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Misunderstandings Regarding State Debt, Pensions,
and Retiree Health Costs Create Unnecessary Alarm
Misconceptions Also Divert Attention from Needed
Structural Reforms
By Iris J. Lav and Elizabeth McNichol
Center on Budget and Policy Priorities
January 20, 2011
http://http://www.cbpp.org/cms/index.cfm?fa=view&id=3372
[moderator: for the complete report including
informative charts and graphs please go to to
http://http://www.cbpp.org/files/1-20-11sfp.pdf
Executive Summary
A spate of recent articles regarding the fiscal
situation of states and localities have lumped together
their current fiscal problems, stemming largely from the
recession, with longer-term issues relating to debt,
pension obligations, and retiree health costs, to create
the mistaken impression that drastic and immediate
measures are needed to avoid an imminent fiscal
meltdown.
The large operating deficits that most states are
projecting for the 2012 fiscal year, which they have to
close before the fiscal year begins (on July 1 in most
states), are caused largely by the weak economy. State
revenues have stabilized after record losses but remain
12 percent below pre-recession levels, and localities
also are experiencing diminished revenues. At the same
time that revenues have declined, the need for public
services has increased due to the rise in poverty and
unemployment. Over the past three years, states and
localities have used a combination of reserve funds and
federal stimulus funds, along with budget cuts and tax
increases, to close these recession-induced deficits.
While these deficits have caused severe problems and
states and localities are struggling to maintain needed
services, this is a cyclical problem that ultimately
will ease as the economy recovers.
Unlike the projected operating deficits for fiscal year
2012, which require near-term solutions to meet states'
and localities' balanced-budget requirements, longer-
term issues related to bond indebtedness, pension
obligations, and retiree health insurance - discussed
more fully below - can be addressed over the next
several decades. It is not appropriate to add these
longer-term costs to projected operating deficits. Nor
should the size and implications of these longer-term
costs be exaggerated, as some recent discussions have
done. Such mistakes can lead to inappropriate policy
prescriptions.
Bond Indebtedness
Some observers claim that states and localities have run
up huge bond indebtedness, in part to finance operating
costs, and that there is a high risk that a number of
local governments will default on their bonds. Both
claims are greatly exaggerated.
States and localities have issued bonds almost
exclusively to fund infrastructure projects, not finance
operating costs, and while the amount of outstanding
debt has increased slightly over the last decade it
remains within historical parameters. Recently, the
Build America Bond provisions of the Recovery Act
encouraged borrowing for infrastructure building as a
way to improve employment; these bonds can only be used
to finance infrastructure. Interest payments on state
and local bonds generally absorb just 4 to 5 percent of
current expenditures - no more than they did in the late
1970s. Municipal bond defaults have been extremely rare;
the three rating agencies calculate the default rate at
less than one-third of 1 percent .[1] Between 1970 and
2009, only four defaults were from cities or counties.
Most defaults are on non-general obligation bonds to
finance the construction of housing or hospitals and
reflect problems with those individual projects; they
provide no indication of the fiscal health of local
governments. While some have compared the state and
local bond market to the mortgage market before the
bubble burst, the circumstances are very different.
There is no bubble in state and local bonds, nor are
there exotic securities that hide the underlying value
of the asset against which bonds are being issued (as
was the case with subprime mortgage bonds). Most
experts in state and local finance do not expect a major
wave of defaults. For example, a Barclays Capital
December 2010 report states, "Despite frequent media
speculation to the contrary, we do not expect the level
of defaults in the U.S. public finance market to spiral
higher or even approach those in the private sector."
Pension Obligations
Some observers claim that states and localities have $3
trillion in unfunded pension liabilities and that
pension obligations are unmanageable, may cause
localities to declare bankruptcy, and are a reason to
enact a federal law allowing states to declare
bankruptcy. Some also are calling for a federal law to
force states and localities to change the way they
calculate their pension liabilities (and possibly to
change the way they fund those liabilities as well).
Such claims overstate the fiscal problem, fail to
acknowledge that severe problems are concentrated in a
small number of states, and often promote extreme
actions rather than more appropriate solutions.
State and local shortfalls in funding pensions for
future retirees have gradually emerged over the last
decade principally because of the two most recent
recessions, which reduced the value of assets in those
funds and made it difficult for some jurisdictions to
find sufficient revenues to make required deposits into
the trust funds. Before these two recessions, state and
local pensions were, in the aggregate, funded at 100
percent of future liabilities.
A debate has begun over what assumptions public pension
plans should use for the "discount rate," which is the
interest rate used to translate future benefit
obligations into today's dollars. The discount rate
assumption affects the stated future liabilities and may
affect the required annual contributions. The oft-cited
$3 trillion estimate of unfunded liabilities calculates
liabilities using what is known as the "riskless rate,"
because the pension obligations themselves are
guaranteed and virtually riskless to the recipients. In
contrast, standard analyses based on accepted state and
local accounting rules, which calculate liabilities
using the historical return on plans' assets, put the
unfunded liability at about a quarter of that amount, a
more manageable (although still troubling) $700 billion.
Economists generally support use of the riskless rate in
valuing state and local pension liabilities because the
constitutions and laws of most states prevent major
changes in pension promises to current employees or
retirees; they argue that definite promises should be
valued as if invested in financial instruments with a
guaranteed rate of return. However, state and local
pension funds historically have invested in a
diversified market basket of private securities and have
received average rates of return much higher than the
riskless rate. And economists generally are not arguing
that the investment practices of state and local pension
funds should change.
A key point to understand is that the two issues of how
states and localities should value their pension
liabilities and how much they should contribute to meet
their pension obligations are not the same. The $3
trillion estimate of unfunded liabilities does not mean
that states and localities should have to contribute
that amount to their pension funds, since the funds very
likely will earn higher rates of return over time than
the Treasury bond rate, which will result in pension
fund balances adequate to meet future obligations
without adding the full $3 trillion to the funds. In
fact, two of the leading economists who advocate valuing
state pension fund assets at the riskless rate have
observed, "the question of optimal funding levels is
entirely separate from the valuation question." [2] The
required contributions to state and local pension funds
should reflect not just on an assessment of liabilities
based on a riskless rate of return, but also the
expected rates of return on the funds' investments, as
well as other practical considerations. As a result, it
is mistaken to portray the current pension fund
shortfall as an unfunded liability so massive that it
will lead to bankruptcy or other such consequences.
States and localities devote an average of 3.8 percent
of their operating budgets to pension funding. [3] In
most states, a modest increase in funding and/or
sensible changes to pension eligibility and benefits
should be sufficient to remedy underfunding. (The $700
billion figure implies an increase on average from 3.8
percent of budgets to 5 percent of budgets, if no other
changes are made to reduce pension costs. [4]) However,
in some states that have grossly underfunded their
pensions in past years and/or granted retroactive
benefits without funding them - Illinois, New Jersey,
Pennsylvania, Colorado, Kentucky, Kansas, and
California, for example - additional measures are very
likely to be necessary.
