Happy New Year to everyone. I am happy to be back from my holiday blogging hiatus. And this week, I go back in the classroom to teach a course on local public policy. One of the biggest challenges facing states and localities at this moment is the underfunding of defined benefit pension plans for public sector workers. According to a recent editorial in The Christian Science Monitor (citing work by Robert Novy-Marx and Joshua Rauh):
By this spring, many states will run out of the $217 billion in stimulus money from Washington. (Illinois is already a deadbeat in paying bills.) Their budget woes will only mount as joblessness persists and politics prevents solutions in state houses.
Most of all, they face an estimated shortfall of $3.23 trillion owed to pension plans for current and retired state workers. Municipalities have an estimated $557 billion in pension liabilities. That adds up to about a quarter of the yearly US economic output.
If you have had your RSS reader set to Mary Williams Walsh of The New York Times, then you have seen this crisis coming for quite a while. Her reporting has been excellent for many years now.
There is nothing inherently wrong with a defined benefit pension plan, but its implementation has been a challenge in both the public and private sectors. It is a promise to pay compensation in the future. To honor that promise responsibly, the plan sponsor needs to fund it adequately in the time interval between when the promise is made and when it is kept. Simply put, that hasn’t been happening in large private sector plans and in most public sector plans. The problems are worse in the public sector because voters don’t pay as much attention to the financial bottom line as shareholders do and because the accounting standards are sharper for private sector plans than public sector plans. For many years, elected officials have been making promises that future (now, near-future) taxpayers are not going to want to keep.
It will be interesting to see how this plays out. The editorial cited above makes a good point — there should be no federal bailouts of state and local public sector pension plans. To the extent the federal government wants to get involved, it should offer loans, not bailouts. Ideally, these loans would have the highest seniority in the borrower’s capital structure and be made at penalty interest rates.