State and Local Pension Funds Face a Shortfall Equal to 0.3 Percent of GDP

Are you scared? How will we pay for that? This is the context that was missing from the discussion of a bill from Utah Senator Orin Hatch which would encourage state and local governments to replace traditional defined benefit pension plans with cash balance type plans tied to an annuity which would be run by the insurance industry.

The piece told readers:

“For local governments and states, the unfunded liabilities are huge, ranging anywhere from $1.4 trillion to more than $4 trillion, depending on the assumptions plugged in by actuaries.”

These shortfalls are calculated over the pension plans’ thirty year planning horizon, a period in which the discounted value of GDP will be in the neighborhood of $500 trillion. It is unlikely that many readers have a clear sense of the projected size of the economy over this period, so they have little basis for assessing these projected shortfalls. If they did know the projected size of the economy they may disagree with the characterization of the shortfall as “huge.” (The difference between the two numbers is based on whether the pension funds calculate their shortfalls assuming that their assets earn their projected rate of return or whether they calculate their shortfall assuming their assets earn the return available on a completely safe asset like government bonds.)

There are a few other points worth noting about this picture. First, the shortfalls are likely to be considerably less next year. Most pensions calculate their current assets using a five year average. Next year 2014 will replace 2009. Unless the stock market plunges in the last three and a half months of the year, this change will lead to a substantial improvement in the funding situation of most pensions.

The second point is that the averages conceal sharp divergences across funds. Most pension funds are reasonably well-funded, with some having funding ratios of over 100 percent. There are a number of outliers, like Illinois, Ohio, and New Jersey, that have badly underfunded plans. This is not due to their investment patterns, but rather their repeated failure to make required contributions.

Finally, it is worth noting that turning over the pension plan to insurance companies will almost certainly raise the fees collected by the financial industry. This means that the same amount of taxpayer dollars will translate into lower benefits on average for retirees. That’s obviously good news for the insurance industry, but bad news for taxpayers and public sector workers.

There is one possible policy justification for throwing this money in the garbage. If an insurance company was an intermediary, it might be more difficult for politicians like New Jersey Governor Chris Christie to avoid making required contributions. As it stands now, the refusal to make these contributions appears to be part of Mr. Christie’s political shtick, allowing him to portray himself as a tough guy standing up to the state’s workers.

If there was an insurance company acting as an intermediary then perhaps the situation may be clearer to the public. Mr. Christie is simply trying to avoid paying bills that he has accrued, effectively stealing money from the state’s workers.