Associate Professor Joshua Rauh predicts taxpayers will bear much of the $3 trillion in state pension liabilities
8/19/2010 - In recent months, discussion surrounding the financial soundness of state pension plans has been hotly contested. In fact, recent research by the Kellogg School suggests that pension programs in as many as 31 states are headed for run outs and financial disaster by 2030.
A new paper co-authored by Associate Professor of Finance Joshua Rauh predicts that taxpayers will bear a large share of the financial burden of the $3 trillion in unfunded legacy liabilities associated with state pension plans.
On Aug. 19, Rauh presented this paper, “Policy Options for State Pensions Systems and Their Impact on Pension Liabilities,” at the State and Local Pensions Conference for the National Bureau of Economic Research, Inc. (NBER) in Moran, Wyo. The paper examines the present value of state pension liabilities under existing policies and separately under several hypothetical policy measures, such as changes to cost of living adjustments (COLAs), full retirement ages, early retirement ages and buyout rates for early retirement. It is co-authored Robert Novy-Marx of the University of Rochester.
“Even if states uniformly eliminated generous early retirement deals and raised the retirement age to 74, the unfunded liability for promises already made would still be more than $1 trillion,” said Rauh. “The feasible measures that could be proposed to make public employees bear the costs simply do not have sufficient power to eliminate these unfunded liabilities.”
To examine the economic magnitude of pension liabilities, the researchers used a database of 116 state government pension funds, including all plans with more than $1 billion in assets that are sponsored by state governments. To determine the impact of potential policy changes on state pension liabilities, they modeled each plan’s cash flow to plan participants using detailed information disclosed by the plans themselves.
Under existing policies, Rauh said unfunded pension liabilities are around $3 trillion, using U.S. Treasury discount rates. His method corrects for the fact that states inappropriately use expected returns on assets to discount promised pension liabilities.
Even moderate policy changes that affect current workers and retirees are highly controversial. Yet the paper shows that the kinds of measures being debated would have relatively small effects on pension fund liabilities. Specifically, a 1 percent reduction in COLAs would reduce total liabilities by 9 to 11 percent; implementing actuarially fair early retirement would reduce them by 2 to 5 percent; and raising the retirement age by one year would reduce them by 2 to 4 percent.
“Even much more dramatic policy changes like eliminating COLAs altogether or implementing Social Security retirement age parameters would still leave liabilities of approximately $1.5 trillion, on top of being even less politically feasible than the incremental reforms,” said Rauh. “The bottom line is that even much more drastic versions of the policy actions currently being discussed don’t come close to solving the problem, since so much of the pension debt is owed to workers who have already retired.”
Rauh noted that some policy changes already adopted by states to reduce liabilities on their pension systems affect new employees only, and have no impact on standard liability measures, which do not consider future employees.
“More than half of the liability is owed to people who have already retired, and the idea of large outright cuts to current retirees is not under serious consideration,” he said. “Assuming states don’t start defaulting on their bonds and other debts, it seems that taxpayers will be footing most of the multi-trillion dollar bill for the pension promises that states have already made to workers.”
To arrange an interview with Professor Rauh or to read “Policy Options for State Pensions Systems and Their Impact on Pension Liabilities,” contact Aaron Mays at 847-491-2112. 
