The federal government may have run up a $1.3 trillion deficit in 2010, but that’s not the only government budget shortfall of note; a new report from the Pew Center on the States found a $1.26 trillion funding gap between states’ retirement promises and the funds available to pay for them.
At the top of Pew’s report – or the bottom, as it were – is the state of Illinois. According to the report, the state’s pension is only half funded, with an unpaid bill that’s north of $126 million.
Unfortunately, the pension problem in the Land of Lincoln is even worse than it appears.
The Pew report relies on the state’s official pension funding figures, which dramatically understate taxpayer’s liability. A more realistic accounting more than doubles the amount coming due.
If you work in the private sector and have a 401(k) plan, your understanding of a retirement account is as follows: You save money from each paycheck, investing more aggressively in your younger years and more conservatively when you’re older.
You may ride a few stock market “waves,” but a lifetime of prudent investments generally yields a nice nest egg upon retirement.
The size of your nest egg is directly related to your contributions and the return on those contributions over time.
Not so with public pensions.
These generous plans – due to past deal-making between public sector workers and opportunistic legislators – guarantee a defined retirement benefit to each participant, regardless of how much is invested or the return on those investments.
States may not have the money to pay for these promises, but they’ve grown exceedingly good at hiding that fact.
If they don’t have the money to fund the pension from current revenues, and they don’t want to rack up additional debt, states can just assume relatively large future returns on invested pension assets, reducing the amount they’re required to contribute today.
The primary problem isn’t in overestimating future market return; it’s in underestimating the liabilities owed – the promised pension benefits. States such as Illinois regularly calculate their future pension liabilities using the assumed return on their pension investments. The problem is that these returns are volatile, risky and far from guaranteed, while pension benefit payments are almost certain – thus, they should be treated differently, like bonds and stocks.
That’s a lot to unpack, so let’s examine whether this makes sense by way of an analogy.
Imagine that you win a $26 million Illinois lottery jackpot.
If you’re the patient type, you can receive the entire sum in 26 annual $1 million payments; otherwise, you could choose a one-time payout worth about $16.5 million.
The immediate payout is less than the full lottery jackpot amount because it reflects the value of receiving future annual payments today; assuming a conservative 4.1 percent effective return, which the state of Illinois does, that money would grow to the full $26 million over the next two-plus decades.
But say the state of Illinois boosts its projected rate of return; that is, the state assumes Illinois lottery winners can get a hearty 8.5 percent return over the next 20-odd years, so it only pays out $11.2 million on a $26 million winning ticket today.
This would be a rip-off of Sears Tower-sized proportions; the savvy lottery winner would pass up the lump-sum payment, confident that future returns are not likely to be as large as the state’s prediction.
Lottery winners wouldn’t make that deal, but cities across the country continue to engage in a similar financial sleight-of-hand with their pension funds.
A large projected return gives the appearance of smooth financial sailing and lower required contributions. In reality, state leaders are gambling on large investment returns to make up for their decision to underfund the pension. If they aren’t realized, taxpayers are stuck with the tab.
This is exactly what’s happening in Illinois and elsewhere – irresponsible behavior by state financial managers has created a yawning gap between pension promises and the funds available to pay them. Northwestern University professor Joshua Rauh estimates that the actual liability in Illinois is closer to $285 million – more than double the estimate from Pew. For the sake of all Illinoisans, this insanity must stop.
We must shift public employees to a more affordable retirement plan, similar to those in the private sector, before the hole grows so large that the state can’t dig itself out.
• John W. Diamond is the Kelly Fellow in Public Finance at the James A. Baker III Institute for Public Policy at Rice University in Houston.