The Looming Shortfall in Public Pension Costs

October 30, 2012

The recent economic crisis has left many state and local governments with underfunded pension benefits for government employees. However, elected officials are unwilling to make the necessary cuts or tax hikes because both options are extremely unpopular, say Robert Novy-Marx, an assistant professor of finance at the University of Rochester's Simon Graduate School of Business, and Joshua Rauh, a professor of finance at the Stanford Graduate School of Business and a senior fellow at the Hoover Institution.

  • Most states have a defined-benefit pension system that guarantees a certain payment upon retirement.
  • But over the past 10 years, states have added a defined-contribution element in which workers share in the market risk of their pension investments.
  • To fully fund current pension benefits, there would need to be an average tax increase of $1,385 per U.S. household.
  • Some states will need to have taxpayers contribute more, such as New York, which would require an additional $2,250 per household over the next 30 years.

Even if states continue to invest cautiously and achieve annual returns of 2 percent, assuming the stock market performs well, households will still have to pay taxes that amount to an average of $756 a year. Every percentage point of growth in gross domestic product would reduce the amount necessary of increased taxes by about $120. However, when the economy expands so do promises of increased pension benefits.

One other avenue that is being considered to solve the pension problem is to increase public employee contributions. This would require a 24 percent increase to obtain the necessary amount to pay for the unfunded liability and stave off further tax increases. However, younger public employees would be disproportionately affected since their income is not as high as more senior government employees.

Some possible ideas include mixing the defined-benefit with defined-contribution plan for all employees. Rhode Island experimented with this and was able to reduce the unfunded liability by more than 40 percent.

Group defined-contribution plans are another avenue for fixing the pension problem. This would leave the responsibility for managing the pension money without the government guarantees, which allows more flexibility if economic conditions are to get worse.

Source: Robert Novy-Marx and Josh Rauh, "The Looming Shortfall in Public Pension Costs," Washington Post, October 19, 2012.

 

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