Virtually every state faces a public pension funding gap, having socked away less than they will need to meet their contractual obligations. Yet five states — New Jersey, Kentucky, Illinois, Connecticut and Pennsylvania — are in a league of their own. Although they represent about 13 percent of the U.S. population, they face more than a third of the total unfunded liability confronting all 50 states combined.

Decisive measures undertaken now could prevent default in these five states. But, as with, say, climate change, while we’re pretty sure bad things await if the problem is ignored, the real consequences of a pension failure will not be known for another 15 or 20 years — even in the states that have dug themselves the deepest fiscal holes. And that makes it extremely difficult to mobilize political will in favor of painful reform.

Is It Bad or Really, Really Bad?

The table below shows both the net pension debt (the pension plan’s liabilities minus its assets) and the funded ratio (the plan’s assets as a percentage of its total obligations) of each of these five states. They have been calculated under two approaches.

The striking difference in the two approaches turns on the use of different discount rates. The Pew figure is based on the median return on assets expected by pension fund managers, while the far lower figure from ALEC is the riskless rate that could be earned by investing solely in bonds with no risk of default. The Pew rate (self-reported by the states) is approximately 7.5 percent. The risk-free rate suggested by the corporate-funded American Legislative Exchange Council is slightly greater than 2 percent.

Pension administrators argue that the most appropriate discount rate is the one drawn from past returns on assets. The method for calculating that rate is prescribed by the Governmental Accounting Standards Board un-der a complicated formula. Backers of this expected-future-return-on-assets model note that the figure is conservative, since long-term (30-year) historical returns have been even higher (approximately 8.5 percent).

Nobody, however, claims that past performance guarantees future results. Indeed, they shouldn’t: the 10-year return as of June 2018 for the three largest public plans covering most of the employees of the states of California and New York (with combined assets exceeding $700 billion) was only 5 percent.

By contrast, ALEC (and most financial economists) argues that the risk-free rate is more appropriate even if the pension fund shoots for far more. Returns in the 7 percent range are plausible. But as Don Kohn, then vice-chair of the Federal Reserve Board, put it in 2008, “The only appropriate way to calculate the present value of a very-low-risk liability is to use a very-low-risk discount rate.”

In current practice, the risk-free rate is generally identified as the yield on the 10-year U.S. Treasury bond (as of this writing, a bit above 2 percent). Corporate plans regulated by the Labor Department are required to use a discount rate equivalent to an AA-rated bond (about 3 percent today). By employing a risk-free rate and fully funding the pension plan, there would be zero chance that pensioners would be disappointed or taxpayers would be required to meet unanticipated shortfalls.

The difference between 7.5 percent and 2 percent is huge when it comes to pension calculations because much of the cash flow of these long-lived plans is from their investment returns. Using the expected-future-return-on-assets model, the net liability of the state pension plans is about $1.4 trillion; using a risk-free rate of 2 percent, the figure exceeds $4 trillion.

The danger of clinging to the risky assets model is clear. The pressure to perform often leads state pension fund managers to embrace more aggressive investment strategies, exposing taxpayers to additional risk. And sometimes that risk can be daunting: during the Great Recession, the value of pension portfolios collapsed just when state tax revenues tanked and the demand on state budgets (think unemployment insurance and food stamps) was ballooning.

All that said, there is no indisputable “right” choice of discount rate. Much depends on the depth of a state’s problem, the degree of goodwill on the part of stakeholders with differing interests, and the practical difficulties in raising taxes later on to cover unexpected shortfalls. The best approach may be to report on funding gaps using both rates with clear, non-jargon-ridden explanations from state budget planners and pension plan actuaries. This, at the very least, would make the problem transparent.

The heterogeneity of the public pension funding problem is evident when examined on a state-by-state level. According to Pew, only four states report funding levels above 90 percent of their actuarial obligations, while 21 states’ plans are currently under 90 percent but widely viewed as manageable. Twenty are less satisfactorily funded, while five (including four of the five described above) are substantially underfunded, with less than half of the assets needed to pay for promised benefits (even under their Panglossian assumptions about expected returns on assets).

The worst-funded states, it should be noted, already have below-median credit ratings, and thus face higher borrowing costs and serious budget crunches, narrowing the choices they face. Actually, the squeeze is even tighter than it first appears: these states already have high taxes, as well as residents who can and do vote with their feet if they feel overtaxed or underserved. All five are among Forbes’ “Ten Most Moved From” states.

Sinking Deeper

How did we dig ourselves into such a deep hole? In large part, it follows from elected officials’ incentives to never pay today what can be put off until tomorrow — especially when more vocal constituents are demanding their own way. Poor accounting practices, some left over from the bad old days when state budgets were subject to little oversight, are also widespread. Many state governments have been able to defer required contributions to their pension plans, allowing net liabilities to balloon over decades.

As the graph shows, the funded ratio in the five most affected states has declined precipitously. Pennsylvania, New Jersey and Kentucky were all more than 100 percent funded in 2000. Today, the one with the smallest
gap — Pennsylvania — is now only 53 percent funded, and the two worst are each at 31 percent. By comparison, the Employee Retirement Income Security Act (ERISA) requires 100 percent funding by corporate pension plans, which, incidentally, is a major reason most corporations no longer provide defined-benefit pensions.

