State Budgets

The Pension Crisis is not a Black Swan Event

Close your eyes and envision a swan. What color is it? Most likely, it is a white swan. Because most of us go our entire lives coming across only white swans, we may inaccurately assume that all swans are white. In fact, the term “black swan” for centuries referenced an impossible event. However, black swans do exist. In finance, a black swan is a new or unexpected outcome not readily predicted by theoretical constructs or experience. Some have likened the twenty-year decline in state and municipal pension funding ratios to the next black swan event.   The pension crisis isn’t a black swan, it’s a perfectly predictable crisis. The continued associated risk is inexcusable.

Estimates of the total unfunded liability vary depending on actuarial assumptions (such as wage growth and life expectancies) and the types of investments deemed risk-appropriate. But the general range of $3 trillion to $6 trillion represents roughly $9,000 to $18,000 for every man, woman and child nationally in unfunded public pension liabilities. This debt load grew over the past decade — despite a booming stock market. Investment mismanagement, overt underfunding by paying less than the annual required contribution (ARC), and covert underfunding by underestimating the ARC have all contributed to this crisis.

State pension crises have occurred in years past. It’s no surprise considering the skewed incentives inherent in public sector defined benefit plans. Three primary stakeholders influence the management of a pension fund: elected officials, employee unions, and fund managers. Each stakeholder has an incentive to game the actuarially required contribution calculation through overly optimistic actuarial assumptions, such as assuming people will die younger or that investment performance will defy economic reality. For elected officials, underestimating the future cost of pensions frees up the revenue necessary to keep their campaign promises and thus propel their political careers. For unions, underestimating the future cost makes it easier to secure more generous benefits at the negotiating table. Oddly enough, pension fund managers often balk at applying more conservative return assumptions out of fear the plunging pension funding ratio may reflect poorly on their performance.

State constitutions or other extremely strong legal barriers often protect pension obligations from being reduced, not to mention the political infeasibility of reducing payments to currently retired state employees. In most cases, these liabilities will eventually have to be paid, it is merely a question of when. The failure to build sufficient return-generating assets forces a constant re-amortization of pension liabilities, deferring painful budget choices. For example, severe mismanagement of the Connecticut State Employee Retirement System in the 1980s generated a large spike in unfunded liabilities. On top of the large debt accrued in the 1980s, Connecticut did not adjust their actuarial assumptions quickly enough to account for the slow economic growth between 2001 and current day, contributing less than they should have. The gap between the assets and liabilities is now being reamortized from 2032 through 2046, pushing the debt service out to 2046. The debt service on unfunded state pension liabilities has and will continue to, crowd out core services and raise tax burdens, suppressing the economic opportunity of the coming generation.

Unfunded state pension liabilities will be a millstone around the neck of taxpayers for at least the next two decades. Tax hikes or slashed services will hamstring a generation. Far from a black swan, this crisis is entirely predictable. Rushing headlong into the abyss past the blaring warnings is inexcusable.

In Depth: State Budgets

Smart budgeting is vital to a state’s financial health. The ALEC State Budget Reform Toolkit offers more than 20 policy ideas for addressing today’s shortfalls in a forthright manner, without resorting to budget gimmicks or damaging tax increases. One way to stabilize budgets over time is to embrace…

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