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State Pension Crisis: Implications and Solutions for Federal Government

Learn why federal government should be concerned about state pension liabilities, potential scenarios, and proposed solutions for a looming crisis.

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State Pension Crisis: Implications and Solutions for Federal Government

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  1. Why the Federal Government Should Worry About State Pension Liabilities Josh Rauh, Kellogg School of Management May 19, 2010

  2. Day of Reckoning • Without policy changes, many state pension funds will run dry in 10-20 years • Assumptions consistent with recent past • Start with September 2009 assets • Assume 8% investment returns • Assume contributions and newly accrued benefits offset each other

  3. When Will State Funds Run Out? • Under these assumptions • Illinois in fiscal year 2018 • 7 states by end of fiscal year 2020 • 20 states by end of fiscal year 2025 • 31 states by end of fiscal year 2030

  4. Examples • Illinois • Main 3 funds together run out in 2018 • Benefits will be $14B annually in 2019-2023,$11B annually already promised today • Governor Quinn: FY2010 revenue of $28B • Other examples • Connecticut and New Jersey (2019) • Louisiana (2020), Michigan (2023) • Ohio (2030), expected annual benefits during 2031-2035 are 100% of 2008 revenue

  5. All 50 States Combined

  6. What Happens in a Run Out? • Many state constitutions protect benefits • Across states that run out by 2025, benefit payments after run outs will average • 31% of 2008 revenues if plans frozen today • 45% of 2008 revenues if plans continue to run • Crisis • Taxpayers revolt • No buyers of state debt at auction • Retirees expecting checks

  7. Scenarios • Could happen sooner if • Workers start running for the exits • Taxpayers start moving • Contributions are deferred or not made • Investment returns are lower than 8% • Could happen later if • States make fundamental reforms • Can borrow enough to fill the hole • Investment returns are higher than 8%

  8. Role of Federal Government • Washington will face massive political pressure to bail out affected states • Consider recent bailout of banking sector, this one would be bigger • Any tough talk that Washington won’t bail out states is not credible • What can be done now?

  9. Reforms For States Troubled states should • Close defined benefit (DB) plans to new workers. New workers must get BOTH: • a defined contribution (DC) plan like the federal Thrift Savings Program (TSP) • Social Security • After (1), issue debt for existing liabilities • Much cheaper and more feasible than it will be if the situation deteriorates • Makes existing worker pensions more secure

  10. Proposed Federal Program • Idea: help states borrow to fund pensions, on condition that states make the reforms • New subsidized version of pension funding bonds, called Pension Security Bond (PSB) • Give states 35% direct interest subsidy for PSBs for 15 years IF the state agrees to three specific austerity measures…

  11. Conditions for Pension Security Bonds State must agree to • Close DB pension plans to new workers, not to start new DB plans for 30 years • Make exactly the annual Actuarially Required Contributions (ARC) for existing DB plan using the new PSBs • Include all new state workers for 30 years in Social Security plus a good DC plan, namely a Thrift Savings Plan spinoff set up by federal government

  12. Estimated Cost of Federal Program • Gross cost of tax subsidy for new PSBs around $250B • states to issue $1.0T in new debt over 15 years using 30yr bonds • Gross savings from Social Security contributions by new workers >$175B • Diamond-Orszag calculations, reduced to usei.) state workers only; ii.) shorter horizon  Net cost of program is $75B… versus $1T+ chaotic bailout

  13. Conclusion • Plan offers benefits to numerous parties • Existing pensions become more secure • New workers get more than an empty promise • Avoids massive taxpayer-financed bailouts • DC plans not perfect but immune to problems that are bankrupting states • State politicians can’t use pensions to borrow on horizons that extend beyond their careers • Federal government should act today to get states to address these problems

  14. Additional Slides

  15. 20 States Run Out by 2025

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