States and localities have managed to build up their
pension trust funds in the past without outside
intervention. They began pre-funding their pension
plans in the 1970s, and between 1980 and 2007
accumulated more than $3 trillion in assets. There is
reason to assume that they can and will do so again,
once revenues and markets fully recover. States and
localities have the next 30 years in which to remedy any
pension shortfalls. As Alicia Munnell, an expert on
these matters who directs the Center for Retirement
Research at Boston College, has explained, "even after
the worst market crash in decades, state and local plans
do not face an immediate liquidity crisis; most plans
will be able to cover benefit payments for the next
15-20 years." [5] States and localities do not need to
increase contributions immediately, and generally should
not do so while the economy is still weak and they are
struggling to provide basic services.
Retiree Health Insurance
Observers claiming that states and localities are in
dire crisis typically add to unfunded pension
liabilities about $500 billion in unfunded promises to
provide state and local retirees with continued health
coverage. These promises are of a substantially
different nature than pensions, however, so it is
inappropriate to simply add the two together.
While pension promises are legally binding, backed by
explicit state constitutional guarantees in some states
and protected by case law in others, retiree health
benefits generally are not. States and localities
generally are free to change any provisions of the plans
or terminate them entirely. States' retiree health
benefit plans differ widely. For example, 14 states pay
the entire premium for retirees participating in the
health plan, while 14 other states require retirees to
pay the entire premium. States clearly have choices in
the provision of retiree health benefits. With health
care costs projected to continue to grow faster than GDP
and faster than state and local revenues, it is highly
likely that current provisions for retiree health
insurance will be scaled back. Many states are likely
to decide that their plans are unaffordable. This would
be a good time for states and localities offering the
more generous plans to decide whether they want to
maintain and fund these liabilities, or whether they
want to substantially reduce their liabilities by
changing the provisions of their plans.
Given the different origins, scope, and potential
solutions to problems in each of these areas, calls for
a "global" solution - such as recent proposals to allow
states to declare bankruptcy [6] or to limit their
ability to issue tax-exempt bonds unless they estimate
pension liabilities using a riskless discount rate -
make little sense in the real world of state and local
finances.[7] Indeed, some proposed solutions could
worsen states' long-term fiscal picture by undermining
their ability to invest in infrastructure and meet their
residents' needs for education, health care, and human
services. What are needed are targeted solutions that
are appropriate to each state and to the nature of its
fiscal problems.
State Structural Deficits
Moreover, the confusion between short-term cyclical
deficits and debt, pensions, and retiree health
insurance - and the overstatement of the magnitude of
the latter set of problems - draw attention away from
the need to modernize state and local budget and revenue
systems and address structural problems that have built
up over time in these systems.
States suffer from "structural deficits," or the failure
of revenues to grow as quickly as the cost of services
during healthy economic times; this makes it difficult
for states to continue meeting their responsibilities
each year. Structural deficits stem largely from out-
of-date tax systems, coupled with costs that rise faster
than the economy in areas such as health care. Fixing
these structural problems would help states and
localities balance their operating budgets without
resort to one-time measures or gimmicks. It would also
help states rebuild their rainy day funds before the
next recession and meet critical needs for
infrastructure investment and adequate funding of
pension obligations. It is far more constructive to
focus on fixing these basics of state and local finance
than to proclaim a crisis based on exaggerations of
imminent threats.
Projected Operating Deficits
Most states and localities have experienced
unprecedented projected operating deficits - which their
balanced-budget rules require them to close - in this
recession and its aftermath. State revenues are 12
percent below pre-recession levels, and localities also
are experiencing diminished revenues. There simply are
few good choices for meeting state and local balanced-
budget requirements during an economic downturn this
long and this deep.
The unemployment rate is close to a post-World War II
high and remains stubbornly elevated 15 months after the
official end of the recession. There were 7.4 million
fewer people employed in December 2010 than there were
prior to the recession, and many workers who are
employed have found only part-time work or work at lower
wages. [8] When residents lose jobs and incomes they
pay less in state income taxes, and the drop in
consumption reduces state and local sales and excise tax
revenues. The weak housing market also is placing
downward pressure on local property taxes and sales
taxes.
Yet the need for public services does not decline during
recessions. To the contrary, increases in unemployment
and poverty have swollen Medicaid rolls and expanded the
need for social services, community college education,
and job training, among other public services.
Most states and localities are required to balance their
operating budgets, even when the economy is weak.
Closing operating deficits requires immediate action:
most states have to enact balanced budgets, and gaps
that develop during the year usually have to be closed
within that year or biennium. In this recession and its
aftermath, the gaps between revenues and needed
expenditures have been particularly large because of the
unprecedented drops in revenue. Although states entered
the recession with record levels of "rainy day funds"
and reserves, and the federal government has provided
fiscal assistance, states out of necessity have made
rather massive cuts in services and raised additional
revenues. State general fund spending in 2011 will be 6
percent lower than it was in 2008, without adjusting for
inflation, according to data from the National
Association of State Budget Officers.
In a few well-publicized instances, states or localities
have closed portions of their deficits in ways that will
harm their future financial health. For example, some
states and cities have sold income-producing assets such
as toll roads, lotteries, or parking meters, and a few
have sold buildings that they then had to lease back at
more expensive rates. While in nearly all cases the
state or locality would have been better off in the long
run simply raising additional revenues, these deals
represent a small fraction of all deficit-closing
actions.
States have closed the vast majority of deficits by
drawing on rainy day funds and reserves, using federal
stimulus funds, cutting expenditures, and raising new
revenues. Only a few states - particularly Illinois -
have failed to close their deficits responsibly in
recent years, instead using a combination of payment
delays, borrowing, and other gimmicks. (The fault in
Illinois has been largely political gridlock rather than
a lack of reasonable options, as explained below.)
Should States Be Allowed to Declare Bankruptcy?
Various pundits have suggested enacting federal
legislation that would allow states to declare
bankruptcy, potentially enabling them to default on
their bonds, pay their vendors less than they are owed,
and abrogate or modify union contracts. Such a
provision could do considerable damage, and the
necessity for it has not been proven.
States have a strong track record of repaying their
bonds. In most states, bonds are considered to have the
first call on revenues; debt service will be paid before
any public services are funded. (In California,
education has the first call on revenues because of the
provisions of a ballot initiative, but bonds are right
behind.)
There are no modern instances of a state defaulting on
its general obligation debt. One has to reach back to
the period before and during the Civil War, when several
states defaulted, or the single state that defaulted
during the Great Depression (Arkansas), to find
examples.
It would be unwise to encourage states to abrogate their
responsibilities by enacting a bankruptcy statute.
States have adequate tools and means to meet their
obligations. The potential for bankruptcy would just
increase the political difficulty of using these other
tools to balance their budgets, delaying the enactment
of appropriate solutions. In addition, it could push up
the cost of borrowing for all states, undermining
efforts to invest in infrastructure.
