The impact of employee pension promises on state and local public finance.

• Author: Rauh, Joshua
• Position: Research Summaries

Most U.S. state and local governments face legal restrictions on the extent to which they can run deficits and issue debt. However, like the U.S. federal government, state and local governments have substantial off-balance-sheet liabilities in the form of pension promises. At the state and local level, these liabilities arise primarily from defined benefit (DB) pension promises made to government employees, including teachers, public safety officials, and other employees of states, cities, and counties. An underfunded pension promise can be thought of as an alternative form of government debt: the government is borrowing from public employees through promises to pay them pensions when they retire.

Robert Novy-Marx and I have written a series of papers in which we investigate the issues in public finance and financial markets that have arisen as a result of this substantial form of off-balance-sheet borrowing at the state and local level. These papers focus on measuring the present value of public pension promises, examining the potential effects of different policy measures on the value of pension promises, and asking whether municipal bond markets have reacted to unfunded pension liabilities. This line of inquiry is related to my previous work on corporate defined benefit pension plans and the issues they pose for firms' investment and capital structure decisions.

What is the Present Value of Public Pension Promises ?

Most U.S. state governments offer their employees DB pension plans. This arrangement contrasts with the defined contribution (DC) plans that now prevail outside the public sector, such as 401(k) or 403(b) plans in which employees save for their own retirement and manage their own investments. In a DB plan, the employer promises the employee an annual payment that begins when the employee retires, and that payment depends on the employee's age, tenure, and late-career salary.

When a state government promises a future payment to a worker, it creates a financial liability for its taxpayers. When the worker retires, the state must make the benefit payments. To prepare for this, states typically contribute to and manage their own pension funds, pools of money dedicated to providing retirement benefits to state employees. If these pools do not have sufficient funds when the worker retires, then the states will have to raise taxes or cut spending at that time, or default on their obligations to retired employees.

State governments have approximately $2 trillion set aside in pension funds. Yet we do not know how the value of these assets compares to the present value of states' pension liabilities. Just as future Social Security and Medicare liabilities do not appear in the headline numbers of the U.S. federal debt, the financial liability from underfunded public pensions does not appear in the headline numbers of state debt. If pensions are underfunded, then the gap between pension assets and liabilities is off-balancesheet government debt.

In fact, government accounting standards require states to use procedures that severely understate their liabilities. (1) In particular, government accounting standards require states to discount their liabilities at the expected return on their assets. In practice, this usually amounts to discounting pension liabilities at an approximately 8 percent rate. The government pension accounting approach also presents analytical problems: the magnitude of pension liabilities, and how a pension's funds are invested, are two separate issues to be considered independently. In practice, however, the accounting standard being used sets up a false equivalence between pension payments, which are...