Unfunded State Benefits: America’s Next Fiscal Crisis

Many cities and states won’t be able to make good on the promises they’ve made to their workers.

The dome of the Texas State Capitol building in Austin, December 8, 2012
The dome of the Texas State Capitol building in Austin, December 8, 2012 (Flickr/Mike)

America’s fiscal crisis looks less pressing than only a few years ago. A combination of spending restraint and tax increases that has resulted from messy compromises between President Barack Obama, a Democrat, and the Republican Congress should help push the deficit down to a manageable 2.5 percent of economic output this year.

Longer term, the rising costs of health and pension programs still look worrisome. But before the problem reaches Washington DC, it could wreak havoc at the state and local-government level.

The health and pension benefits public-sector workers enjoy are often generous. Most city and state governments offer their workers defined-benefit pensions based on their years of service and final salary (on top of Social Security, the federal program). These plans are supposed to be covered by funds specifically set aside for them. But there’s not enough money in the pension pots. By the states’ own estimate, their retirement plans are only 73 percent funded.

That’s bad enough, but — as The Economist has reported — nearly all states apply an optimistic discount rate to their obligations, making the liabilities seem smaller than they are.

If a more sober one is applied, the true ratio is a terrifying 48 percent. And many states are much worse. The hole in Illinois’ pension pot is equivalent to 241 percent of its annual tax revenues: for Connecticut, the figure is 190 percent; for Kentucky, 141 percent; for New Jersey, 137 percent.

By one estimate, the total pension shortfall is $2.7 trillion, or 17 percent of America’s entire gross domestic product.

And that doesn’t even include the unfunded pension obligations of city governments, nor health-care obligations of all sorts made by cities and states.

It’s no coincidence that places long run by Democrats tend to be worse off than those governed by more frugal Republicans. But both parties are to blame for not solving the problem.

On the one hand, Democrats are resistant to cutting benefits for fear of upsetting friendly public-sector workers and their unions. On the other, Republicans refuse to raise taxes to plug the hole.

There are a few states that have taken measures. Nebraska stopped offering final-salary pensions to new hires in 1967 and is now doing fine. Other states should follow its example.

States should also consider shifting to defined-contribution pension schemes, where workers get out what they put in. These are the norm in the private sector — and in the public sectors of many other wealthy nations.

Sadly, most state governments don’t feel the situation is urgent at all. It might have to get a lot worse before it gets better.