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Associate Professor of Finance Joshua Rauh

Associate Professor of Finance Joshua Rauh

State pension funds headed for crisis of national proportions

Associate Professor Joshua Rauh foresees the need for more bailouts if state pension programs are not addressed — and offers a long-term solution

5/19/2010 - Taxpayers, public workers and state and federal officials alike have cause for serious concern about an issue that often falls under the radar but poses serious risk to the future health of the national economy: state pension liabilities.

Data presented May 19 by Associate Professor of Finance Joshua Rauh at the “New Retirement Realities: Pensions at a Crossroads” conference in Washington, D.C. demonstrates that several state pension funds will not last the decade. The situation will place tremendous pressure on the federal government to bail out financially insolvent states at a price tag likely to match or exceed the recent bailout of the U.S. financial system.

Rauh predicts that without basic reform to the current pension system, many large state pension funds will run out, even if they achieve predicted 8 percent annual returns. As a result, Rauh warns, promised benefit payments would be so substantial that it would be infeasible to raise state taxes to make the payments, leaving no other option than to call on the federal government to bail out the failing states.

  To read the full plan and the presentation, visit the Everything Finance blog
As an example, Rauh points to Illinois. If the state’s three main pension funds earn 8 percent returns and the state makes contributions accordingly, the funds will run out of money in 2018. In the following years, benefit payments owed to existing state workers would be an estimated $14 billion — more than half the revenue Illinois is projected to receive in 2010. States are legally obligated to make these payments.

“This is a problem of monumental proportion,” said Rauh. “Given that we see the same issue in many states, the total size of a federal rescue plan could exceed the seriousness of the recent economic crisis and potentially cost more than $1 trillion total. Plus, this scenario could happen sooner if taxpayers flee to other states with lower taxes and higher services, if contributions are deferred or not made, or if returns are lower than expected.”

While Illinois is currently at the highest risk, pension funds in other troubled states — Louisiana, New Jersey, Connecticut, Indiana, Oklahoma and Hawaii — could dry up by the end of 2020. And by 2030, as many as 31 states could be affected.

To counter this problem, Rauh outlined an innovative plan. It notes that fundamental state reform is essential, and underscores the urgent need for a federal program that offers incentives to stop the growth of unfunded liabilities. He recommends that states be allowed to issue tax-subsidized pension funding bonds for the next 15 years if they agree to a specific program of major pension reforms. To get the subsidy, states must agree to close defined benefit plans to the approximately one million new workers who take state jobs every year, and instead to offer the new hires a defined contribution plan similar to the federal Thrift Savings Program, as well as guaranteed access to Social Security.

“Right now only a quarter of all public workers contribute to Social Security,” said Rauh. “While the cost for the pension security bonds over 15 years would be about $250 billion, under this plan the Social Security system would see a net gain of over $175 billion. All told, the cost to the federal government for such a program would be around $75 billion, far less than the minimum $1 trillion it could risk if the state pension fund system is left in disrepair.”

Rauh’s plan offers a cogent solution for the tens of millions of police officers, firefighters, teachers and other public service and state employees who will enter the workforce over the next decade, while maintaining consistency for workers already in the system.

“Existing pensions would become more secure and new workers would get more than an empty promise, while the country would avoid another massive taxpayer-financed bailout,” he concluded. “It is imperative that we act today to give states the incentives they need to put themselves back on a path to fiscal sustainability.”