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A Nudge from the Feds for State Pension Reform

1:10 PM, Jan 18, 2012 • By DOUG HOLTZ-EAKIN
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A fundamental tension endemic within the conservative movement is whether and when the federal government should intervene in issues that fall almost entirely within the realm of the state. For instance, do the feds have an obligation—or even a right—to try to save a state from self-immolation? If the federal government will be left to clean up the charred remains, the answer is clearly yes. This is a key difference from the administration’s perspective, which indulges state profligacy and treats the federal taxpayer as a state spending contingency fund.

Senator Orrin Hatch.

Senator Orrin Hatch.

One of the greatest threats to our nation’s long-term economic health is the potentially ruinous cost of state pensions. Fortunately, Senator Orrin Hatch sees the smoke on the horizon and he’s sounding an alarm: His staff on the Senate Finance Committee released a report last week detailing the alarming funding shortfall in defined benefit plans for an increasing number of state governments and warning of the substantial risks these deficits pose to the federal budget.

The report appropriately emphasizes that these funding gaps are not solely attributable to the recent recession, as many are inclined to believe. The implosion of the stock market bubble in the late 1990s revealed lurking structural imbalances in pension funds in a large number of state budgets that have only grown since then, owing to ineluctable demographic forces and acquiescent state legislatures that refused to confront state unions.

But the roots of the current state pension crisis go back even further—the General Accountability Office pointed out over thirty years ago that the states’ defined benefit plans were structurally underfunded and would ultimately cause fiscal hardship, and since that time a fair proportion of states actually increased benefits for retirees. The arithmetic only worked by suspending disbelief and assuming that state pension funds could indefinitely earn a rate of return in excess of eight percent. It did not take the great recession for that assumption to prove unsound, and politicians found it politically expedient to kick the problem past the next election as long as there was enough money in the till to pay benefits until then.

Today, total compensation for public sector employees—a measure that includes health benefits and promised pension benefits—exceeds compensation for private sector workers with similar levels of education and experience. A savvy public servant can usually figure out a way to retire in his fifties for a benefit that comes close to his final salary working for the state. These early retirees can potentially receive these generous benefits in retirement for longer than their public service. So while many retirees then enter the private sector with two incomes, taxpayers remain on the hook for pension benefits predicated on promises that could never really be met. The result is that finances in states like California and Illinois, the two states with the biggest per-capital shortfalls, are not dissimilar from Greece.

And just like in Greece, virtually no one in office has the appetite to make the decisions that would begin to address the long term fiscal imbalance. With the exception of Rhode Island, no state has enacted pension reform that impacts the growth in benefits of any current employees, and without that step a long-term solution is simply arithmetically impossible: trillions of dollars of unfunded obligations due over the next 30 years cannot be paid for by simply reducing benefits of new government workers when they retire 40 years from now. The defined benefit plans and generous benefits that remain will burden state budgets and taxpayers —and the Finance Committee report warns that the federal government may find itself on the hook for the most woebegone states, since there’s no provision for states declaring bankruptcy.

The economist Herb Stein famously said that something that cannot continue will eventually stop. The various states cannot continue to promise the generous—and unfunded—pension benefits it has been providing, and the only question is who will be left holding the bill when it comes due: the retirees, state taxpayers, or the federal government. The Hatch report makes it clear it should not be the Feds.

Doug Holtz-Eakin is president of the American Action Forum.

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