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January 24, 2006

Looming Crisis or Tempest in a Tea Pot? State and Local Government Pensions

State and local government pension obligations have been growing at a rapid rate. Payouts from major public pensions rose by 50% from 2000 to 2004 to $118 billion according to the U.S. Census Bureau . While this payout only represented a little less than 2.5% of total 2003 state and local government spending, the picture may worsen as aging government work forces reach retirement age in greater numbers.

There are nearly 14 million state and local government workers and six million current retirees who are owed more than $2.3 trillion dollars in eventual pension payouts by more than 2,000 different governments. Strains to make these payouts will be especially acute for those governments that have not kept their contributions current in funding obligations and where economic growth is lagging, such as parts of the Midwest. In such regions, government cannot outgrow its obligations through economic and population growth, but must rather dig deeply into current spending on public services or raise taxes to meet the pension obligations of the past. Not a promising recipe for a revival of growth and development in lagging regions.

How this pension crisis occurred and what can be done about it will be the focus of a half-day program organized by Rick Mattoon to be held at the Chicago Fed on February 28, 2006 (conference announcement and agenda)and cosponsored by the Civic Federation and the National Tax Association. At this event, pension experts will describe the current condition of state and local public pensions and offer some solutions for returning fiscal balance. Issues that will receive particular scrutiny will include:

  • To what extent are today’s pension systems funded, especially in the Midwest? What are the demographics of the state and local government work force and the attendant size of the potential pension funding stress? What are the resulting implications for general fiscal stress and strain?

  • How do public pension systems compare with private pensions and Social Security? Can and should they be structured differently? Most public pensions are still “defined benefit” plans where payouts are guaranteed over the retiree’s lifetime regardless of contributions. Should pension benefits for future retirees be changed to reflect their actual contributions?

  • What will be the likely financial impact of new accounting regulations that will require governments to recognize non-pension retiree expenses such as health care costs as future liabilities?

Solving the pension problem is more than a fiscal issue. Conference speaker Lance Weiss from Deloitte Consulting will talk about the human resource needs of state and local governments and the effect that pensions can have on retaining and recruiting new talent. For many public sector employees, a guarantee of a stable and secure pension has been a key component of compensation programs designed to keep workers in the public sector. Managing the transition to new types of pension programs will be a key human resource strategy for government managers.

Fred Giertz of the University of Illinois and Executive Director of the National Tax Association will contrast public pension programs with those in the private sector and the social security system. Giertz will examine regional differences in accounting standards, financing mechanisms and benefit levels, and discuss the relative health of these pension programs.

Laurence Msall, President of the Civic Federation, will lead a panel that will look at options for improving the health of public pensions. Governments have been attempting new strategies for managing pension obligations, including adopting less generous plans for new employees and offering incentives for employees to take a portion of their pension in a lump sum to limit future payouts. Still, many public finance experts predict that either existing government services will need to be reduced to provide enough revenue to meet pension obligations or taxpayers will be asked to bail out pension programs.

A final concern is the regional aspect of pension underfunding. States in the Midwest face a particular challenge in that much of their state and local work force is older and approaching retirement. In addition, some states face significant funding gaps and future liabilities that will only grow if left unaddressed. It is plausible that the pension problem is more acute in the Midwest, where projections for slow population and tax revenue growth will make it more difficult to grow the region out of the problem. For example research by the University of Illinois suggests that state pension programs should be 97% funded given the rate of income growth; current funding is at 62%. Further, the Civic Federation has found that Illinois has consistently shortchanged its pension contribution since the 1970s. For the state to reach its goal of being 90% funded in the next 40 years, it will need to come up with $275 billion. Illinois’s five major pension funds are currently $35 billion underfunded. Considering that the general operating budget of the state is $43 billion, the size of the deficit seems particularly daunting.

In the end, the future of public pensions is a national issue. Some estimates put the state and local government pension funding gap at nearly $700 billion, compared with a private-sector pension funding gap of $123 billion. Solving this problem will undoubtedly be a large public finance issue facing many states and localities in coming years.

Posted by Testa at January 24, 2006 4:35 PM


Is the amount paid to public sector employees by employment grade or type (or individually) a matter of public record that can be accessed by taxpayers (or others)? Is the annual cost to the state or munipality that should be put aside to pay defined benefit retirements publicly available, either in total or by pay grade? If not, how can these data be obtained?

Posted by: George J. Benston at January 27, 2006 11:20 PM

In response to a previous comment, governance and reporting structures for public pensions vary widely since there are few accounting standards that public funds must strictly follow. While a diligent individual could find out much of the information described by filing Freedom of Information requests, comprehensive information is frequently unavailable. In particular data on pension liability by job grade can be difficult to come by. Some pension funds do have websites that post financial statements that can be of use.

In addition, a couple of studies address these issues. I would check the website of the Public Pension Coordinating Council. It does a survey that includes some information on plan administration. Also a paper by Tongxaun Yang and Olivia S. Mitchell "Public Pension Governance, Funding and Performance: A Longitudinal Appraisal" Pension Research Council Working Paper PRC WP 2005-2 out of Wharton addresses some of these issues. It reports that only 25% of pension funds have annual reporting requirements including actuarial estimates of appropriate pension contributions.

The bottom line is that these funds have no set standards and that is part of the problem.

Posted by: Rick Mattoon, Senior Economist Chicago Fed at January 30, 2006 7:10 PM

Has any researcher estimated the amount of the State income tax increase required to meet the defined benefit pension plan and post retiree medical benefit obligation for state employees? I have the same question for the cities and counties as regards their local sales tax?

Such a study even if for just one situation would reveal the cost in concrete terms we could all relate too. My concern is that without this data none of us can realistically judge the true impact of continuing to fund these plans.

Posted by: Dr. Peter Hughes at March 20, 2007 10:01 AM

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