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U.S. Pension Crisis: States Choose Bondholders Over Public Employees

The Daily Ticker
Daily Ticker

Editor's Note: This post is written by our guest Josh Barro, who writes about economics and U.S. public policy for Forbes.com. The Daily Ticker's Dan Gross interviewed Josh about the growing public pension crisis in the U.S.


Around the country, state and local fiscal pictures are starting to look better. Tax revenues rose in every state in 2011, and while states continue to have structural budget gaps to close, this year's gaps are a small fraction of the ones states were dealing with in 2009 and 2010. But one big problem continues to show little improvement-- unfunded pension liabilities.

Measured on a market value basis, these unfunded liabilities (combined with those for retirees' health care) exceed $4 trillion, which is more than the total amount of bond debt outstanding from states and localities. And because of the way pension accounting works, most states and local governments can expect to see continued sharp rises in required payments into pension funds at least through 2014. While most parts of states' fiscal pictures are improving, this one continues to deteriorate.

In 2010, the pension problem prompted Meredith Whitney to warn of an impending spate of state and local defaults, as governments struggle with promises they can't afford to keep. But in practice, we are seeing that states are treating payments to bondholders as job one. It's rare for debt service to make up more than a few percentage points of a state's budget, meaning that there is little to gain from stiffing bondholders, while there is a lot to lose. I expect no general obligation bond defaults by states and only a smattering by localities, hardly something that will amount to a crisis.

Last year, when the small city of Central Falls, Rhode Island entered receivership, the state passed a law to move bondholders to the front of the priority list for payment, making it essentially impossible for municipalities to default on bond debt. Meanwhile, the state enacted an aggressive pension reform that both cut benefits that workers can earn in the future and froze cost of living adjustments-- effectively reducing the benefits that current workers and even retirees had earned in the past. It didn't matter that Rhode Island is a state with politically powerful unions; a loss of access to the bond markets was far scarier to state lawmakers than anything the unions could do.

And Rhode Island isn't the only state that has withdrawn previously earned pension benefits: Colorado, Minnesota, New Jersey and South Dakota have all passed laws that retroactively reduce benefits through changes to COLA formulas. The largest pension fund for teachers in Illinois, where pension benefits are constitutionally protected, has warned that retirees' benefits are at risk anyway due to the fund's dire funding situation.

But while states have shown a surprising inclination to abrogate pension benefits already earned, they generally are not doing enough to make sure they don't make unaffordable promises in the first place. Rhode Island's reform will reduce the cost and the fiscal risk associated with pension benefits going forward. But in most states, pension reform has not significantly changed the nature of the benefits offered or sufficiently reduced their cost. That means that in the next recession, states will be back in the same place they are today, struggling to come up with cash to pay for pension benefits that are wildly more expensive than anyone realized.