A Case for Underfunding State Pensions?

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Mar 2, 2010

In the last few weeks, the lousy funding status of state and local pension plans was back in the news, thanks primarily to a new study released by the Pew Center on the States (click here for a link to the study).

 

The news is not good.  The study reports that there is a $1 trillion gap “between the $3.35 trillion in pension, health care and other retirement benefits states have promised their current and retired workers as of fiscal year 2008 and the $2.35 trillion they have on hand to pay for them.”  In fact, the news is probably even worse because this study was conducted before the worst of the equity market decline in late 2008.  

 

For those readers here in Illinois, you probably already know that our state is among the worst.   According to the Pew Study, “Illinois was in the worst shape of any state, with a funding level of 54 percent and an unfunded liability of more than $54 billion.”  Not that any of us are surprised to learn that Illinois is a case study in bad governance …

 

I’ve written before (here) about why the pension funding hole may be even worse than the official statistics indicate, especially in those states that have constitutional guarantees of benefits.  What I thought I would do today is make a simple point about an important asymmetry in how funding levels affect pension obligations and what this implies about appropriate funding levels and portfolio allocations.

 

Let me be clear at the outset – I am usually an advocate of fully funding our pensions.  And I wish we lived in a world in which politicians could engage in rational policy-making based on good economics.  This would include providing responsible levels of pension benefits to public employees and properly funding them.  Unfortunately, we do not live in such a world.  So I thought it would be fun to speculate for a moment about what this political reality implies for pension funding.

 

I’ve read quite a bit about the history of state pension plans over the past few decades.  I believe the following is almost surely true:  in good economic times (rising state revenues, high equity values, more fully funded pension funds), state governments appear much more likely to increase the generosity of pensions.  But in bad economic times (falling revenues, low equity values, larger funding shortfalls), these same states are legally and/or politically unable to decrease the generosity of pensions.    

 

This assymetry (increasing benefits in good times, but not being able to cut them in bad times) creates a bit of a conundrum for those of us who normally advocate full funding of pensions.  The reason is that the asymmetric political response suggests that some level of under-funding might actually be optimal (at least in a “second best” sense) because it serves as a constraint on further benefit increases!  

 

In short, we may prefer that our politicians underfund the pension obligation in order to limit the size of the obligation that ultimately needs to be funded.  Rational economic policy would not have to resort to such tactics.  Real economic policy in a political world might need to do so.

 

I do, of course, realize the irony here.  Namely that bad economic policy – our inability to have a rational, coherent approach to benefits for public sector workers – is serving as the basis for justifying more bad economic policy – underfunding our pensions.  But as the “theory of the second best” points out, in the presence of one distortion, sometimes society is better served by a second distortion that helps to offset the first.