The severity and consequences of these operating
deficits should not be minimized. Throughout the
country, residents are losing services on which they
depend - sometimes on which their very life depends, as
in the refusal of Arizona's Medicaid program to fund
organ transplants. But these deficits are cyclical and
temporary; they will diminish as the economy improves.
[9] They should not be confused with the longer-term
structural budget problems that a number of states have.
[10]
State and Local Debt
Almost all state and local debt is long-term debt
incurred to pay for capital expenditures, not to cover
operating expenses. (Unlike the federal government,
states and localities maintain separate operating and
capital budgets.) States issue long-term debt - various
types of bonds - primarily for infrastructure projects
such as roads and bridges, schools, water systems, and
hospitals. States typically prohibit the use of bond
proceeds for funding operating expenses,[11] although
that has occurred in a few instances, most notably in
Louisiana in 1988 and Connecticut in 1991. [12] One
recent example occurred in Connecticut, which in 2009
sold a bond to cover its operating budget, with a seven-
year repayment schedule.
A small number of states issue short-term debt
instruments, known as revenue anticipation notes, which
they use to match the timing of their revenue
collections to the timing of the expenditures in their
operating budget. This type of debt must be repaid
during the same fiscal year as the borrowing.
California, a major user of this type of debt, made
headlines in 2008 by saying it could not find buyers for
its debt and asking the federal government for
financing. Ultimately, however, California was able to
sell the bonds without federal assistance, as was
Massachusetts when it faced a similar situation.
In the vast majority of states, debt levels have risen
only modestly during this downturn, largely as states
took advantage of the federal Build America Bonds
program (which expired at the end of December 2010) to
encourage infrastructure development and thereby create
jobs. Claims that state and local governments are using
the new bonds to finance their operating budgets are
incorrect, [13] since the bonds can only be used to
finance infrastructure.[14] Claims that Build America
Bonds have led to an explosion in outstanding state and
local bond debt are incorrect as well, as outstanding
debt remains within its historical range. In the second
quarter of calendar year 2010, state and local
government outstanding debt stood at 16.7 percent of
GDP, up from a recent (and relatively brief) low of 12
percent in 2000 but similar to the average levels from
the mid-1980s to the mid-1990s. [15] (See Figure 1.)
Some who claim there is a state debt crisis have likened
states' problems to those in Greece or other European
countries. [16] There is no way directly to compare the
state debt situation with a national government's debt
situation, but Greece's situation was clearly far worse
than the situation in the U.S. today. Greece's total
governmental debt stood at 115 percent of GDP at the end
of 2009 and was projected to peak at 150 percent of GDP
if countermeasures were not taken. [17]
It also should be noted that states and localities spend
a modest 4 or 5 percent of their budgets on debt
payments.[18] (See Figure 2.)
Other observers have suggested that the problem in some
states isn't the aggregate state and local debt, but
rather debt issued by localities for specific projects.
They worry that some states may have to "bail out" or
assume their local government debt, which in turn would
put pressure on state finances. Alternatively, they
worry that many localities will repudiate their debt
through bankruptcy or other means, undermining
confidence in state and local bonds. (Localities can
and occasionally do declare bankruptcy, but states
cannot.)
One frequently cited instance is Harrisburg,
Pennsylvania, where a trash-to-energy project using
experimental technology for which the city had borrowed
did not work out, resulting in higher debt service than
the city could afford. The state provided extra
financial support to the city in the fall of 2010 and is
helping the city find options to work its way out of its
problems. Another frequently cited example is a sewer
project in Jefferson County, Alabama that ran into
trouble relating to corruption and fraud, causing the
price of the bonds issued for the project to drop
precipitously.
Although there were consequences - employees were laid
off, sewer rates increased, people responsible for the
problem went to prison, and some Wall Street firms are
being sued - and the county did technically default in
2008, actions have been taken to protect the
bondholders, who will likely be paid.[19] [20]
Studies show that defaults on municipal bonds are rare.
As the National League of Cities has pointed out, the
annual default rate for municipal (local government)
debt is a miniscule one-third of 1 percent across the
three bond rating agencies. [21] Moreover, the large
majority of defaults (74 percent in a Moody's study and
80 percent in a Fitch study) were in the health care and
housing sectors. Between 1970 and 2009, only four
defaults were from bonds guaranteed by cities or
counties; the remainder was from bonds based on the
revenues from specific projects. Defaults in these non-
general obligation bonds are not an indicator of state
or local fiscal health.
A Barclays Capital December 2010 report states, "Despite
frequent media speculation to the contrary, we do not
expect the level of defaults in the U.S. public finance
market to spiral higher or even approach those in the
private sector. We hold this view in large part because
of the steps taken thus far by the preponderance of
municipalities and the control that public entities can
exert over the expense and revenue portions of their
balance sheets."[22] Other financial advisers and the
bond rating agencies [23] have issued similar
statements. Finally, states and localities have many
options, from raising taxes or fees to reducing
spending, to make good on their bonds. As mentioned
above, states and localities generally will pay their
bondholders before paying nearly any other expenditure.
In sum, there is no bubble in state and local bonds.
States and localities in aggregate have not overextended
themselves with respect to their debt-financed capital
spending. Indeed, many analysts decry the deteriorating
state of infrastructure in this country and its negative
effect on economic development.[24] For this reason,
and to shore up the economy in the short run, the
manageable uptick in outstanding state and local capital
debt is entirely appropriate.
Pensions
Some who argue that states and localities are in a
crisis claim that they have large amounts of "hidden"
debt in the form of underfunded pension funds. A figure
of $3 trillion in pension underfunding is sometimes
cited; other estimates place the underfunding at levels
as low as about $700 billion, or less than a quarter of
the $3 trillion figure. While some pension funds are
indeed underfunded, there are a number of misconceptions
about the extent and depth of the problem - and about
states' ability to resolve pension funding issues over
time without disrupting their ability to continue public
services.
States and localities currently make annual
contributions to their pension trust funds equaling an
average of 3.8 percent of their general (operating)
budgets. They began to make deposits to pre-fund their
pension costs in the 1970s. Each year, they are
supposed to deposit in a trust fund an amount that
equals the present value of the future pensions their
employees earned that year. (The present value is the
amount that has to be invested today to grow to the
desired amount in the year the employees are expected to
retire.)
As of 2000, state and local pension obligations were
fully funded on average, if obligations are discounted
at 8 percent per year, which was the return on pension
fund investments over the previous two decades. (See
Figures 3 and 4.) Since then, however, the nation has
experienced two recessions, during which some states and
localities have reduced or skipped pension trust fund
deposits to help balance their budgets. In addition,
the recessions have caused significant investment
losses. By 2008, state and local pensions in aggregate
were funded at 85 percent of their future liabilities;
the other 15 percent is considered to be the "unfunded
liability." The Center for Retirement Research at
Boston College projects that, in the aggregate, state
and local pensions were funded in 2010 at 77 percent of
their future liabilities, a ratio projected to decline
to 73 percent by 2013.[25]
A drop to funding in the 70 percent range is a
significant problem, although not an imminent crisis.
