made for years now without a care about how it will be paid for — because the negotiator will likely be long gone when obligations come due. This is a true case of the fox in charge of the hen house. Thus runaway financial promises have deeply accumulated in state governments for which it cannot properly budget, while binding future governments not yet in office.

The Great Recession has made the problem more acute in recent years. “As the economy struggles to get back on track, states’ fiscal health also suffers, making it more difficult for state officials to make up for the shortfalls with greater contributions. As bond yields have suffered due to interest rates being held at historic lows, the fair market valuation of public pension liabilities also took a hit.”

Furthermore, most, if not all states, have hidden the vast problem by using accounting tricks — probably hoping the economy or investment will bounce back, or else just passing the buck year after year so it becomes someone else’s problem.

For instance, “state pension funds use a high discount rate. Discounting liabilities is a necessary part of fund management. Fund managers must assume that the current assets will be worth more in the future due to a number of factors, notably the return on investing those current assets. The problem arises because the discount rate is not based on the nature of the assets held by the pension plan, but is rather based on the assumed rate of return.”

The assumed rate of return: herein lies the problem. By continuing to perpetuate and promise rates of return of 5-8% for pensions, state governments show on paper that their liabilities are much smaller than they are. However, for years now, returns have been much closer to 2-3%. Yet state governments fail to make those realistic adjustments because it sounds neither glamorous nor generous to the employee.

What’s more, some states are facing such enormous financial pressures and shortfalls in all sectors of the state budget that they have reduced or skipped the yearly contribution to the pension funds altogether, thereby making the gulf that much wider. New Jersey balanced its budget (again) this year by reducing (again) the payment by $2.4 billion; Virginia skipped its payment back altogether in 2010 — although it did implement a repayment plan over subsequent 5 years to make up for that choice.

In fact, a cursory glance back at these practices reveal that the games have been ongoing for several years now. A Wall Street Journal article on this subject from Spring of 2010 — nearly 5 years ago — discusses how states were reducing and skipping payments and delaying the “day of reckoning”. New Jersey, California, and Illinois were some of the worse offenders then.

Is it any wonder that these three states are in the top ten for the amount of unfunded liabilities? California has the worst, $754 billion. In terms of funding ratios, Illinois leads the list with only 22% of its obligations funded. You can look at the full and various lists here.

The crisis will only continue to worsen unless changes are made. The outlook is gloomy for state governments and, based on past performance, is not likely to get better anytime soon. For most states, the “kick the can” approach allows them to coast while the liabilities fester, letting it become the problem of other future governments at some undefined point in the future. That is reprehensible.