Public Corruption and Pension Underfunding in the American States

• Author: Cheol Liu,Tima T. Moldogaziev,John Mikesell
• Published date: 01 August 2021
• Date: 01 August 2021
• DOI: http://doi.org/10.1177/0275074021992891
• Subject Matter: Articles

https://doi.org/10.1177/0275074021992891

American Review of Public Administration

2021, Vol. 51(6) 449 –466

© The Author(s) 2021

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DOI: 10.1177/0275074021992891

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Article

Introduction

Unfunded public pension obligations represent a great

challenge for state and local government policy makers. The

funding gaps in several states remain substantial, and if

unaddressed, they have a great potential to cause fiscal dis-

ruption. By 2016, assets as a percentage of plan liabilities

(the amount the plan needs to cover the cost of earned

employee benefits) were expected to be at below 50% in

Colorado, Connecticut, Illinois, Kentucky, and New Jersey,

whereas 17 more states had less than two thirds of estimated

funds necessary to cover future liabilities. Even with eco-

nomic recovery post-Great Recession, the Pew Charitable

Trust estimated that the net funding gap for the American

state pension systems was almost US$1.24 trillion by 2018

(PEW, 2018). To put that aggregate sum in a context, the

funding gap equals to almost 40% of total revenues that state

and local governments collected in the same year. This means

that, if corrective policies are not taken early, several pension

funds are likely to face an unsolvable fiscal challenge. As

employees seek to retire, insufficient levels of fund accumu-

lation may mean that state governments must face the choice

of whether to fulfill pension liabilities, reduce spending for

current services, increase taxes, or adopt some combination

of all these options—all the while subject to existing fiscal,

legal, political, and demographic constraints.

The problem is largely with regard to “defined benefit”

liabilities, which remain the most common pension option

for public employees even after years of reforms (Ali &

Frank, 2018; Chen, 2018; Frank et al., 2012). In these pro-

grams, an employee is guaranteed a monthly pension benefit

that is based on some formula—for instance, involving a

number of years employed, salary at retirement, cost-of- living

adjustments, and so on (Chen, 2018)—and not necessarily

on the amount of funds that has been set aside for that par-

ticular employee. The logic of the system is that sufficient

annual contributions from an employee and their employer

will be deposited in a retirement fund at certain intervals,

which will then be invested to protect the time value of

money, and the benefits are paid out at certain intervals to

employees upon retirement.

When funds are insufficient, any shortfall must often be

met from general government funds, generated by higher

taxes, reduced spending for public services, or both (e.g.,

Rhode Island, New Jersey, California). In short, underfund-

ing can and does place the extra cost of pension benefits on

the citizens through a combination of taxes, spending cuts,

and even debt financing expenses (e.g., pension obligation

992891ARPXXX10.1177/0275074021992891The American Review of Public AdministrationLiu et al.

research-article2021

1KDI School of Public Policy and Management, Sejong, Republic of Korea

2Indiana University, Bloomington, USA

3The Pennsylvania State University, University Park, USA

Corresponding Author:

Cheol Liu, KDI School of Public Policy and Management, 263 Namsejong-

ro Sejong-si (S445), Sejong 30149, Republic of Korea.

Email: cliu@kdischool.ac.kr

Public Corruption and Pension

Underfunding in the American States

Cheol Liu1, John Mikesell2, and Tima T. Moldogaziev3

Abstract

Unfunded public pension obligations represent a great challenge for policy makers in the American states. We posit that

a part of pension underfunding relates to the level of public corruption. Empirical findings in the article show that funding

ratios in public pension funds are inversely related to the incidence levels of corruption in the state, with other fiscal,

political, and institutional covariates held constant. We show that this can happen through higher pension benefits, lower

actuarially required contributions (ARCs), lower percentage of actual ARC contributions, and poorer investment outcomes.

Based on empirical estimates, we find that a reduction of corruption by one standard deviation around the mean would

permit the states to save on pension benefits by 10.24% annually (or US$1,894.64 per recipient), increase required ARC by

4.40%, increase actual ARC contributions by 8.46%, and improve investment returns by 4.72%. Therefore, policies to reduce

public-sector corruption, or to improve the insulation of pension funds in relatively more corrupt environments, can make a

significant contribution toward tackling the public pension underfunding crisis in the American states.

Keywords

public corruption, public pension underfunding, US states’ fiscal health

450 American Review of Public Administration 51(6)

debt). As a Wall Street Journal article summed it up, “Their

obligations to beneficiaries are ironclad and, in many cases,

constitutionally guaranteed, but what they happen to put on

paper depends on projections they decide themselves”

(Jakab, 2019). And the government may not even do what it

is expected or has promised to do. Consequently, underfund-

ing is a product of misappropriated contributions, unscrupu-

lous selection of pension fund management practices, and

non-risk-return-based criteria for fund investments. This can

happen when an environment of public corruption permits

some public managers to respond to sweetheart contracts,

bribes, kickbacks, in addition to a short-sighted desire to

spend on current services rather than covering future retire-

ment benefits.

