An often-stated goal of public employee pension systems is to achieve fully funded pension systems in 30 years. In a newly released paper with Robert Novy-Marx, covered in a New York Times article, we calculate the increase in contributions that will need to be devoted to these funds on an annual basis to achieve this goal, starting with estimated December 2010 asset levels. Without changes to pension formulas, state and local pension contributions across the US would have to immediately increase by a factor of 2.5, reaching 14.2% of the total own-revenue generated by state and local governments (taxes, fees, and charges). This represents a tax increase of $1,398 per U.S. household per year, above and beyond revenue generated by expected economic growth.
There is substantial variation across states, with New Jersey needing to find additional revenues of $2,475 per household per year to fund state and local systems, and Indiana only needing an additional $329 per household per year. Five states require contribution increases of more than $2,000 per household per year and thirteen states require increases of more than $1,500 per household per year. These baseline calculations assume no migration of the tax base across state borders in response to the wide variation in fiscal condition of the states. Modeling of such migration increases the revenue requirements of the states already in need of the highest contribution increases and reduces the revenue requirements of the states whose required increases are already small.
The paper also illustrates how the current government accounting standards do not reflect the reality of the costs of making more benefit promises. With the possible exception of Indiana, no state in 2009 contributed the full present value of new benefit promises when such promises are measured using government bond yields as discount rates — despite the fact that a number of states have been purporting to both pay the cost of new benefit promises and to make payments towards unfunded liabilities.
We also calculate required contribution increases under several potential policy changes that would reduce future benefit accruals. A “soft freeze,” which entails placing new workers in defined contribution (DC) plans, would reduce the average annual contribution to $1,223 per household from $1,398 per household, while also having transparency benefits. However, for states with large numbers of workers outside of the Social Security system, the extent of cost savings is limited by the likelihood that governments undertaking a soft freeze would have to start paying into Social Security and bearing most of the cost of doing so themselves. A “hard freeze,” which entails stopping all future defined benefit accruals even for existing workers would save money for every state, even assuming workers not in Social Security will have to be brought in fully at taxpayer expense. Nonetheless, contributions would still need to rise by more than $800 per household per year nationally to achieve full funding in 30 years.
You can read about all that in the paper, so let me conclude by speculating a bit on the role of such calculations. I would hypothesize that one of the reasons public employee pension promises have come to exceed assets set aside by such a large margin is that it is difficult for taxpayers to assess the true cost of the promises on an ongoing basis. This has turned public employee pension programs into large sources of off-balance-sheet debt finance for state and local government politicians to spend money without actually raising taxes, telling voters they can have their cake and eat it too. Perhaps calculations of the per-household tax cost of public employee pension promises will remove some of the opacity and present a picture of this pension-related debt that is more informative to taxpayers. As a policy prescription, as I have written before, we need to start paying or stop promising.
[…] on his blog about a new study that he just released, with Robert Novy-Marx, that estimates state and local pension contributions need to increase by a factor of 2.5 to reach solvency in 30 ye…. That amounts to a tax increase of $1,398 per household, per […]
[…] on his blog about a new study that he just released, with Robert Novy-Marx, that estimates state and local pension contributions need to increase by a factor of 2.5 to reach solvency in 30 ye…. For the average American household, that amounts to a tax increase of $1,398 per household, per […]
This analysis assumes annual economic growth of just 1.8 percent. which is the lowest average 10-year rate of economic growth this nation has experienced in at least 60 years. This is an unrealistic assumption being used to derive an unrealistic conclusion. The projections in this paper would be significantly different if a more realistic assumption for economic growth were applied.
If our nation’s economic growth continues at the same pace as it has been over the last 10 years, our pension costs will be among the least of our problems.
Our study assumes annual real GDP growth of 1.98%. Using the official BEA statistics, my calculation of average annual postwar real GDP growth is 2.99%. Increasing the assumed growth rate by one percentage point from 1.98% to 2.99% would cut $120 per household off of the $1,398, leaving each household’s tax increase at $1,278. This calculation is symmetric to our finding in the paper that $120 per household is added if GDP growth is 1% slower. So if the growth rate is the postwar average instead of the average over the past 10 years, only 10% of the problem would be solved.
Do we think we’ll see real GDP growth of 3% for the next 30 years? That implies that the real size of the US economy will be 2.4 times as high in 2040 as in 2010. A factor of 1.8 times, consistent with 2% real GDP growth, seems more likely. A real growth assumption of 2% isn’t particularly pessimistic. Indeed, to claim the next sixty years are going to be like the last sixty is basically saying there was no luck involved in the postwar era economic performance, i.e. that we are going to have the best performing economy in the developed world once again, because the US just grows faster.
Regardless, we can see from the calculations that economic growth is not going to bail the state and local governments out of the joint problems of legacy liabilities and the fact that government accounting standards distort the economic cost of ongoing benefit promises.
Thank you for your response.
Your study also assumes a real rate of investment return of 1.7 percent, far below the actual historic experience of public pension funds and other investors, What would be the effect of a more realistic real rate of return, say, of four percent?
I don’t see this assumption as particularly bearish – if current inflation forecasts hold, it implies realized returns of around 4.5%. The NYT graphic presents our calculations of the returns that would be needed to bail states out of their problems. The mean is about 13.5%. So assuming pension funds get lucky and earn a couple percentage points of additional return isn’t going to solve the problem either.
More to the point, it is irresponsible policy to assume that the pension funds will receive with certainty the same returns they earned in the past by betting on the stock market. The fact that most systems are attempting to target 8% returns in an environment where the 10-year bond is yielding 3.0% necessarily means that they are taking on even more substantial investment risk than in the past, exposing taxpayers to an even larger downside since the pensions have to be maintained regardless. Governments should not set policy by assuming that historically good stock market realizations will continue indefinitely and are risk-free.
For what it’s worth, Social Security projects a long-term GDP growth rate of around 2.2 percent and CBO is pretty similar. GDP growth will be slow just because labor force growth will be slow, mostly due to population aging. Given the size of the fiscal problems at the federal level, which these GDP projections ignore, I wouldn’t be too surprised if we were in the 2% range.
[…] Read more…. […]
[…] I posted about my new paper, “The Revenue Demands of Public Employee Pension Promise,” which finds that […]
[…] put out a new paper: the revenue demands of public employee pension promises….and he’s asked for responses. Here’s some of the responses he’s gotten so far. And another response (from […]
[…] put out a new paper: the revenue demands of public employee pension promises….and he’s asked for responses. Here’s some of the responses he’s gotten so far. And another response (from […]
The simple question that should be asked first is why are government employees entitled to defined benefit pensions when they are virtually extinct in the private sector, having been converted to defined contribution plans or 401Ks.
Simply converting the plans would ensure the employees get what has been paid in for them, without letting public employees hold the taxpayers hostage if investment returns are below par. Moreover, the cost of defined contribution plans is clearly visible each year, which would lead to better cost control and accountability to taxpayers.
The abuse of public sector defined benefit pensions by govt unions is a back door way of extracting above market compensation and hiding it from the public.
[…] in recessiontax.com: Really Bad Reporting in Wisconsin: Who Contributes to Public Workers Pensions?The Revenue Demands of Public Employee Pension PromisesWill Attempts By Politicians To Steal Police Pensions Be The Wake-Up Call Cops Need?Portland Fire […]