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Paying the pension tab

Associate Professor Joshua Rauh calculates the tax hikes and spending cuts that will be needed to fulfill public pension promises

By Aaron Mays

6/22/2011 -
Click here for the full study, "The Revenue Demands of Public Employee Pension Promises" (pdf)
Latest study by Professor Joshua Rauh calculates the tax hikes and spending cuts necessary to fulfill pension promises
Economists predict that American households will have to contribute an average of $1,398 per year to fulfill pension promises, according to a new study.

The paper, “The Revenue Demands of Public Employee Pension Promises,” is co-authored by Joshua Rauh of the Kellogg School and Robert Novy-Marx of the University of Rochester. Rauh and Novy-Marx calculate the increases in state and local pension contributions that would be required to achieve full funding of state and local pension systems in the U.S. over the next 30 years.

“This figure is above and beyond revenue generated by expected economic growth,” said Rauh, associate professor of finance at the Kellogg School. “To achieve fully funded pension systems within 30 years, contributions would have to rise today to the levels we calculate, and then continue to grow along with the economy.”

For taxpayers, these contribution increases would likely be in the form of tax hikes or spending cuts in public services. Without policy changes, a total of 13 states would require contribution increases of more than $1,500 per household per year, according to the study. Five of those states would need contribution increases of more than $2,000 per household per year. New Jersey would require the largest annual per household contribution increase of $2,475.

“It’s similar to credit card debt,” he explained. “The longer we wait to start paying down these promises, the more the contributions will have to rise.”

State accounting methods are not reflecting the reality of the tax increases or spending cuts that will be required to pay for pension promises, Rauh said. The distortions made by public sector accounting have hidden the fact that if pension promises are to be honored, taxpayers and recipients of public services will feel substantial financial pain in many states, he added.

As a baseline, Rauh and Novy-Marx assume that each state’s economy, public sector, and employee contributions to pension systems will grow at its historical rate of Gross State Product (GSP) growth. For the primary dataset, the economists used information from the Comprehensive Annual Financial Reports (CAFRs), analyzing 193 state and local government defined benefit (DB) pension systems—116 pension systems at the state level and 77 pension systems at the local level. The economists raised all assets and liabilities to their estimated values as of December 2010, accounting for the recent rebound in the stock market.

Rauh said that the pension situation has arisen because the current flawed state accounting standards also do not reflect the reality of the costs of making more benefit promises.

The authors found that there is no state, with the possible exception of Indiana, for which the current total contributions by all state and local government entities are greater than the true present value of newly accrued benefits for those entities.

Additionally, Rauh and Novy-Marx calculate contributions under several alternative scenarios and policy changes that would reduce future benefit accruals. They consider the possible effects of taxpayer mobility from high-tax to low-tax states, which would make the situation worse for some states and better for others. They find that the contribution requirements over the next 30 years may be higher for states that already have a significant amount of debt on their books and cannot tap municipal bond markets as easily for large contributions.

As for policy changes, the study considered the effects of soft and hard freezes. A “soft freeze,” which entails placing new workers in defined contribution (DC) plans, would reduce the average annual contribution to $1,223 per household from $1,398 per household. For states with large numbers of workers outside of the Social Security system, the extent of cost savings is limited by the likelihood that governments undertaking a soft freeze would have to start paying into Social Security and bearing most of the costs themselves.

Another alternative for states is a “hard freeze,” which entails stopping all future benefit accruals, even for existing workers. Under this option, no earned benefits (including cost of living adjustments) are revoked, but pensions cease to grow with service and salary, and future contributions are placed into DC accounts. Hard freezes in the private sector are relatively common and have been implemented to deal with pension liabilities, Rauh said. However, he believes that even a hard freeze of all benefits at today’s levels would not be a panacea, as the unfunded legacy liabilities would still need to be paid off.

“A hard freeze would save money for every state, even assuming workers not in Social Security would have to be brought in at taxpayer expense,” he said. “Nonetheless, contributions would still need to rise by more than $800 per household to achieve full funding in 30 years.”

MORE INFORMATION: To arrange an interview with Professor Rauh, contact Aaron Mays. Professor Rauh can be followed on Twitter via @joshrauh.