Many experts argue that 80 percent funding is sufficient
for public pensions because states and localities, as
ongoing entities, can use tax revenues to make up a
shortfall if necessary. [26] A private company, in
contrast, can go out of business, at which point the
federal Pension Benefit Guarantee Corporation (PBGC)
pays the company's employees their accrued benefits out
of a combination of the assets the company accumulated
before it went out of business and the insurance
premiums the PBGC collects from private-sector employers
with pension plans. [27] (Federal law generally
requires private companies to be 100 percent funded so
the federal government does not have to make up any
shortfall. [28])
Some states - such as Illinois, New Jersey, and
Pennsylvania (and to a somewhat lesser extent Colorado,
Kentucky, Kansas, and California) - have skipped or
reduced deposits to trust funds and/or expanded future
pension benefits without providing the commensurate
funding. Over time, to reach adequate funding, these
states may have to institute changes more difficult than
the potential solutions discussed below. These states,
however, are not representative of states in general.
The issue of whether states' discount-rate assumptions
are reasonable is more complicated. The "discount rate"
is the interest rate used to translate future benefit
obligations into today's dollars. Discount rates are
important, since 60 percent of pension trust fund
revenues come from trust fund earnings (see Figure 5),
and discount rates help determine how much money a state
should put into the fund each year.
One school of thought argues that it is appropriate
to continue to use the actuarial method recommended by
the Governmental Accounting Standards Board (GASB),
which is to use as a discount the historical return on
funds' assets - about 8 percent. (State pension trust
funds invest their assets in a diverse mix of stocks,
bonds, and other instruments until they are needed to
pay for benefits.) Others, most prominently Joshua Rauh
at Northwestern University and Robert Novy-Marx at the
University of Rochester, argue that a much lower
assumption is warranted: because pension obligations
are guaranteed, they argue, the assumed growth of assets
(the discount rate) should be similarly "riskless" and
based on the returns from the safest investments such as
Treasury bonds - around 4 percent or 5 percent.
The alarming reports that pension funds are about to run
dry or that unfunded pension liabilities number in the
trillions of dollars generally rely on these more
conservative assumptions about the appropriate discount
rate. For example, a recentWashington Post editorial
said that "Public-employee pension funds are notorious
for understating their liabilities through the use of
vague projections and rosy investment return
assumptions" and took note of a proposal by three
members of Congress - Paul Ryan, Darrell Issa, and Devin
Nunes - that would force pension funds to calculate
their liabilities using a riskless discount rate. [29]
While economists generally support use of a riskless
rate in valuing state and local pension liabilities,
they do not generally argue that the investment
practices of state and local pension funds should
change. State and local pension funds historically have
invested in a market basket of private securities and
have received rates of return much higher than the
riskless rate. As Figure 4 shows, the 8 percent
discount rate that most funds now use reflects actual
returns over the past 20 years.
Even if state and local pension liabilities were valued
at the riskless rate, that would not mean that states
and localities "owe" $3 trillion to their pension funds.
The issue of how states and localities value their
pension liabilities and the issue of how much they have
to contribute to meet their pension obligations are not
the same. The $3 trillion of unfunded liabilities is
not equivalent to the amount that states and localities
should contribute to their pension funds. It thus is
mistaken to portray this as a huge liability that will
lead to bankruptcy or other similarly dire consequences.
Indeed, Novy-Marx and Rauh, the leading economists
advocating valuation at a riskless rate, have observed,
". the question of optimal funding levels . is entirely
separate from the valuation question." [30] The
required contributions to state and local pension funds
should take account of expected rates of return on their
investments, as well as other practical considerations.
While it may make sense to reconsider whether the
typical 8 percent discount rate is the right one going
forward, simply basing annual state contribution amounts
to pension funds on the return to riskless investments
appears to go much farther than is necessary for a
number of reasons:
Pension funds invest for the long term, so a few years
of below-average returns can be averaged out with years
of higher returns. As noted, the 8 percent discount
rate that most states assume reflects the experience of
the trust funds over the last 20 years (including the
2008 stock market decline); median returns for the last
25 years were even higher, at 9.3 percent. While the
rates of return on investments were much lower in the
recent recession, it is generally assumed that they will
rise in the future, even if they do not return to the
very high rates of the late 1980s. A business may be
sold or go out of business at any time, so it is
important to keep its pension plan 100 percent funded
for benefits earned to date.[31] Governments, in
contrast, will be in continuing existence, so it makes
sense to average or "smooth" expected investment returns
over a long period. This also promotes
intergenerational equity, enabling the state to
contribute approximately the same amount for each cohort
(assuming that it makes appropriate contributions each
year).
The stated concern of some that basing required
contributions on actual rates of return will lead
pension managers to put funds in risky investments is
overblown. Pension funds have a long history and have
been invested prudently except in rare situations. Most
states have other effective barriers to overly risky
investing in place (although these could be
strengthened), including oversight boards, reporting
requirements, and regular actuarial reviews. A discount
rate that is too low would require a state to put money
into the pension funds that it could be using instead to
support public services, resupply reserve funds, invest
in infrastructure, or return to taxpayers in the form of
tax cuts.
In addition, if the pension fund assumes a 4 or 5
percent discount rate and actually gets higher returns
on its investments, funds will build up in the trust
fund. When pension trusts have been overfunded in the
past this has led to problems such as employee demands
for increases in pension benefits that later proved
unsustainable. Overfunding also has led jurisdictions
to skip payments that they subsequently found difficult
to resume because programs were funded or taxes were cut
permanently by the amount of the skipped pension
contribution. The 2008 GAO report noted experts that
said: ". it can be politically unwise for a plan to be
overfunded; that is, to have a funded ratio over 100
percent. The contributions made to funds with "excess"
assets can become a target for lawmakers with other
priorities or for those wishing to increase retiree
benefits." [32]
Nevertheless, improvements in pension plans' policies
clearly are needed. There are a number of ways that
most states with unfunded liabilities can improve their
pension funding without causing major disruptions in
their ability to provide public services.
As noted, current employer contributions for public
employee pensions average only 3.8 percent of state and
local budgets, an amount that pales beside states'
largest expenses - education and health care. Pension
contributions are smaller than the amounts spent on
transportation, corrections, and many other services. If
all states and localities were to fund their pensions
based on the "riskless" rate, Boston College researchers
calculate that they would have to contribute
approximately 9 percent of their budgets, on average.
(This calculation uses 5 percent as the riskless
rate.[33]) A contribution amount this high would cut
into states' and localities' ability to provide other
public services; it arguably would not strike the
appropriate balance between funding currently needed
services and funding past pension liabilities.
If states and localities continue to use an 8 percent
discount rate for calculating required contributions, a
funding increase to 5 percent of their budgets would be
required on average to fully fund their pensions. This
level is not likely to be unduly burdensome after the
economy recovers, and states could reduce it somewhat by
adopting various pension reforms. (States should not
begin to increase their contributions while the economy
is still weak, because the budget cuts this move would
require would further slow the economy.)
