The city of Detroit is an easy target for those who like to scoff at government mismanagement. Over the last decade it has been characterized by debt, depopulation and dilapidation, as negligent politicians disregarded essential reforms. The city’s decay reached critical mass in July 2013, when decades of passing the buck led to the largest municipal bankruptcy in US history. As tragedy unfolded in slow motion, the rest of the country watched with morbid fascination. Yet while non-Detroiters were merely spectators in this saga, it’s a tale that threatens to affect a town, municipality or state near them. Public sector pensions, a staggering liability across the United States, brought down the Motor City. As this problem continues to grow, other places will struggle to avoid ending up like Detroit.
The Great Recession caused securities to lose a tremendous amount of value across the board. The S&P 500 index plummeted by about 57 percent from October 2007 to March 2009, leaving millions of households reeling. Ostensibly safe assets, like pension plans, were not spared. State and local governments rely heavily on investing pension plans in order to meet the extensive retirement debts they will owe their employees. As of 2006, policymakers were counting on capital gains and dividends from such investments to provide for 60 percent of public pension obligations. But when the financial crisis hit in 2008 and expected returns went unfulfilled, a principal source of revenue for old-age benefits dried up. Even if the stock market grows robustly, non-federal pensions are now underfunded to the tune of about $1 trillion.
Legislatures and city councils all over the country may be in even greater arrears than that worrisome figure suggests. As calculated by the Center for Retirement Research at Boston College, the $1 trillion shortfall is based on an annual discount rate — the anticipated rate of return on investments — of 8 percent. While 8 percent was the states’ median yield from 1990 to 2009, politicians neglected the fact that over that timespan the actual rate of return was in decline. During the 2000s, the yearly return for pension funds was only 3.9 percent. According to David Crane, an SIEPR Research Scholar at Stanford University, this means that “by 2008, public pension funds had already fallen far short of the returns guaranteed from 2000-2007.” Because lawmakers were overestimating pension funds’ rates of return they failed to adequately raise their states’ annual contributions to employees’ retirement funds. Pensions were on the wrong track even before the recession, and if legislators continue to overstate expected capital gains and dividends, they will exacerbate the shortfall.
In light of heightened concerns over pension fund shortfalls, a growing cohort of economists is making the case that state and local governments need to use a more methodical tool to predict the yield on their investments. This tool, they say, should be United States Treasury Bonds. The main attraction of using Treasuries is that they are the standard for low-risk investment. Like Treasuries, investing pensions is ideally a low-risk game because, as economists Jeffrey Brown and David Wilcox explain, “[i]n most state and local plans, pension benefits are protected by constitutional, statutory, or common law guarantees.” Since pensioners have an ironclad promise from the state, the state should try to minimize the likelihood that it will have to renege on that promise. It does so by pursuing a long-term, risk-averse investment strategy. Because less risk also means less return, growing pensions is a naturally slow and steady process.
Policymakers usually do play it safe: the yield on US Treasuries hovered around 3 percent in 2012, close to the aforementioned 3.9 percent rate of return on pensions. However, this has not stopped lawmakers from expecting unrealistically high gains. In a June 2014 report, Pew researchers observed that “[f]rom 1992 to 2012, the median pension fund’s assumed rate of return changed only modestly, decreasing by 0.25 percentage points, from 8 percent to 7.75 percent. In contrast, the yield on risk-free, 30-year Treasury bonds declined by 4.75 percentage points during this period, from 7.67 percent to 2.92 percent” (emphasis added). Whereas expectations for pension funds started in tandem with Treasury bonds, they soon diverged from the realities of the marketplace. If politicians continue to rely on these dubious figures, they will perennially underfund pensions for the foreseeable future.
Using Treasury rates — as opposed to the inflated 8 percent return rate — economists Joshua Rauh and Robert Novy-Marx, two leading experts on the public pensions crisis, pegged the nation’s pension shortfall at $3 trillion in 2010. In October 2011, that estimate was updated to $4 trillion. Of course, this amount is not evenly distributed across the states. Some places, like New York, have their pensions more than 90 percent funded. But across the board, funding has been on the decline since the recession, with half of states on track to meet only 70 percent of their obligations. This is a good deal less than the 80 percent that the federal government prescribes as minimally sound. On the low end of the spectrum, the problem is becoming increasingly urgent. Illinois, which is slated to have only 40 percent of what it needs for promised old-age benefits, is in the worst shape. It will have to come up with tens of billions of dollars over the next several years to meet its obligations.
Time is of the essence. Joshua Rauh estimates that if the pension investments yield an optimistic 6 percent return, 31 states will be in dire straits by 2025. Even if lawmakers are correct to predict an 8 percent yield — which has been a dubious proposition in recent history — 20 states will still be in trouble. Fortunately, some legislatures and city councils have been listening. Many states have introduced and passed measures to curb benefits to new employees and renegotiate promised perks. New Jersey Governor Chris Christie, for example, just recently began to promote a plan to redress his state’s pension crisis. Considering that 50 percent of New Jersey’s pension obligations are unfunded, Christie’s action is timely. Yet reducing retirement benefits is just one side of the coin. Seriously underfunded pension systems may need to increase their annual contributions from 3.8 percent of state and local spending to 12.5 percent, assuming a 5 percent discount rate. Even states and cities that are not immediately vulnerable might need to triple their spending on retirement plans in the short term. Many politicians will doubtlessly find all of this difficult; cutting benefits and raising expenditures is a hard sell to constituents. However, as Fareed Zakaria points out, the biggest task is to stop the “fraudulent” accounting “at the heart of government pension plans” from continuing. If that is done, maybe lawmakers will start to grapple with the true proportions of their funding problems. Otherwise, new Detroits will start popping up.