A new analysis by Josh Rauh at Stanford University's Hoover Institution says state and local governments’ collective unfunded pension liabilities are actually about three times the amount they claim. Rauh, a finance professor who has long been a critic of public pension accounting, arrived at his figure by assigning pension plans a much lower assumed investment rate of return.
Pension plans in 2015 collectively reported about $1.3 trillion in unfunded liabilities. In other words, they have about 72 percent of the assets they need to meet their estimated total liabilities. That figure assumes plans will earn an average of 7.4 percent each year on their investments.
Rauh, pointing to the wild swings of the stock market and the fact that pensions are putting more of their assets into volatile, alternative investments, says that assumption is too risky. He argues it's more responsible to consider a rate of return closer to what long-term bonds earn: slightly less than 3 percent. Under those assumptions, Rauh says unfunded U.S. public pension liabilities would roughly triple to $3.8 trillion, or less than half-funded.
The Takeaway: Rauh is arguing for accounting responsibility. And to be sure, the underwhelming returns of pension plans over the last two years bolster his case. Several pension plans have already acknowledged that their investment return assumptions likely won’t hold up in the long term and have lowered their assumed rates of return to 7 or 6.5 percent. But to drastically lower return assumptions would be devastating for governments and impair their ability to provide services to constituents.
Rauh even cites those consequences in his research. In the worst example, Illinois in 2015 put a whopping 11 percent of its own revenue into its pension plan. Even though that's a far higher share than other states, Illinois' payment was still short -- it actually needed to contribute more than 16 percent. Under Rauh’s approach, Illinois would have to contribute more than 23 percent of its revenue to avoid a rise in liabilities. That would dwarf education spending and make pensions second only to Medicaid as the state’s highest single expense.
Budget Shortfalls Roll Downhill
On the heels of Connecticut’s multiple downgrades, its capital city also took a credit hit this week. S&P Global Ratings flagged Hartford's reliance on state aid as a major concern when it downgraded the city's credit rating to one notch above junk status. Half of Hartford's $612 million budget for the next fiscal year relies on state funding.
The downgrade was based on “the heightened uncertainty” as to whether the state could boost financial aid or otherwise lend the necessary support to prevent Hartford from further fiscal deterioration. Connecticut has suffered under chronic budget shortfalls and is facing a more than $2 billion deficit for the next two years.
Adding to rating agencies' concerns was Mayor Luke Bronin’s open acknowledgment this month that his office is seeking advice from municipal bankruptcy lawyers. “While a bankruptcy filing remains distant, in our opinion, by raising the possibility, we believe that elected officials are seeking to better understand the legal qualifications, process and consequences associated with this action if there is no budgetary support at the state level,” wrote S&P's Victor Medeiros and Geoffrey Buswick.
The Takeaway: Connecticut’s budget crisis will likely be solved, in part, on the backs of local governments. In his proposed budget, Gov. Dannel Malloy would make local governments pick up a third of teacher retirement contributions (a collective $400 million alone for the upcoming fiscal year). For already dire places like Hartford, such an action would push local officials into new territory: Officials are already less gun shy about publicly discussing the “B” word.
While bankruptcy is still everybody’s last choice, the experience in places such as Detroit; Central Falls, R.I.; multiple cities in California; and most recently Puerto Rico; have seemingly made the process less taboo.
What Ratings Agencies Really Want in a Rainy Day Fund
State officials know that maintaining their rainy day funds aren’t just important for the next fiscal downturn, but also for their credit rating. But new research by the Pew Charitable Trusts says that correlation has long confused policymakers. After all, if the reserves are not to be used in times of fiscal stress, what are they for?
The research found that even in states with the agencies’ highest rating (triple-A), policymakers often are unsure about how best to manage their rainy day funds to earn or keep high credit ratings. “As a result,” the report says, “some state officials are reluctant to tap reserves even during recessions for fear of a ratings downgrade.”
But the report also found that ratings agencies don’t automatically punish a government for drawing upon its reserves. If the action fits within what credit ratings agencies consider prudent fiscal policy, the report says, it won't factor into a downgrade.
The Takeaway: So what is prudent fiscal policy where rainy day funds are concerned? According to Pew, it's:
- Defining rainy day funds savings goals and codifying them so they aren’t subject to the whims of changing administrating and legislatures;
- Considering a state’s revenue volatility and the business cycle when designing a fund’s deposits, withdrawals and savings targets, and;
- Basing the decision to tap rainy day funds on a state’s fiscal situation, “withdrawing money as appropriate during budget crises but resuming deposits when economic and fiscal conditions improve.”
Indeed, establishing prudent fiscal policy for rainy day reserves can help boost a credit rating and ultimately save taxpayer money. For example, in early 2015, Fitch Ratings upgraded California to A+ in part because of the state’s newly institutionalized savings policy and bolstered reserves. Following the upgrade, the state refinanced $1 billion in bonds, saving taxpayers nearly $200 million in debt service costs.
To read this regularly, subscribe to "The Week in Public Finance" newsletter for free.
