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Even a recovery won't fix U.S. states' pension mess Add to ...

Jock Finlayson is the executive vice-president, policy, for the Business Council of British Columbia

Across the United States, dozens of states and hundreds of local governments are grappling with seemingly intractable fiscal challenges. Forty-nine of the 50 states have constitutional prohibitions against running budget deficits (borrowing for capital projects is usually permitted).

This differs from the situation in Canada, where the provinces can (and often do) incur budget deficits when revenues fall below current spending commitments. When the economy slumps and deficits loom, states have three choices: cut spending, hike revenues, or beg Washington for assistance. Today many states are aggressively pursuing all three options. But federal financial aid to the states is set to drop as the Obama administration’s stimulus spending initiatives wind down.

This will intensify the squeeze on state budgets.

The fiscal crisis afflicting state and local governments stateside is playing out in various ways. California and New York have slashed funding for universities and colleges; Arizona has disposed of the state capitol and legislative buildings in a bizarre sale and leaseback scheme; Illinois has collateralized future lottery receipts in a bid to help close a chronic fiscal gap; and various states have increased taxes and fees.

Recently, some hard-pressed states have taken direct aim at compensation for public sector workers. Several Republican governors have sought to roll back collective agreements, including reducing the costs of the defined benefit pensions enjoyed by state employees. Indiana and a number of other states have required newly hired public sector workers to switch to defined contribution plans. Chris Christie, the governor of New Jersey, has engineered pay and benefit reductions for state employees and teachers. And last month, the new governor of Wisconsin invited the legislature to pass a bill that strips most state workers of the bulk of their collective bargaining rights.

That pensions are now in the gun-sights of U.S. state policy-makers is no surprise. Various think tanks and academics have produced estimates of the gap between what US state and local governments have promised their workers in retirement and health benefits, versus the monies actually set aside to finance these promises. The published figures point to an overall funding shortfall of between $1-trillion ( Pew Institute); and $4-trillion ( economists Robert Novy-Marx and Joshua Rauh).

Three key factors help to explain the huge retirement-related funding gaps across broad swathes of the American state and local government sector.

First, some state and local government employers (and their workers) have long failed to make sufficient annual contributions to pension and retiree health plans. Academic studies suggest that many U.S. state and local government pension plans were substantially underfunded even before the onset of the 2007-08 recession and financial crisis.

Second, a decade of dismal stock market returns delivered a body blow to hundreds of U.S. pension plans (to say nothing of university endowments, mutual funds and private portfolios). From the start of 2000 to year-end 2009, the overall return on the S&P 500 index (including dividends) was actually negative. Equity returns matter to the health of defined benefit pensions: as of 2008, American state pension plans had 53 per cent of their invested assets in public equity, along with 8 per cent in private equity and 7 per cent in real estate equity. Only a third of invested assets were in fixed income securities.

Finally, the trustees of public sector pension plans have tended to used high discount rates when converting future pension liabilities into present value costs. A popular rule of thumb has been to adopt an 8 per cent discount rate for purposes of assessing the financial status of state/local government pension plans. The U.S. Government Accounting Standards Board says that future pension liabilities should be discounted at the same rate as expected returns on pension assets. But the latter is unknown, and asset returns can vary greatly from one decade to the next, as pension plan trustees have painfully discovered. Some economists now believe an 8 per cent discount rate is too high. A more appropriate discount rate for pension plans may be closer to the “risk-free” rate on government debt instruments – say 4.5 or 5.0 per cent.

A lower discount rate dramatically increases the magnitude of the unfunded liabilities of U.S. state and local government retiree plans. A 2010 Stanford University study found that with a lower discount rate, the funding gap for California’s three main state employee pension plans (covering government workers, teachers, and the university/college system) stood at half a trillion dollars as of 2009. This was nine times greater than the stated amount of unfunded liabilities collectively reported by the three pension plans.

What does the future hold? It’s possible that the current decade will bring significantly better equity market returns, which would ease the pressure on state and local government pension systems. This prospect isn’t far-fetched, as the poor equity returns seen over the 2000-2009 period may be anomalous.

Absent a sustained turnaround in U.S. equity markets, taxpayers will be required to stump up more cash to assure the solvency of state/local government pension plans, other public services will need to be pared back to fund generous retiree benefits, or public sector employees will be forced to pay more to fund their pensions or accept reduced benefits – including a shift toward defined contribution plans in some jurisdictions.

One thing is clear: the U.S. state and local government pension mess won’t soon be resolved and will provoke bitter conflict in many states even if the American economy continues to recover.

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