The Price of Myopia

The experience of the five frailest states shows how careless planning and irresponsible fiscal management can bring a public-sector retirement system to the brink. As noted above, New Jersey actually began the millennium with an overfunded plan. But in 2000, New Jersey lawmakers celebrated by hiking public pension benefits across the board without identifying how they would pay the bill. And since then, the failure by one administration after another — both Republican and Democratic — to meet its annual required contribution left the state’s plans with the largest funding gap in the country.

As goes New Jersey, so goes Pennsylvania. The legislature retroactively increased benefits by nearly one-quarter in the early 2000s, when coffers were flush. The increase was later reversed — but only for new hires and only beginning in 2011.

The picture is more stable in Connecticut and Illinois — but no prettier from the perspective of residents. Both are now shoveling about 15 percent of state revenue into the pension plans. And Illinois is so far behind that 15 percent doesn’t cover its required contribution, let alone make a dent in the long-term problem.

The Required-Contribution Albatross

In Illinois, the annual required contribution has grown to 17 percent of total state revenues; in New Jersey the figure is 14 percent. This drain on state budgets exacerbates a vicious cycle, reducing the quality of state services, pushing state and local taxes higher and eroding the tax base by increasing the incentives of the affluent — especially the elderly affluent — to move to lower-tax states.

The slightly good news leavening this otherwise bleak picture is that policymakers, especially those in the most vulnerable states, are slowly taking steps to reduce the squeeze on taxes and services. Almost every state has made changes in benefits since the Great Recession. Thirty states have reduced their plans’ cost-of-living adjustments, 37 have increased employee contributions, and nine have changed plan designs with the goal of reducing risk for both employees and taxpayers.

Still, daunting obstacles remain. For one thing, there is no legal requirement for state governments to make their annual “required” contributions; nor is anyone holding politicians accountable when they don’t. As we have seen time after time, legislatures find it easy and convenient to defer their required contributions when state budgets are tight — which they invariably are. Even when a state wants to act responsibly, it may find the hill is just too steep to climb.

New Jersey, for example, passed a law five years ago mandating an annual increase to its required contribution based on the previous year’s payment, with the process to be phased in over five years. Just two years in, though, the state threw in the proverbial towel, conceding it was unable to follow that schedule. To no one’s surprise, smaller-than-mandated payments meant the fund ended up deeper in deficit at the end of the year.

Another obstacle to reform that’s now facing states: lack of a sense of political urgency. Even the states in the worst shape, Illinois and New Jersey, will not find the well running dry for another decade or more. So there is little impetus for executive or legislative branches to act. What’s more, some officials believe the Pension Benefit Guaranty Corporation (PBGC), an independent federal agency that insures payouts for some 24,000 defined benefit corporate pension plans, may bail them out if they default on their obligations to teachers and public employees. That, however, is a serious misreading of the political landscape, since the PBGC is itself in severe financial distress.

The Search for Sustainable Fixes

Unfortunately, there is no painless way out of the widening pension mess. Puerto Rico offers one (painful) option that might work for states saddled with crushing pension debt. In the spring of 2017, the commonwealth declared a form of bankruptcy. With $49 billion in unfunded pension obligations and around $74 billion in bond debt, it won permission from Congress for bankruptcy like proceedings that gave the island extraordinary power to impose losses on its creditors.

As The New York Times pointed out at the time, “Puerto Rico’s case could show public workers and retirees that seemingly inviolate pension systems can be changed, too.” Under current law, states cannot declare bankruptcy. But Congress has the power to alter this — just as it did for Puerto Rico. In the end, however, the most promising solution for states is reform, not default.

What would such reform look like? States that have done the best job managing their pension affairs have followed the same straightforward script: governments must (1) set aside enough money today to pay for future benefits, (2) invest that money prudently and (3) resist the temptation to boost benefits during good times.

There are some positive examples. Wisconsin and Tennessee consistently pay their bills while also continuing to take action to control costs. And among the most challenged states, both Pennsylvania and Connecticut have increased contributions, trimmed benefits at the margins and created commissions charged with further examining costs — and perhaps deflecting some of the political heat for encouraging legislatures to do the right thing.

In New Jersey, a blue-ribbon commission appointed by the governor developed a common-sense plan anchored on the principle that employee pension and health care outlays combined should not exceed 15 percent of the state’s budget. The commission stayed within that safety zone through a reform that froze pensions of active employees (while preserving all benefits earned to date) and created in their place a “cash balance” plan — a hybrid of defined-benefit and defined-contribution retirement programs. To help pay the bill, the commission suggested deployment of the anticipated $2 billion of savings from health-benefits reform to fund the pension system. That initiative was stalled on difficult political shoals. However, it is currently being reexamined.

States are discovering that pension reform is even tougher than they expected, in large part because the interests of diverse constituents — taxpayers, retirees, employees, all with competing claims on the budget — rarely align. Continuing to hand the pension problem off to the next set of policymakers and legislators, however, is a risky business. Without a realistic plan to pay down their pension debt, states are at the mercy of external factors ranging from rising interest rates to recessions that will undo efforts to control deficits. It will never be easy to get these plans back on track — and it’s only getting harder.