States that have significantly underfunded their
pensions, such as California, Illinois, and New Jersey,
would require higher contributions (7.3 percent, 8.7
percent, and 7.9 percent of their respective budgets),
even using the standard 8 percent discount rate. These
states will have to consider more significant changes to
their pension plans to bring their required
contributions down to a more reasonable level. [34]
More than 20 states have enacted changes to reduce
pension costs in recent years, including raising the
length of service and age requirements for receiving a
pension and reducing the factor that determines the
percent of salary that an employee receives as a pension
payment for each year of service. It is difficult to
defend a system where public employees can retire at age
55 with a pension after 25 or 30 years of service,
particularly if their work is not physically arduous,
while the age for receiving full Social Security
benefits is set to increase to 67. While these types of
changes generally can be applied only to newly hired
employees, they will help with a pension plan's longer-
term funding. Another option that could have a more
immediate effect would be to increase the contribution
that employees make toward their pensions, as a number
of states have done, particularly in places where
employee contributions are particularly low.
Public-sector employees generally receive lower wages
than their private-sector counterparts, and employee
benefits such as pensions make up only part of the
difference.[35] If pensions (and/or retiree health
benefits, discussed below) are made less generous,
current wages may have to increase so that the public
sector can continue to attract high-quality employees.
Given the difficulty that some jurisdictions have in
funding deferred compensation, this may be a reasonable
trade-off.
In addition, all states and localities need to ensure
that their employee pension provisions do not permit
abuses, such as the ability to inflate pay in the year
or two before retirement in order to receive an outsized
pension benefit. Reforms in this area are needed in a
number of states. States also need to review their
provisions for disability pensions to ensure that only
employees who are appropriately qualified can retire on
a disability pension. While these issues are not the
major source of financial stress of pension systems,
abuses are frequently publicized and undermine
confidence in the administration and fairness of public
employee pensions.
In short, there are significant issues with public
pensions, but they do not amount to a crisis. In part,
pensions' funding status will improve as the economy and
investment returns improve. Some states and localities
already are taking actions to improve their pension
funding; at an appropriate time when the economy is
stronger, more states and localities can, if necessary,
increase their pension trust fund contributions to put
them on a path to funding their unfunded liabilities
over the next few decades. A number of states also will
need to institute various pension reforms. But for the
reasons cited above, the evidence does not support the
claim that states and localities are on the verge of
bankruptcy because of massive unfunded pension
liabilities.
Retiree Health Benefits
The final point typically made by those who claim that
states and localities are in dire crisis concerns health
insurance for retirees. Some jurisdictions have
promised that their employees' health insurance benefits
will continue into retirement - in particular, that
those benefits will bridge the gap between retirement
and eligibility for Medicare at age 65. But, with few
exceptions, states and localities have not set aside any
funding to finance those benefits. In 2004, the GASB
began requiring states and localities to assess their
future liabilities for retiree health insurance,
although it did not put forth any requirements for pre-
funding those liabilities. [36] Most states continue to
fund retiree health insurance benefits on a pay-as-you-
go basis, from operating revenue. Estimates suggest
that aggregate state and local unfunded liabilities for
retiree health insurance are approximately $500 billion.
[37]
It makes little sense to add this large number to state
operating deficits, state infrastructure debt, or even
to pension liabilities. Promises for retiree health
insurance are quite different from any of those other
liabilities:
While pension promises are legally binding - backed by
explicit state constitutional guarantees in some states
and protected by case law in others - retiree health
benefit promises generally are not. States and
localities in many cases are free to change the
provisions of the plans, the years of service or other
eligibility rules, and the share of the insurance
premium the retirees must pay as these elements pertain
to current employees.
While most state pension plans are roughly similar to
one another, state retiree health plans differ much more
widely. In 2006, 14 states provided only an implicit
subsidy, allowing retirees to be a part of the state
health insurance plan but requiring them to pay the full
premium. [38] At the other end of the spectrum, 14
states paid retirees' entire premium. [39] The
remainder of the states fell in between these two poles.
[40] All three groups include states from different
regions, political tendencies, and degrees of
unionization. States should have reasonable flexibility
to modify retiree health provisions if necessary.
If health care costs continue to rise faster than GDP
and faster than state revenues, as they are projected to
do for the foreseeable future, it is likely that states
that pay all or most of the premiums for their retirees
will not be able to continue to do so without making
significant cuts in public services or raising
substantial additional revenues. For example, the
Government Accountability Office projects that the cost
of retiree health benefits is expected to increase at an
annual rate of 6.7 percent between now and 2050. [41]
Whether states continue to finance retiree health
benefits on a pay-as-you-go-basis or move to pre-fund
some or all of those costs as they do for pensions, the
reality of health care cost growth suggests that the
status quo of benefit provisions is unlikely to prevail
over time. [42] It is also worth noting that the
recently enacted Affordable Care Act may lead to
significant changes in health insurance markets and in
health care cost growth.
Unlike pension costs, which behave in predictable ways
based on actuarial tables, the future cost of retiree
health insurance is subject to various sources of
uncertainty. This would be a propitious time for states
and localities to rethink their retiree health benefit
promises and decide whether it makes sense to modify
these promises rather than pre- fund them. The
important point is that states have the flexibility to
modify their policies regarding retiree health benefits
as needed in order to ensure that these benefits remain
affordable.
Structural Deficits
As the previous sections of this report have explained,
states and localities are not in imminent danger of
financial collapse and there is no need for such changes
as a new federal law allowing states to declare
bankruptcy. States have many ways to meet their
obligations through adjustments in taxes or budgets;
they should not be encouraged to abrogate those
responsibilities through bankruptcy. [43] Nor is it
appropriate to force all states and localities to report
pension liabilities using a "riskless" rate as a
condition of issuing tax-exempt bonds, which would
likely give a distorted view of how much funding states
and localities have to save in order to pay future
pensions. [44]
Most states, however, do face a set of fundamental
problems in their revenue and budget structures that
will continue once the economy recovers. These
problems, often called "structural deficits," make it
difficult to fund the ongoing cost of public services
year after year. Structural deficits occur when annual
revenue growth, in the absence of legislated changes,
lags behind economic growth and behind the annual growth
in the cost of services.
In significant part, this is a problem of health care
costs, which as discussed above are projected to grow
much more rapidly than revenues over the foreseeable
future. In addition, the cost to states and localities
of K-12 education has grown faster than the economy over
the past 20 years, rising from 3.58 percent of GDP in
1988 to 4.02 percent of GDP in 2008; it remains to be
seen whether that trend will continue after the economy
recovers. [45] And while efforts at improving
efficiency in these and other areas of the budget are
always appropriate, there are limited opportunities for
states to reduce cost growth in either area.[46]
Since education and health care expenditures account for
more than half of state budgets and more than a third of
local budgets, jurisdictions cannot balance their
budgets year after year if these two spending areas are
growing faster than the economy and revenues are growing
slower than the economy. Yet that is the situation in
most states, and it can lead to poor public finance
practices even in good economic times, as policymakers
often devise temporary solutions rather than fixing the
underlying problems.
