This is Dominic Pino filling in for Jim Geraghty.
On the menu today: Depending on which estimate you use, state governments’ unfunded pension liabilities are anywhere between $1.35 trillion and $6.96 trillion. When a crisis happens, Republicans at the national level must stand up for taxpayers and refuse to create moral hazard by bailing out failing state pension funds. The best time to make that commitment is now, before such a crisis occurs.
Why State Pensions Are in Trouble
Defined-benefit pensions are a thing of the past for most American workers, if they ever had them, yet they persist for many government employees. Today, the defined-contribution model is more common for the private sector. A 401(k) account is defined-contribution.
Defined-benefit means that retirees get a promised payout no matter how the fund performs or how much they contributed. Defined-contribution means employees contribute a proportion of their pay into their own account, matched in part or in whole by their employer, that will pay varying amounts in retirement depending on how well it performs and how much they contribute.
One of the reasons defined-benefit pensions went away is that the federal government passed the Employee Retirement Income Security Act (ERISA), a law heavily regulating them, in 1974. But that law exempted government pensions. So while the private sector had to adjust to reality by shifting just about everyone to defined-contribution retirement plans, government was allowed to persist with defined-benefit pensions.
When fund performance comes up short to pay retirees what they were promised, the government has to find the money elsewhere. That means raising taxes or borrowing (which is really just raising future taxes).
Governments also sometimes fail to make annual required contributions to their pension funds. Even if they did, they’d probably still come up short because many state pension funds use unrealistic assumptions of financial returns to calculate how large the annual required contributions should be. Most states assume discount rates of 7 percent or higher, a very difficult return to achieve with investments safe enough to be in a pension fund.
Then governments will play politics with the money they invest. This has received a lot of attention recently with many Republican states decrying the effects of ESG investing on pension funds, but the problem is much older. It primarily stems from the fact that managers of a defined-benefit fund have weaker fiduciary responsibilities than managers of a defined-contribution system. Workers own their retirement account in a defined-contribution system, so they have a legal course of action if fund managers shirk their fiduciary duties. In the defined-benefit system, workers don’t have an individual account that they own, so they effectively have to trust the system.
Governments have abused that trust for years. The American Legislative Exchange Council wrote a report on this issue in 2016, before complaints about ESG were commonplace. Types of politically motivated investment include:
- Preference for local investments. The Retirement Systems of Alabama, for example, had 16.3 percent of its investments in-state in 2014. The probability that 16.3 percent of the best investment returns in the world were located in Alabama, or in any single state, is basically zero.
- Kickbacks for political insiders. Public-pension funds often invest more in in-state firms that make political contributions or spend a lot on lobbying state governments than other retirement funds would. The governance of the California Public Employees’ Retirement System (CalPERS), for example, is dominated by politically connected unions who steer investment to favored causes.
- Moral crusades. States might performatively divest from fossil fuels or from hedge funds managed by individuals whose political views they don’t like. The American Federation of Teachers pressures state pension funds to divest from hedge funds with managers who support school choice, for example. Pension funds also engage in shareholder activism with money that ultimately belongs to workers.
Of course, none of this stuff actually works to create economic growth or reduce climate change or end school choice. But it does result in lower returns on state pension funds than would otherwise be possible if managers were simply pursuing the best investments.
Why Bailouts Would Be Wrong
Many states are in trouble, but many states are not. The performance of state pension funds varies widely from state to state, indicating that failing pension funds are not an inevitable national problem and states actually can exert a significant amount of control on outcomes if they want to.
Here are some positive examples of states that made reforms that have solidified their retirement systems:
- Oklahoma began enrolling all new state-government hires in defined-contribution retirement plans starting in 2015. The old defined-benefit system will pay the people who were already in it without taking on any new liabilities from new employees. Oklahoma has more than enough assets to cover its debt and improved its pension-funding ratio by 52 percent between 2012 and 2021.
- Wisconsin made major public-pension reforms as part of the Act 10 fight in 2011, requiring public employees to contribute to their own retirements where previously they did not contribute at all. The state now has overfunded pension benefits by more than $2 billion.
- In 2014, Tennessee introduced hybrid retirement plans that include a defined-benefit component and a 401(k). That has allowed the state to stabilize its pension payments while still giving the same, or better, benefits to retirees. The hybrid plans saved Tennessee about half a billion dollars between 2014 and 2022, and Tennessee also has overfunded pension benefits.
- Michigan passed laws in 2017 and 2022 that make state grants to local-government pension funds conditional on reforming the funds. These laws include strict state oversight of funds that receive grants and require them to use more realistic discount rates and make full annual required contributions. In part because of these reforms, Michigan’s credit rating was upgraded by S&P from AA- to AA in 2018.
Those are four examples from states of different sizes and with different political makeups which made positive changes to their pension systems in different ways. There is no one-size-fits-all answer, and states have significant space to be creative in their solutions.
But some states continue to fail, year after year. Illinois’s pension problem is so severe that pension payments will consume 20 percent of its general funds this fiscal year, yet it is still contributing $4.5 billion less than it should. Illinois has unfunded pension benefits totaling $146 billion. New Jersey’s public-pension system is several times more generous than a typical 401(k), and despite the state’s making its scheduled pension payments the last few years, it is still nowhere close to solvency.
It’s not a perfect red-state/blue-state issue. Kentucky has a poorly funded pension system, and New York has a well-funded one. But it will shake out to a red vs. blue issue in Washington, D.C., if states come begging for bailouts. That’s because Illinois will likely be the first to crash, but it’s also because the primary beneficiaries of any such bailout would be public-sector unions.
A large part of the reason states have persisted in offering obviously unsustainable benefits to retirees is that public-sector unions demand it, and they fund state-level Democratic politics. Unlike in the private sector, where union demands are tempered by competition between firms and the profitability of the companies they bargain with, public-sector unions can ask for anything because governments can’t go out of business. They are in many cases bargaining with politicians whom they helped elect, who can shake down taxpayers for the needed money.
When those politicians run out of other people’s money in their states, they should not be rewarded with other people’s money from the federal government. Yet we have seen how Democrats approach pension shortfalls for unionized workers in the American Rescue Plan Act: They sent failing multiemployer pension funds for private-sector union workers almost $90 billion, with no strings attached. The bailouts included no requirements to reform the funds. And Joe Biden stood with AFL-CIO president Liz Shuler and Teamsters president Sean O’Brien to brag about this naked transfer of taxpayer money to irresponsible union pension funds.
One of the primary functions of the Democratic Party in government is to transfer taxpayer money to public-sector unions. One of the primary functions of the Republican Party should be to make sure that does not happen. If one failing state pension fund gets bailed out with federal money, it will set the expectation that they all will, and it will remove any incentive for states to enact positive reforms. The ones who have already enacted such reforms will look like suckers, having made difficult decisions to restructure benefits for no reason.
We are still likely a few years away from a major state pension crisis, but it will be easier to show resolve when one does occur if federal Republicans announce their position now: No state pension bailouts.
ADDENDUM: Check out this state-by-state pension database from Truth in Accounting to see how your state is doing.