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Commentary By Diana Furchtgott-Roth

The State and Local Pension Crisis

Governance, Economics Tax & Budget

President Obama's new budget, with its trillion dollar deficit and interest payments of $5.6 trillion on the debt over the next decade, is only part of America's unfunded liability.

The state and local pension crisis is the subject of a new report by the Republican staff of the U.S. Senate Committee on Finance, entitled "State and Local Government Defined Benefit Pension Plans: The Pension Debt Crisis that Threatens America."

Senator Orrin Hatch, a Utah Republican and ranking member of the Senate Finance Committee, said last month, "Today, public pension debt stands at an alarming $4.4 trillion with outstanding state and local municipal debt at nearly $3 trillion. The public pension crisis plaguing our nation demands a real solution."

The Hatch report shows that the unfunded pension liabilities of state and local governments have been rising. Mr. Hatch plans to bring forward a series of proposals to reform public pension plans over the next few weeks.

By law, these pensions will have to be paid over time to the 19 million men and women who work for state, county, school district, and municipal government. The Hatch report warns that if pension fund income is insufficient to cover these obligations, they will have to be paid also by the taxpayers, either of the respective states or-possibly-by all of us, if Congress decides to ride to the rescue.

The latest estimate of unfunded pension and healthcare obligations for state and local government, $4.4 trillion, comes from Josh Rauh, a finance professor at the Kellogg School of Management at Northwestern University.

In 2009, Professor Rauh estimated $3 trillion in unfunded health and pension liabilities, based on Treasury bond yields ranging from 4.4 percent for 30-year bonds to 2.6 percent for 5-year bonds. Now yields are one-and-a-half percentage points lower, implying that liabilities are 23 percent higher, assuming a duration of 15 years. In either case, cities and states will not have adequate revenues to meet their obligations.

For many years a growing economy propelled increases in stock prices, enhancing the coverage of many pension plans, public and private. But stocks have not fully recovered from the market's collapse in 2007-2008. Prudent planning cannot assume that stocks will resume their prior course, and so the problem must be examined, and a prudent mid-course corrections must be devised.

Funding levels of state and local pension plans began deteriorating in 2000 with the popping of the dot-com boom. Now, the Pew Center on the States, a nonpartisan research organization based in Washington, estimates that 31 states have funding levels below 80 percent of full coverage.

An increase in unfunded liabilities could not have come at a worse time for state and local governments already staggering financially. Many states not only face record operating deficits from the recession, but they are looking at a potential expansion of Medicaid obligations when health reform is fully implemented in 2014. And, to balance their budgets, they have been laying off employees, thereby shrinking the number of people paying into their respective pension funds.

There is no tidy approach to resolving these problems. The states are essentially autonomous. Congress does not regulate their pension operations. The Employee Retirement Income Security Act, enacted in 1974, applies only to private-sector pensions.

Rather, state and local pension funds operate under guidelines of the Government Accounting Standards Board. It is essentially a federally-sponsored, private-sector advisory body, without enforcement power.

In the private sector, gains and losses of pension funds must be smoothed over seven years under the Pension Protection Act of 2006-ten years when requested by the plan's administrators. By contrast, in the public sector, gains and losses may be smoothed over 30 years.

This means that public funds can incur greater near-term deficits than private plans, because projected gains 30 years hence can be used to offset near-term losses, at least on paper.

The disparity raises a question as to whether the states and cities need to be held to a stronger discipline, according to the Hatch report.

Even states that are making large contributions to their pension plans find themselves in difficulties. Rhode Island and Utah both contributed the amounts suggested by the Government Accounting Standards Board, yet both have plans that are seriously underfunded.

Although private plans can reduce employee benefits and increase contributions to bring underfunded plans into financial health, many public sector plans have been prohibited by the courts from doing this. New employees can be charged a higher contribution rate for lower benefits, but not current employees who were hired under more favorable terms.

Underfunded public pension plans are legal obligations of the state, and have to be paid either with taxpayers' dollars, or with increased contributions from new state employees, or both. State and local tax rates will have to rise to pay for this.

Some analysts think that the problems are so severe that the federal government will end up bailing out the states. That's one reason, according to Standard and Poor's, why the ratings agency downgraded the U.S. government's debt in August, 2011.

Ratings agencies believe that Uncle Sam will step in because about 5 million state and local government workers are not covered by Social Security. Therefore, if their pension plan goes bust, they would have nothing except their own savings.

What can states do? The Hatch report reviews some options, and will publish more in coming weeks.

One option is to gradually raise the retirement age. Right now, in many states, you can retire at age 50 and start collecting benefits. State could allow workers to retire at the same age but postpone the age at which workers begin to collect benefits. Of course, that would cause some employees to keep working, adding to their eventual retirement benefit.

As it is now, many workers retire, collect benefits, and get another job.

States could also convert pension plans to defined-contribution plans, such as 401(k) plans in the private sector, which have been gradually displacing corporate defined-benefit pensions.

Plans can be closed to new entrants while retaining existing employees. Or, a plan could be closed to new employees, and present workers can be moved to a defined-contribution plan. In either case, the state remains responsible for liabilities of present retirees and the future benefits owed to current workers.

States have a responsibility to workers to disclose the condition of their pension funds, using realistic assumptions. If interest rates are low, it is imprudent to gloss over the weakness of the plan by assuming high, future rates of return.

Of the utmost importance is preventing the state and local pension crisis from becoming a further drag on the federal government. Mr. Obama's budget shows that Uncle Sam is in no position to fund states' liabilities.

This piece originally appeared in RealClearMarkets

This piece originally appeared in RealClearMarkets