Most states' revenue systems are in dire need of
modernization; they have remained largely the same for
the last 40, 50, or 60 years. But the world is very
different than it was 60 years ago. The role of
services in the economy has greatly increased, Internet
commerce has come on to the scene, telecommunications
and exotic forms of commerce have multiplied, and income
has become far more concentrated among the wealthy, to
mention just a few trends. State revenue systems have
not kept up.
For example, few states adequately tax the sales of
services on an equal basis with the sales of tangible
goods. Similarly, most Internet sales go untaxed. And
the majority of states focus their taxes on moderate-
and middle-income residents; they fail to maintain
progressive income tax systems that adequately tax the
rapidly growing incomes of the top 1 percent or 5
percent of earners.
In addition, states do large amounts of spending through
their tax codes by giving tax breaks that are intended
to accomplish policy purposes such as economic
development, and provide large tax exemptions for the
elderly and for retirement income regardless of the
income of the taxpayer. Yet they rarely scrutinize this
spending through the tax code on the same basis as on-
budget spending. Together, these and other chronic
problems cause revenue growth to lag behind economic
growth. Fixing these problems for the long term should
be high on states' agenda.
In addition, most states need to overhaul the processes
by which they enact budget and revenue changes. For
example, there are no more than a handful of states in
which budgets include accurate projections of revenues
and expenditures, adjusted for expected cost inflation
and utilization changes, for as much as four or five
years into the future. Without such information,
policymakers have no way of understanding the long-term
budgetary impact of the changes they are making,
especially when such changes are phased in over several
years. Moving to accurate multi-year budgeting is one
of the most important reforms that states can adopt.
Illinois is an extreme example of the implications of
failure to fix these types of problems. It has a flat,
low-rate income tax that does not adequately capture
income growth, and income tax revenues thus routinely
lag behind economic growth. The state relies heavily on
a state and local sales tax that is almost exclusively
applied to goods and excludes almost all services.
It is among the states that exempt from state income tax
the largest share of income received by elderly
individuals, regardless of their income levels. Illinois
also does a relatively poor job of scrutinizing its
spending through the tax code. Its budget considers
only the single upcoming fiscal year, and policymakers
often have taken budget actions without full
consideration of the longer-term implications.
Because Illinois is chronically short of the revenues it
needs to cover its expenses, it has engaged in a number
of poor fiscal practices over the years. It has
postponed payments to vendors, failed to make adequate
pension contributions or borrowed money to make the
contributions, securitized or sold assets, and taken
other dubious actions. As a result, it has had a
particularly difficult time coping with revenue declines
during this recession, with a fiscal year 2012 deficit
projected to equal half of its general fund budget, and
has developed an large overhang of longer-term debt and
unfunded liabilities.
But it is important to remember that the root cause of
Illinois' problem is a revenue system in urgent need of
modernization, one that cannot support the level of
expenditures that the state has chosen. Proposals have
repeatedly been made over the last 25 years to remedy
many of these problems, but political gridlock has
prevented solutions to Illinois' well-known budget
problems from being enacted. In January 2011 Illinois
temporarily increased its personal and corporate income
tax rates to close a portion of its budget gap. But it
still plans to borrow to cover its pension contributions
and has not addressed the fundamental problems in its
revenue system that are the principal cause of its large
structural deficit.
Most states are not in as dire shape as Illinois.
Nevertheless, if states fail to reduce their structural
deficits and improve their budget processes, it will be
more difficult for them both to maintain needed services
and to prepare for the next cyclical downturn by
accumulating adequate reserves. Nor will they have the
funds to fix the problems that have been identified in
the funding of public pensions and other areas.
End Notes:
[1] Chris Hoene, "Crying Wolf about Municipal Defaults,"
National League of Cities blog, December 22, 2010,
http://citiesspeak.org.
[2] Robert Novy-Marx and Joshua Rauh, "Public Pension
Promises: How Big Are They and What Are They Worth?"
Journal of Finance, forthcoming (posted October 8, 2010
on Social Science Research Network), p. 5.
[3] Data are for 2008, the most recent year available
from Census.
[4] Alicia H. Munnell, Jean-Pierre Aubry, and Laura
Quinby, The Impact of Public Pensions on State and Local
Budgets, Center for Retirement Research at Boston
College, October 2010.
[5] Alicia H. Munnell, Jean-Pierre Aubry, and Laura
Quinby, "Public Pension Funding in Practice," NBER
Working Paper 16442, October 2010.
[6] See, for example, David Skeel, "Give States a Way to
Go Bankrupt," The Weekly Standard, November 29, 2010,
http://www.weeklystandard.com/articles/give-states-way-go-bankrupt_518378.html
and Grover G. Norquist and Patrick Gleason, "Let States
Go Bankrupt," Politico, December 24, 2010.
[7] A bill proposed by House of Representative members
Paul Ryan, Darrell Issa, and Devin Nunes (H.R. 6484 in
the 111th Congress) would require states and localities
to report pension liabilities to the federal government
using U.S. Treasury Bond rates to discount liabilities
as a condition of issuing tax-exempt bonds.
[8] Seasonally adjusted employment of 139.206 million in
December, 2010 compared to 146.584 million in November,
2007. Bureau of Labor Statistics, "Labor Force
Statistics from the Current Population Survey,"
extracted January 7, 2011.
[9] The end of the federal stimulus funding at the end
of June 2011 and the pending expiration of some
temporary state tax increases enacted during the
recession mean that revenue growth would have to be
extraordinarily strong over the next year or two to
eliminate state deficits; this is unlikely unless the
economy grows much more strongly than is currently
projected. An unwinding of the housing crisis - an end
to elevated levels of foreclosures and resumed growth in
the prices of housing and commercial real estate - will
likely be necessary to fully eliminate local deficits.
[10] The depth and persistence of the economic slump,
and thus the deficits in this recession, raise the issue
of whether it makes sense to leave states and localities
with the problem of balancing their operating budgets
when revenues decline and service needs increase. It is
worth considering a permanent federal countercyclical
facility that ties additional aid to the states to
economic conditions, since it is appropriate for the
federal government to deficit-spend to stimulate the
economy during recessions. Aid to state and local
governments is an important macro-economic tool for the
federal government: it can help prevent states and
localities from creating a fiscal drag as they cut
spending and raise taxes to meet their balanced-budget
requirements.
[11] According to the National Conference of State
Legislatures, "It is extremely rare for a state
government to borrow long-term funds to cover operating
expenses." National Conference of State Legislatures,
State Balanced Budget Requirements, updated April 12,
1999 and reviewed December 3, 2003,
http://www.ncsl.org/default.aspx?tabid=12660.
[12] National Conference of State Legislatures, "NCSL
Fiscal Brief: State Balanced Budget Provisions,"
October 2010,
http://www.ncsl.org/default.aspx?tabid=12651.
