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The Truth About the State Pension Crisis: Separating economic myth from economic fact

By Veronique de Rugy -
Myth 1: Unfunded state pensions do not represent an immediate threat and are therefore not in crisis.
Fact 1: In the best case scenario, some state pension funds will run out as soon as 2017. And the
longer the states wait to fully fund their pensions, the more drastic the financial consequences will be.
The fact that state pensions only represent a small share of state budgets doesn’t mean that they aren’t
in crisis. Take the case of New Jersey. According to Joshua Rauh, professor of finance at Northwestern
University, under the best case scenario, New Jersey’s pension funds (there are 5 of them) are
scheduled to run out as soon as 2017. Once those state pension plans run out of money, pension
payments will have to come out of the state’s general fund revenues—that is, out of the pockets of state
Furthermore, there is reason to believe these estimates are too conservative. When private-sector
accounting methods are used to show the true market value of state pension liabilities, the situation
becomes even more critical than it initially appears.

According to Andrew Biggs of the American Enterprise Institute and my Mercatus Center colleague
Eileen Norcross, the state of New Jersey reports that its pension systems are underfunded by $44.7
billion. Yet when those pension plan liabilities are calculated in a manner consistent with private-sector
accounting requirements—methods that economists almost universally agree to be more appropriate—
New Jersey’s unfunded benefit obligation rises to $173.9 billion.
In other words, New Jersey has made a $173 billion promise without any idea of how it will pay for it. I
would say that’s a crisis.
Plus, this is serious money. As Biggs and Norcross note,
This amount is equivalent to 44 percent of the state’s current GDP and 328 percent of its current explicit
government debt. This calculation applies a discount rate of 3.5 percent (the yield on Treasury bonds with
a maturity of 15 years) to reflect the nearly risk‐free nature of accrued benefits for workers. It is
estimated if state pension assets average a return of 8 percent, New Jersey will run out of funds to meet
its pension obligations in 2019. If asset returns are lower than 8 percent, they will run out of funds
This has real implications. State actuaries estimate that under certain assumptions, New Jersey’s
pension plans will run out of enough assets to make benefit payments beginning in 2013.
The irony is that New Jersey, like other states, has put itself in a financial binder even before the
pension crisis really hits. That says a lot about the state’s future ability to address the problem.
Myth 2: State debt accurately reflects state liabilities. And state default is not a concern because the
federal government will bail the states out before they reach that point.
Fact 2: Many government pension liabilities are kept off the books, so most states and cities
underestimate their actual debt.
Consider Connecticut. Bonds are only a small part of its total debt. Like many other states, Connecticut
also owes to its pensions and retiree health care funds, which are not clearly disclosed, and which will
cost even more in the long run.

Northwestern’s Joshua Rauh and Robert Novy-Marx, an assistant professor of finance at the University
of Rochester, have added Connecticut’s unfunded liability to the state’s debt. As you can see in the
chart above, the state’s reported debt is roughly $23 billion. The official estimated value of its unfunded
pension liabilities is $48.4 billion. That’s $71.4 billion. On top of that amount we should add another
$28.2 billion in underestimated liabilities due to poor accounting standards. Now you have a total state
debt of almost $100 billion.
Would the federal government really have the ability to bail out 50 states whose individual debt often
exceeds $100 billion? That would cost roughly $5 trillion. And while all of that money wouldn’t be paid
out at once, it is still unrealistic for the states to count on a federal bailout.
Myth 3: State and local workers are not overpaid. And even if they are, changing their compensation
won’t make a difference.
Fact 3: While this is a complex issue, the total compensation package for state workers does tend to
exceed that of their private-sector counterparts.
Take the case of Ohio.
The Buckeye Institute for Policy Solutions has an interesting report out called “The Grand Bargain is
Dead.” As we see in this example from Ohio, compensation costs for state and local employees begins
at a higher level than that of their private-sector counterparts and continues to diverge throughout the
employees’ careers. According to the Buckeye Institute, for 26 careers in state and local government
paying around the median wage rate, government employees were consistently and significantly paid
above the corresponding private-sector wage rate.
Ohio has an on-the-book $8 billion budget gap. The data shows that in the Buckeye state, where almost
one new public-sector job was added to the economy for each private-sector job from 1990 to 2010,
realigning state worker compensation packages to match those of their private-sector peers would save
taxpayers over $2.1 billion in the next two years (or 28 percent of this year’s $8 billion deficit).
It is true that comparing compensation is a tricky business. While taking a closer look at the differences
between public and private-sector employees explains some of the compensation differential, it is not
great enough to explain the difference in wages between comparable public and private employees.

