An often-stated goal of public employee pension systems is to achieve fully funded pension systems in 30 years. In a newly released paper with Robert Novy-Marx, covered in a New York Times article, we calculate the increase in contributions that will need to be devoted to these funds on an annual basis to achieve this goal, starting with estimated December 2010 asset levels. Without changes to pension formulas, state and local pension contributions across the US would have to immediately increase by a factor of 2.5, reaching 14.2% of the total own-revenue generated by state and local governments (taxes, fees, and charges). This represents a tax increase of $1,398 per U.S. household per year, above and beyond revenue generated by expected economic growth.
There is substantial variation across states, with New Jersey needing to find additional revenues of $2,475 per household per year to fund state and local systems, and Indiana only needing an additional $329 per household per year. Five states require contribution increases of more than $2,000 per household per year and thirteen states require increases of more than $1,500 per household per year. These baseline calculations assume no migration of the tax base across state borders in response to the wide variation in fiscal condition of the states. Modeling of such migration increases the revenue requirements of the states already in need of the highest contribution increases and reduces the revenue requirements of the states whose required increases are already small.
The paper also illustrates how the current government accounting standards do not reflect the reality of the costs of making more benefit promises. With the possible exception of Indiana, no state in 2009 contributed the full present value of new benefit promises when such promises are measured using government bond yields as discount rates -- despite the fact that a number of states have been purporting to both pay the cost of new benefit promises and to make payments towards unfunded liabilities.
We also calculate required contribution increases under several potential policy changes that would reduce future benefit accruals. A "soft freeze," which entails placing new workers in defined contribution (DC) plans, would reduce the average annual contribution to $1,223 per household from $1,398 per household, while also having transparency benefits. However, for states with large numbers of workers outside of the Social Security system, the extent of cost savings is limited by the likelihood that governments undertaking a soft freeze would have to start paying into Social Security and bearing most of the cost of doing so themselves. A "hard freeze," which entails stopping all future defined benefit accruals even for existing workers would save money for every state, even assuming workers not in Social Security will have to be brought in fully at taxpayer expense. Nonetheless, contributions would still need to rise by more than $800 per household per year nationally to achieve full funding in 30 years.
You can read about all that in the paper, so let me conclude by speculating a bit on the role of such calculations. I would hypothesize that one of the reasons public employee pension promises have come to exceed assets set aside by such a large margin is that it is difficult for taxpayers to assess the true cost of the promises on an ongoing basis. This has turned public employee pension programs into large sources of off-balance-sheet debt finance for state and local government politicians to spend money without actually raising taxes, telling voters they can have their cake and eat it too. Perhaps calculations of the per-household tax cost of public employee pension promises will remove some of the opacity and present a picture of this pension-related debt that is more informative to taxpayers. As a policy prescription, as I have written before, we need to start paying or stop promising.
By Josh Rauh, Associate Professor of Finance
Kellogg School of Management, Northwestern University