Academic journal article Economic Commentary (Cleveland)

When States Default: Lessons from Law and History

Academic journal article Economic Commentary (Cleveland)

When States Default: Lessons from Law and History

Article excerpt

In most states, local governments have a contractual obligation to provide predetermined benefits (pension and healthcare) to their public employees when they retire. These future benefits are to be paid from the governments' and public employees' accumulated annual contributions to a public pension fund, as well as the returns the contributions generate when invested.

The Great Recession had a detrimental impact on this arrangement. States and local governments reduced their employer contributions in response to tight budget constraints, and as a result, most pension funds don't have the assets they need to cover their liabilities. The dire state of public pensions increases the likelihood that, at some point in the future, retirees may find themselves competing with other stakeholders for the same tax dollars in the appropriations process. Bondholders will also insist on being repaid, and residents will still need roads, sewers, water, and education.

In this Economic Commentary, I examine how a fiscal crisis might be handled if a state were to repudiate all its obligations. I discuss the legal protections that apply for retirees dependent on public pensions and the extent to which those protections might withstand a fiscal crisis and the competing claims of bondholders. Drawing on legal precedents and the experience of Arkansas after its default in 1933, I argue that in spite of the protections that exist, no public retirement system is completely immune to impairment if the money runs out.

Public Pensions Present and Future

Millions of people's retirements depend on the benefits state and local governments have promised them. According to the 2015 Annual Survey of Public Pensions, the 6,299 state and local pension funds in the United States paid $266 billion in benefits to 9.97 million retirees and received contributions from 14.72 million active employees. Nearly a quarter of this population is not covered by Social Security.1

When states and local governments reduced their employer contributions to their public pension funds during the Great Recession, they in effect borrowed from those pension funds. If governments hope to meet their contractual obligations to their employees, they must pay these delayed pension contributions back at some point. To envision the impact of these reductions on a pension fund, imagine skipping a contribution to your personal 401(k) account. To offset the skipped payment, you have to make an extra contribution in the future and you have to make up for the lost return you could have earned if you had made a timely payment.

A measure of the problem's magnitude can be seen in the size of funded pension obligations (that is, the share of pension entitlements covered by assets in hand) in figure 1. Despite employers' increasing contributions during the recovery and employees' contributing larger shares of their incomes toward retirement, the funding gap remains wide; as of March 2017, pension funds had about 66 percent of the assets they needed to cover their liabilities, and the unfunded liability is nearly $1.9 trillion.

It's notable that the problem is not evenly spread across the United States. By the end of 2015, public pension funds in Kentucky, New Jersey, and Illinois had 40 percent or less of the assets they needed to meet their obligations to their retirees. Puerto Rico's funded ratio was an abysmal 1.57 percent (figure 2).

While the money owed to future retirees seems large, governments do not have to pay it in one big contribution. It is acceptable to spread the payments over 30 years (the typical assumption for the amortization period of unfunded liabilities). Yet even these payments can be a burden. Figure 3 shows that if Illinois, New Jersey, Connecticut, or Puerto Rico had made its 30-year amortizing pension contribution in 2014, the sum of that contribution and the government's debt service (interest) payment as a share of its ownsource revenue (taxes and fees) would have exceeded the debt service burden of the last state to default in our nation's history: Arkansas. …

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