There is bad news and worse news for state governments faced with underfunded pension promises. First, a new academic study shows that not only is the total gap between the pensions that state governments have promised to pay their employees and the available resources much larger than previous estimates, but that gap cannot be closed with easy changes to those promises.
Using the usual method of calculating the cost of pension promises, the study estimates that 116 major pension plans sponsored by the 50 states have assets of about $1.8 trillion to pay pension promises of between $3.6 trillion and $5.2 trillion. This leaves a gap of between $1.8 trillion and $3.4 trillion.
Unfortunately, fixing this problem won’t be easy. Increasing the retirement age by a year would reduce pension promises by only 2–4 percent; keeping future cost-of-living adjustments (COLAs) 1 percent below the actual increase in cost of living would reduce those promises by only 9 to 11 percent. Even uniformly increasing the retirement age to 74, eliminating COLAs altogether, or similar moves still leaves a total deficit of over $1 trillion.
To make matters worse, solving the problem will be even harder because nine states have constitutional provisions that appear to prohibit those states from reducing pension promises, while other states’ ability to change state and local pension promises are limited by a history of court cases. Thus, while Colorado, Minnesota, and South Dakota limited COLAs earlier this year, all three states have been sued by state employees and retirees seeking to block those reductions.
Not all state and local pension plans are in trouble. Many are properly funded and conservatively managed, but among those that are in the most trouble, the situation is becoming dire. For instance, at least five statewide Illinois pension plans have had to sell off about 10 percent of fund assets in order to pay benefits after the state government failed to make its full contributions to the plans.
The size of the underfunding combined with the complexity of reducing benefits will inevitably result in calls for a federal bailout, perhaps combined by an override of state constitutional language limiting the restructuring of pension promises or other federal involvement. Congress has voided parts of state constitutions in the past.
A federal bailout would be the worst possible outcome—even if it were accompanied by reform measures. Taxpayers in states or cities that have been responsible should not see their tax dollars used to relieve those states that have been irresponsible. States and local governments must resolve their own problems, or many will simply make cosmetic changes and then come back for another federal solution when things deteriorate again. Real change will happen only when they are forced to confront the full consequences of their past actions.