[13] A statement that appeared to originate in a Reuters
blog post, "the lack of a BAB program would make it
harder for states to borrow to cover a $140 billion
budgetary shortfall next year, as estimated by the
Center for Budget and Policy Priorities," conflates
capital borrowing and operating deficits but
nevertheless was repeated in a number of other places.
See James Pethokoukis, "Secret GOP Plan: Push States to
Declare Bankruptcy and Smash Unions,"
http://blogs.reuters.com/james-pethokoukis/2010/12/07/secret-gop-plan-push-states-to-declare-bankruptcy-and-smash-unions/ .
[14] The Recovery Act created a new kind of taxable
state and local bond, called Build America Bonds,
because policymakers thought the existing provisions
under which states and localities issued bonds for
infrastructure were not encouraging a sufficient amount
of infrastructure building. It is long-standing policy
that interest on state and local bonds is exempt from
federal taxation. This has provided a subsidy for state
and local infrastructure development because investors
are willing to accept a lower interest rate if they
don't have to pay federal tax on the income. Public
finance experts have questioned the efficacy of the
subsidy, however, because the spread between the
interest rate on tax-exempt state and local bonds and
comparable taxable corporate bonds has at times not been
as great as the tax exemption implies it should be -
which suggests that investors, rather than states and
localities, have been reaping outsized benefits.
Build America Bonds ensured that states and localities
received the full subsidy that theoretically would
accrue if a high-income taxpayer purchased the bond by
making the bonds taxable to the investor but giving
states and localities a direct 35 percent federal
subsidy for interest costs. The idea was to make the
bonds more attractive to institutional investors and
other purchasers or accounts that could not benefit from
the tax exemption. The Build America Bonds could be
issued only by governments and only for capital
expenses, not operating expenses.
[15] The 16.7 percent figure includes all forms of debt,
both long-term and short-term, whether or not backed by
the full faith and credit of the jurisdiction. The
Census definition of debt, used here, is: "All long-
term credit obligations of the government and its
agencies whether backed by the governments' full faith
and credit or nonguaranteed, and all interest-bearing
short-term credit obligations. Includes judgments,
mortgages, and revenue bonds, as well as general
obligations bonds, notes, and interest-bearing warrants.
Excludes noninterest-bearing short-term obligations,
interfund obligation, amounts owed in a trust or agency
capacity, advances and contingent loans from other
governments, and rights of individuals to benefits from
government-administered employee retirement funds."
[16] See, for example, Michael Cooper and Mary Williams
Walsh, "Mounting Debts by States Stoke Fears of Crisis,"
The New York Times, December 4, 2010.
[17] International Monetary Fund, Frequently Asked
Questions: Greece,
http://www.imf.org/external/np/exr/faq/greecefaqs.htm#q1
. For an article cited in many U.S. news-gathering
sites likening state and local problems to Europe's, see
Andrew Beatty, "Fears Grow of Euro-style Debt Crisis in
U.S.," Agence France Press,
http://news.yahoo.com/s/afp/20101221/ts_alt_afp/useconomydeficitlocal/print
Greece's is far higher than the total governmental debt
in the U.S. - state, local, and federal - which stood at
83 percent of GDP at the end of 2009.
[18] There are two data sets on debt, one from Census
and one from the Federal Reserve. Similarly, there are
two sets of data on state and local expenditures, one
from Census and one from the Bureau of Economic Analysis
Income and Product Accounts. In 2008, debt service was
4.0 percent of state and local spending using Census
data for both debt service and total expenditures, and
5.4 percent of current expenditures using the Federal
Reserve Bank Flow of Funds Data for debt service and
total expenditures from the Bureau of Economic Analysis.
[19] A Moody's analyst said: "The appointment of the
receiver is a credit positive for the county, as it
provides a mechanism for additional revenue through rate
growth on the sewer system, increasing the likelihood
for full repayment on the $516 million in unpaid
principal to date." Shelly Sigo, "Moody's Sees JeffCo
Sewer Receiver as Positive Move," The Bond Buyer,
September 28, 2010.
[20] The city of Vallejo, California, did declare
bankruptcy in May 2008, citing unsustainable labor
contracts and dwindling tax revenue. Caught in the
housing crisis, its median real estate prices fell 67
percent between 2006 and 2008, and revenues plummeted.
While the city plans to suspend debt service payments
for three years, the debt does not appear to be the
precipitating cause of the bankruptcy. Randall Jensen,
"Vallejo, Calif., Officials to Weigh Chap. 9 Recovery
Plan," The Bond Buyer, November 30, 2010.
[21] Chris Hoene, "Crying Wolf about Municipal
Defaults," National League of Cities blog, December 22,
2010, http://citiesspeak.org.
[22] Barclays Capital, Municipal Research, Taxable
Municipal Market Commentary, 2011 Outlook, December 3,
2010.
[23] Some have dismissed the opinions of the rating
agencies by noting that they failed to predict the
bursting of the housing bubble. But the two cases are
very different. The slicing and dicing of mortgages
into exotic securities sold through brokers was a
relatively new phenomenon, and there was no way to judge
the underlying value of those securities. By contrast,
rating agencies and other players in the state and local
bond market have been following the municipal bond
market for many years and have experience in detecting
problems. Moreover, while there was a problem in
knowing the underlying quality of the mortgages that
made up the exotic securities, the basic financial
information about states and localities is available.
[24] Estimates suggest that a sustained 1 percent
increase in public capital growth translates into a 0.6
percentage-point increase in the growth rate of private-
sector GDP. For discussion, see Appendix G of Investing
in America's Economy: A Budget Blueprint for Economic
Recovery and Fiscal Responsibility, jointly produced by
the Economic Policy Institute, Demos, and The Century
Foundation, November 29, 2010,
http://epi.3cdn.net/b3c2500a206a5ea13a_n7m6vzdpr.pdf.
[25] Alicia H. Munnell, Jean-Pierre Aubry, and Laura
Quinby, The Funding of State and Local Pensions:
2009-2013, Center for Retirement Research at Boston
College, April 2010.
[26] U.S. Government Accountability Office, "State and
Local Government Retiree Benefits: Current Funded Status
of Pension and Health Benefits," GAO-08-223. The GAO
report noted on p. 15, "Many experts and officials to
whom we spoke consider a funded ratio of 80 percent to
be sufficient for public plans for a couple of reasons.
First, it is unlikely that public entities will go
bankrupt as can happen with private sector employers,
and state and local governments can spread the costs of
unfunded liabilities over up to 30 years under current
GASB standards. In addition, several commented that it
can be politically unwise for a plan to be overfunded;
that is, to have a funded ratio over 100 percent. The
contributions made to funds with `excess' assets can
become a target for lawmakers with other priorities or
for those wishing to increase retiree benefits."
[27] PBGC operations are financed by a combination of
insurance premiums set by Congress and paid by sponsors
of defined benefit plans, assets from pension plans
trusteed by PBGC, investment income earned on the PBGC's
assets, and recoveries from the companies formerly
responsible for the plans.
