States and Cities Should Be Afraid of the Next Downturn

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For a large portion of my childhood, my goal was to become a state police officer. Whenever I would tell people this, they would almost always comment on those great benefits that I would receive, including that healthy pension that I would be eligible for after a few decades of work.

As I am now long past these police ambitions, I am honestly glad I won’t be relying on a state pension for down the road.

Why is this? Simply put, these state pension systems are growing to be the largest fiscal issue for every state in the U.S.

Pensions are what policy makers call unfunded liabilities since increases in benefits do not necessarily require higher funding from the government. They instead have traditionally relied on the contributions of the state employees who are then eligible down the road for benefits (police, teachers, civil servants, etc). Today, these contributes are supplemented by the return on investment for state’s fund as well as budget contributions.

It is pretty clear though that this current mix of funding is falling short of future liabilities that state have. Young public employees: precede with caution.

Growing Pains

State pension funds took a big hit during the great recession, losing about 28% of their total value, according to BC research data. Since retirees need to be paid regardless of how the market is doing, this drop off in cash inflow created a significant gap between liabilities and assets on hand.

(It is important to note that these liabilities are based on expected future payouts and the assets assume an estimated rate of return. The gap may fluctuate based on what estimate you are looking at, depending on what rate of return they use).

Graph 1

As graph 1 shows, the gap has remained ever since. Even with a record length bull market that has seen stocks performing at record highs, the aging population and growing number of retirees has continued to push up future liabilities. Higher market returns have helped only to maintain the overall gap rather than decrease it.

This data is for every state aggregated together, and there is of course differences state to state in how well funded they are. Unfortunately though, according to Fed data, no state has more assets than liabilities. Wisconsin is the closest, being 85% funded as of 2016. Only 6 states were over 60% funded though, for the same year. Illinois is in the worst spot, with only 25% of total liabilities on hand.

For comparison,  in 2004, 37 states had over 60% liabilities on hand, and 5 had over 80%.

And This is in a Strong Economy

If pension funds are this behind during a long economic expansion and a strong equity market, I am very fearful of how deep the hole will get come the next downturn.

The unfortunate reality is that the U.S. population is only getting older, which means ever increasing liabilities that states will need to cover. If the gap between assets and liabilities continues, states will have to find alternative ways to fund them. This likely means states making more space in their budgets for higher pension contributions, at the expense of other programs. As one can see with Illinois, healthcare and public safety may lose funding at the pension fund’s expense.

The other option that makes more sense to me is cutting back on benefits. A majority of states have been working to do just this since the financial crisis 10 years ago, but with mixed results. Illinois, with the country’s worst pension shortfall, saw reforms tossed out by the state Supreme Court in 2015. Kentucky also saw reforms tossed out after their Supreme Court found that they were pushed through the legislature unconstitutionally.

Even the states who have passed reforms still face major gaps. The Wall Street Journal took a deep look at the situation up Maine, where reforms have been successfully passed. Even here though , where the legislature has been successful, the gap has only been reduced by 1/3.

With the strength of unions and state’s constitutions requiring public retiree protections, reforms are very difficult. This has contributed to the continued gap in assets and liabilities over the 10 year economic expansion. With limited success during the good times, rough economic times are going to make the pension shortfall even worse.

State legislatures should be fearing a recession that is likely to happen within the next year or two. The current headache is only about to get worse when tax revenues fall off and the stock market dips down.

As for young workers entering the public workforce, it may be a good idea to save some money on the side. Who knows how much of that guaranteed pension will be available after possibly 25 years of underfunded systems.


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