This chart from The New York Times shows that there are 12 percent more white-collar workers in local
government than there are in private employment and 19 percent more white-collar workers at the state
level. Some argue that this is the reason for the difference in compensation. It’s the diplomas stupid!
Maybe, but all the diplomas in the world can’t explain the 221 percent difference in lifetime employment
costs witnessed by workers in Ohio.
Myth 4: The financial crisis, which caused a depreciation of pension assets, is the real culprit behind
pension underfunding.
Fact 4: While the recession dealt a severe blow to state pensions, the problem of pension underfunding
dates back to the early 2000s. Many states had already failed to cover the cost of promised benefits
even before they felt the full weight of the Great Recession.

The problem started long before the recession. A 2010 Pew study called “The Trillion Dollar Gap,”
found that in 2000, slightly more than half of the states had fully funded pension systems. By 2006, that
number had shrunk to six states. By 2008, only four states—Florida, New York, Washington and
Wisconsin—could make that claim. The chart above, taken from the Pew study, illustrates this point.
Here’s the bottom line: We can argue endlessly over when the pension plans will run out of cash, or
what the true value of the unfunded liabilities is. We can even debate what the true meaning of being
broke. But there is one issue where there is no room for debate. Once the pension plans run out of
money, the payments will have to come out of general funds, meaning out of the pockets of taxpayers.
If the states want to avoid this, they must push through reforms as soon as possible. A good first step
would be to switch to accounting methods that show the true market value of their liabilities. Once those
methods are in place, lawmakers should consider moving away from defined benefit pensions.
The squeeze on pensions
The Conservative Party has outlined plans to raise the state pension age for men
to 66 from 2016 - eight years earlier than planned.
The pension age for women will also rise to 66 by 2020 under Tory proposals -
something the party says is needed to help reduce the UK's national debt.
The Labour government has already committed to raising the pension age for men
gradually from 65 to 68 between 2024 to 2046. For women it will rise from 60 to 65
over ten years from 2010.
So why do the two parties want the pension age to go up?
Currently, there are more than 12m pensioners in the UK - with many more women
than men in retirement.

The move by politicians to raise the state pension age comes not only amid difficult
financial conditions, but also as the UK population ages, putting increased pressure on
government resources.

However, the UK is not alone. The world's population is also growing older and many
other countries are facing similar problems.
The ageing UK population means there will be many more pensioners to support. In
2001, the government's Actuary Department calculated there were 3.32 people of
working age to support every state pensioner.
By 2060, it says the ratio will have fallen to 2.44 people of working age for every one
state pensioner. In other words, there will be fewer working people contributing
towards the system that finances the state pension.
Both the Conservatives and Labour have proposed raising the state pension age, taking
into account people's longer lives.
This means the amount of time spent in retirement, as well as government expenditure,
will be reduced.
Meanwhile, the value of state pensions has declined since the link with average
earnings was cut by Margaret Thatcher's Conservative government in 1980.

Although a top-up benefit or pension credit has been introduced to ensure no pensioner
has to live on less than £130 a week, Labour has legislated to bring back the link with
average earnings by 2015 at the latest - a plan supported by the Tories.
You can find out more about pension credit on the Directgov site.