[28] The Pension Protection Act of 2006 requires private
defined benefit plans to be 100 percent funded and to
make full contributions each year, although there is the
possibility of a waiver for economic hardship. It also
requires plans that are not fully funded to pay higher
premiums to the PBGC. The discount rate that private
plans use is tied to corporate bond rates.
[29] Washington Post, "Pension Reality Check," December
8, 2010.
[30] Robert Novy-Marx and Joshua Rauh, "Public Pension
Promises: How Big Are They and What Are They Worth?"
Journal of Finance, forthcoming (posted October 8, 2010
on Social Science Research Network), p. 5.
[31] See discussion in National Conference on Public
Employee Retirement Systems, The Advantages of Using
Conventional Actuarial Approaches for Valuing Public
Pension Plans, November 2008,
http://www.ncpers.org/News/PageText/documents/ResearchSeriesIII.pdf .
[32] GAO-08-223.
[33] Alicia H. Munnell, Jean-Pierre Aubry, and Laura
Quinby, The Impact of Public Pensions on State and Local
Budgets, Center for Retirement Research at Boston
College, October 2010. Munnell et al. use 5 percent
for the riskless rate. They say, "Just what rate
represents the riskless rate is a subject of debate..
Currently, the yield on 30-year Treasury bonds, about 4
percent, is likely less than the riskless rate due to
the valuable liquidity they offer investors. Therefore,
we would suggest increasing the current [Treasury] rate
by about one percentage point and using a number of
about 5 percent for 2009." Alicia H. Munnell, Richard
W. Kopcke, Jean-Pierre Aubry, and Laura Quinby, Valuing
Liabilities in State and Local Plans, Center for
Retirement Research at Boston College, June 2010.
[34] A report by Novy-Marx and Rauh suggests that
various potential changes in pension policies - even
relatively extreme ones - could only reduce unfunded
liabilities by half, and changes more likely to be made
would reduce liabilities by much less. But the authors
are measuring impact on unfunded liabilities funded at
the riskless rate. Some changes could have a larger
impact at a more conventional discount rate. See Joshua
Rauh and Robert Novy-Marx, "Policy Options for State
Pension Systems and Their Impact on Plan Liabilities,"
National Bureau of Economic Research, Working Paper
16453, October 2010.
[35] Studies find that public workers are paid 4 percent
to 11 percent less than private-sector workers with
similar education, job tenure, and other
characteristics. The wage deficit is highest for
higher-wage public workers. Low-wage state and local
workers, by contrast, do receive a small wage premium.
Benefits are more generous and secure for public
employees than for most private-sector workers;
factoring in the value of these benefits reduces but
does not eliminate the gap between state and local
employees and their private-sector counterparts in
comparable jobs. See Keith A. Bender and John S.
Heywood, Out of Balance? Comparing Public and Private
Sector Compensation over 20 Years, Center for State &
Local Government Excellence (CSLGE), National Institute
on Retirement Security, April 2010; and John Schmitt,
The Wage Penalty for State and Local Government
Employees, Center for Economic and Policy Research
(CEPR), March 2010.
[36] GASB does not have the power to compel state and
localities to follow its recommendations, but they
usually do follow those recommendations because
financial markets prefer that they do so.
[37] Robert L. Clark and Melinda Sandler Morrill,
Retiree Health Plans in the Public Sector: Is There a
Funding Crisis?, (Cheltenham, UK and Northampton, MA,
USA: Edward Elgar, 2010).
[38] They are Idaho, Indiana, Iowa, Kansas, Minnesota,
Mississippi, Montana, Nebraska, Oregon, South Dakota,
Washington, West Virginia, Wisconsin, and Wyoming. The
ability to participate in the state plan is a
significant benefit in itself, enabling retirees to join
an insurance pool with younger and healthier workers and
thus pay lower premiums than if they had to buy
insurance in the individual market.
[39] They are Alaska, California, Hawaii, Illinois,
Kentucky, Maine, New Mexico, New Hampshire, New Jersey,
North Carolina, Ohio, Pennsylvania, Rhode Island, and
Texas.
[40] United States Government Accountability Office,
State and Local Government Retiree Benefits: Current
Status of Benefit Structures, Protections, and Fiscal
Outlook for Funding Future Costs, September 2007,
GAO-07-1156.
[41] United States Government Accountability Office,
State and Local Government Retiree Health Benefits:
Liabilities Are Largely Unfunded, but Some Governments
Are Taking Action, November 2009, GAO-10-61. GAO
projects that the cost of retiree health benefits will
rise from 0.9 percent of total operating revenues to 2.1
percent, on average. But this figure includes states
that do not provide much in the way of benefits; the
costs would be higher in the states that pay all or most
of retiree premiums.
[42] An employee who wants to retire at age 55 could
either get a different job that offers health benefits
or pay the full cost to remain in the state/local plan.
Or, this person could decide not to retiree until he or
she is eligible for Medicare. Moreover, if states and
localities change their pension plans to increase the
normal retirement age, those changes would also reduce
their retiree health liabilities.
[43] See, for example, David Skeel, "Give States a Way
to Go Bankrupt," The Weekly Standard, November 29, 2010,
http://www.weeklystandard.com/articles/give-states-way-go-bankrupt_518378.html
and Grover G. Norquist and Patrick Gleason, "Let States
Go Bankrupt," Politico, December 24, 2010.
[44] A bill proposed by House of Representative members
Paul Ryan, Darrell Issa and Devin Nunes (H.R. 6484 in
the 111th Congress) would require states and localities
to report pension liabilities to the federal government
using U.S. Treasury bond rates to discount liabilities
as a condition of issuing tax-exempt bonds.
[45] U.S. Census Bureau, Annual Survey of State and
Local Government Finance, 2008.
[46] Health care cost growth is a national problem that
will require national solutions, and states have limited
flexibility to influence that growth. And while the
Affordable Care Act is intended ultimately to reduce the
annual rate of growth of health care costs, that is
unlikely to happen within the next several years;
experimentation with potential avenues to "bend the cost
curve" will take considerable time. Nor is there a lot
of flexibility with respect to education costs; to the
contrary, the pressure is to improve education and
particularly teacher quality. The ratio of adults aged
25-64 (potential teachers) to children aged 6 -17 is
projected to decline in future years, so these costs may
have to rise more rapidly rather than less. In
addition, there is evidence that as half the teachers
become eligible for retirement in the next decade,
teacher quality will decline unless salaries are
increased substantially. A McKinsey report estimates
that it would cost $30 billion to increase the
percentage of new teachers drawn from the top third of
their college classes from the current very low 14
percent up to 68 percent. (The report also projects
large gains for the overall economy if this were to be
done.) Byron Auguste, Paul Kihn, and Matt Miller,
Closing the Talent Gap: Attracting and Retaining Top-
third Graduates to Careers in Teaching, McKinsey &
Company, September 2010.
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