The implications of public pension underfunding on pub-

lic finances are important. First, public pension debt has been

a major contributing factor in the rare but notable bankrupt-

cies and fiscal crises of state and local governments in the

United States, including Vallejo, CA; Detroit, MI; or Central

Falls, RI, as well as Puerto Rico and the State of Illinois

(Bonilla & Boglio-Martínez, 2010; Dabrowski & Klingner,

2016; Thornburg et al., 2017; Weingarden, 2014). Second,

public pension underfunding relates to credit ratings and

borrowing costs to state and local governments (Liu &

Moldogaziev, 2018; Marks et al., 1988; Martell et al., 2013;

Moldogaziev et al., 2017; Novy-Marx & Rauh, 2011). Third,

pension underfunding, by shifting a portion of the present

cost liabilities of public employment to the future, hides and

understates the true cost of current government services

(Rich & Zhang, 2014). Thus, pension underfunding both

generates fiscal illusion and leads to interperiod inequity by

shifting current costs to future taxpayers (Giertz & Papke,

2007; Stalebrink, 2014).

How did state pension finances get so bad? Existing stud-

ies offer evidence of a mix of factors—generously defined

pension benefit promises, poor actuarial estimates of retiree

behavior and longevity, manipulations of accounting prac-

tices, excessive estimates of what pension fund balances

could earn, and failure to make the necessary annual pay-

ments into the pension fund to support future benefits (Chen,

2018; Chen et al., 2015; Coggburn & Kearney, 2010; Novy-

Marx & Rauh, 2011; Stalebrink, 2014). Because these fac-

tors may be manipulated by public officials for institutional

and for private financial gain, it is useful to consider whether

contexts with public corruption are at play and, hence,

potentially exacerbate the underfunding of state pension

plans (Andonov et al., 2018; H. Zhang et al., 2017).

Corruption in public-sector studies is generally defined as

misuse of public office by both private institutional- and

individual-level interests (Beeri & Navot, 2013). Liu (2017)

summarizes the extensive literature on the causes, conse-

quences, and cures of public-sector corruption and we direct

the reader toward this work for further details. With regard to

our study, there is episodic legal evidence of the relationship

between public-sector corruption and pension funding in the

American states. The U.S. Department of Justice (DOJ)

reports that a number of corruption cases under review are

related to factors that are known to contribute to underfund-

ing of public pensions. Most are so called “pay-to-play”

schemes in which a potential contractor pays a bribe to pro-

vide services to a pension fund (investment management,

actuarial estimations, etc.). Rather than picking the best pro-

vider, the fund may pick from providers that offer attractive

bribes.

Recent documented public pension corruption cases

include bribery and fraud schemes of the New York State

Common Retirement Fund (NYSCRF) in 2017, the California

Public Employees’ Retirement System (CalPERS) in 2015,

and the NYSCRF in 2005 (Raymond & Ingram, 2016). In

Maryland, the state pension system continued contracts with

a management firm, which allegedly had a strong tie with the

governor. The state continued to pay management fees that

were 2 to 3 times greater than other similar firms were charg-

ing, despite working with a management firm that was con-

sistently one of the fund’s worst investment performers. The

pension system and the said management firm were accused

and convicted of fraud. The U.S. Attorney Preet Bharara

stated at the time that such “age-old and classic tale of quid-

pro-quo” was persistent in public pension fund management

practices (Raymond & Ingram, 2016). Our research adds to

the literature by investigating the extent to which public cor-

ruption relates to pension finances in the American states in

a systematic manner.

Corruption, Public Finances, and

Financial Risks

Two strands of literature merge in this analysis of the rela-

tionship between public-sector corruption and public pen-

sion underfunding. The first is a literature on how public

corruption affects many aspects of state and local govern-

ment finances and financial risk exposures (Bayoumi et al.,

1995; Beckett-Camarata & Grizzle, 2014; Butler et al., 2009;

Denison & Gibson, 2013; Depken & LaFountain, 2006;

Moldogaziev et al., 2017; Retnasaba, 2006). Overall, a

review of empirical evidence suggests that public corruption

has a substantial adverse impact on government spending,

resource allocation decisions, public debt expansion and

pricing, and tax structure and, in rare cases, can drive local

governments toward bankruptcy (Beckett-Camarata &

Grizzle, 2014; Denison & Gibson, 2013).

Corruption in this strand of research appears to manifest

itself through two channels, controlling for key political and

governance factors. The first one is a direct link between

individual acts of crime and fiscal malperformance, although

as Johnson et al. (2011) write, not all corruption scandals—

such as Illinois Governor Blagojevich’s case or the corrup-

tion among New Jersey city mayors—necessarily make it

into academic journals. As an exception, Denison and Gibson

(2013) evaluated the Chapter 9 bankruptcy filing of Jefferson