Pension Underfunding is Just a Form of Debt

Guest Blogger

For the Balkinization symposium on David Schleicher, In a Bad State: Responding to State and Local Budget Crises (Oxford University Press, 2023).

Amy Monahan

State and local finance has an enormous impact on the lives of nearly all Americans, yet is too often ignored in favor of splashier or more digestible areas of public life. I was therefore delighted to see David Schleicher’s new book, In a Bad State: Responding to State and Local Budget Crises, take a sustained look at both the complex world of state and local finance, and how federal actors might think through whether and how to respond to state and local fiscal crises.

I will begin with a few disclaimers. First, there were so many interesting issues raised by this book that I had a difficult time limiting myself to a length appropriate for this online symposium. I have therefore chosen to highlight just one of many potential discussion points, which I hope will be of broad interest to readers. Second (and maybe in contradiction to my first disclaimer regarding broad interest), I am going to focus my comments on In a Bad State’s treatment of distressed state and local employee pension plans (referred to as “public pensions” for the sake of simplicity).

For the uninitiated, most state and local employees receive retirement benefits in the form of a traditional pension plan that pays a participant a specified benefit amount every month beginning at retirement and continuing for the rest of the participant’s life (or surviving spouse’s life). These plans play a significant role in retirement security for state and local workers, particularly for the quarter of state and local employees who do not participate in federal social security. Ideally, public pension plans are funded in advance as benefits are accrued, with contributions set aside in a trust that can be used to pay out benefits once a participant retires. According to the Boston College Center for Retirement Research, such plans were on average only 76% funded in 2021. But this average figure obscures significant differences at the individual plan level. Some plans are fully funded, while others have a funded ratio of only 20%. In dollars, the total amount of unfunded pension liability at the state and local level was estimated to be $1.45 trillion in 2022.

While the existence of significant unfunded pension liabilities at the state and local level is by now widely known within policy circles, In a Bad State powerfully explains why such underfunding is so common and why it is a particularly problematic type of debt.

As Schleicher explains, there are both structural and political explanations for widespread pension underfunding. Shortchanging public pensions has been a convenient method for states and cities to avoid balanced budget requirements because, nonsensically, such shortfalls do not count as debt for purposes of either balanced budget requirements or state constitutional debt limits. This sets up an enormous incentive for politicians who are facing budgetary pressure to avoid tradeoffs by simply putting a little (or a lot) less than is due into the pension trust year after year. After all, the effect of that underfunding in most cases won’t be felt for decades.

The end result is policymakers in many jurisdictions succumb to a rather irresistible temptation to systematically underfund these plans. And while such underfunding is clearly a form of debt, Schleicher points out that it is fundamentally different from most other municipal debt. Generally, states and cities borrow money for infrastructure investments. This makes sense. If you are going to build a bridge, several generations will benefit from the investment and should therefore share in its costs. Pension debt, however, violates these norms of intergenerational fairness, by requiring future generations to pay for yesterday’s services. As Schleicher explains, “[h]eavily underfunded pensions mean today’s taxpayers are paying for two school systems – today’s and yesterday’s,” which then crowds out other governmental services.

Where a public pension plan has been underfunded for years or decades, the annual contributions that are required grow larger and larger, eventually exerting real pressure on state and local budgets. And while politicians could simply ignore these increased funding needs, underfunding typically gets to a point where it becomes politically salient, and public employees begin to exert significant pressure to ensure plans can continue to pay benefits for the foreseeable future. The result is that this pension debt that was allowed to accrue year after year often leads to public employees, bondholders, and taxpayers fighting over limited resources. 

While the book is focused on offering a framework for federal policymakers to analyze the tradeoffs involved in federal assistance to states and municipalities in crisis, it does devote chapters to how such crises might be prevented in the first place – including some proposals related to pension underfunding. Of the solutions offered, I think the most powerful is the proposal to reform state constitutional debt limitations to include pension underfunding within the definition of debt. I am intrigued by this idea because it both addresses the political and structural incentives to underfund pensions and because it results in paying compensation expenses when they are accrued rather than allowing them to be shifted to future taxpayers. Imagine how quickly pension funding behavior would change if politicians had to receive voter approval to make less than the required annual pension contribution.

To make this theoretically sound idea a reality, however, would require addressing many fine details. The state would need to specify in detail how pension debt is to be calculated for state constitutional purposes. As states like to do with any number of budgetary matters, it would be easy to use gimmicks to claim that there was not pension debt even when a plan was significantly underfunded, for example, by using outrageous investment return or actuarial assumptions, or flawed funding methods. And the level of detail necessary to prevent such gimmicks would be highly unusual to commit to a state constitution. Such details are more naturally found in statute, creating the possibility that future legislatures may simply change those rules when faced with difficult fiscal choices.

In addition, there would need to be a plan for existing unfunded pension liabilities. Perhaps existing pension liabilities could be grandfathered and not considered debt for constitutional purposes. But this solution fails to address a significant source of potential state and local distress. Maybe a grace period could be specified that allows a state to pay down legacy pension debt over a specified number of years, with any amounts that are not repaid treated as unconstitutional debt.

And last but not least, there are the mechanics of implementing the jurisprudential change even if we could agree on the details. Presumably an amendment to the state constitution would be required, or a refinement of existing precedent, neither of which are easy lifts.

Another potential avenue to achieve a similar result, which is not discussed in In a Bad State, is using federal tax law to impose external discipline on state and local pension funding. While In a Bad State discusses the role of federal tax policy in municipal bond markets, in my view it misses an opportunity to discuss how federal tax policy might also be used to address the proclivity of state policymakers to underfund public pensions. In the 1970s, in response to highly publicized private employer pension defaults, Congress imposed funding standards and a federal insurance program for defined benefit pension plans through the federal tax code and the Employee Retirement Income Security Act (ERISA), but chose to exempt state and local plans from such requirements. The exemption was justified in part on the premise that public plans were not at risk for default because states held the power to tax and therefore could not run out of money to pay benefits. But this position was somewhat controversial, and as a compromise Congress included in ERISA a requirement to study the issue of state and local plans. In the fifty years since, nothing has changed. The federal government provides a tax exemption to public pension plans but does not require those plans to satisfy any funding requirements or standards. Now that we have a better idea of the funding challenges faced by state and local plans, perhaps the best federal intervention would be to revisit the funding exemption for public plans.

As with the proposed state constitutional change, many details would need to be addressed in crafting federal legislation. But one advantage of this approach is that the federal government has already done a lot of the heavy lifting in developing funding standards for private employer plans. There are of course still difficult choices that would need to be made – such as the desirability of including public plans in the federal pension insurance program – but many technical details are already well known by the stakeholders involved. While still not easy, the federal path to controlling state and local pension debt may be a more realistic and more efficient option than state-level constitutional reforms. And In a Bad State makes clear why the federal government has a particular interest in avoiding the fiscal distress that can result from systemic underfunding of state and local pension plans.

In focusing on its treatment of public pensions, I haven’t been able to highlight the many other contributions of In a Bad State, which is a great read for anyone interested in state and local finance. While it bills itself as a framework for analyzing federal intervention, it provides a wonderful history of state and local fiscal crises and a clear-eyed look at the challenges and tradeoffs. In a Bad State concludes with what is in my view the very crux of the matter. One of the primary reasons fiscal crises are allowed to develop is that “most voters know little and care less about state politics.” We would all be better off if someone could devise a solution to that fundamental problem.

Amy Monahan is Distinguished McKnight University Professor and Melvin C. Steen Professor of Law at the University of Minnesota Law School. Her email is monahan@umn.edu.