Will State Pension Funds Need a $1 Trillion Bailout?

Wednesday, May 19, 2010

The federal government could face another economic disaster and massive bailouts within a decade if it doesn't force state pension funds to revamp their operations soon, an economist says.
Even if they meet "aggressive" 8 percent growth targets, several states will see the reserves in their pension funds dry up by the end of 2020, with many more running out of cash within another decade, says Joshua Rauh, an economist at Northwestern University's Kellogg School of Management. Broke states are likely to go begging to the federal government, which would probably have to bail them out to the tune of more than $1 trillion, he argues in a new paper. The funds are under legal obligation to pay out to state employees, and they're way behind. For example, New Jersey—one of the states in the most trouble—is chipping in only about 6 percent of what it needs to remain solvent.
"This is really a problem of promises having been made that cannot be met," Rauh says. "It's less demographics and more just that employees have been compensated using these promises, and these promises have not been adequately funded. Politicians have been able to promise benefits that don't come due until long after their political horizon, beyond their term [in office]."
If and when states run out of reserves, they'll have to dip into their annual budgets to pay out benefits. But most states are required by law to have balanced budgets, and pension benefits could equal up to half a state's annual revenues. To reach that mark, they'd have to make cuts as large as the brutal measures California is taking to balance its budget.
More likely, they'd ask for a bailout. Letting state governments fail just isn't really an option for the feds. Cash from Washington is already helping to float many states' budgets, but it's likely that state and local governments will be in for more pain over the next few years because their budgets tend to be a lagging indicator. Tax revenues typically slip more than a year after an economic shock, when property values sink and citizens pay taxes on diminshed incomes. Furthermore, the federal government already backs private companies' pension plans through the Pension Benefit Guaranty Corporation, but that fund is running large and growing deficits, and it would likely be forced to back states, as well.
Rauh suggests that the government instead offer tax incentives for states to reform their pensions' structures, moving from a system that promises set benefits in the future to a model of giving employees money to invest now, and putting public workers into Social Security. He calculates that the government would end up spending around $75 billion—a far cry from a $1 trillion bailout.
But is anyone listening? Rauh is presenting his paper today in Washington, D.C., but the most important audience might be his friend and former colleague Austan Goolsbee. Goolsbee is now a member of President Obama's Council of Economic Advisers, but both were professors at the University of Chicago's Booth School of Business until recently. Rauh decided to write the paper after discussing the looming pension problem with Goolsbee.
Rauh said: "He [Goolsbee] said, 'State and local problem,' and I convinced him that we do need to worry about it. So he said, 'OK, you convinced me. So what do we need to do about it?'"