You hear it said, almost always by mournful Democrats, that the Reagan era in Washington ushered in a retreat from active government around the nation. One number might serve to negate that claim: Since 1988, when Ronald Reagan was concluding his presidency, the outstanding liabilities of (or entitlements from) state and local public pensions have increased tenfold, to $10 trillion.
Not only that, but a good portion of that obligation is borrowed money—many times in politically conservative “red” states, where commitment to fiscal responsibility might not be as rock-ribbed as expected.
Red States’ Pension Problem
Pension promises to public employees reflect more than a contemporary bent for bigger government—they are also an unyielding draw on future taxpayers, to the extent that the pensions are inadequately funded through contributions and investment returns. And right now, that “extent” is real and growing. An estimate by the conservative American Legislative Exchange Council (ALEC), which calculates using an admittedly low expected rate of return on investments, puts the unfunded total for state pension funds alone at a mind-boggling $8.2 trillion. (Separate city or county funds weren’t included.) Analysts at the more liberal Pew Charitable Trusts have the gap much smaller, especially after the bull markets of 2021, but agree that it is cause for alarm.
Figures gathered by the U.S. Bureau of Economic Analysis show this breach developing in the 1970s, then growing larger after the dot-com bust in 2001 and nearly gaping during the Great Financial Crisis. It’s proceeded to get worse in the 15 years since then.
Here’s the real shocker, though: In addition to gaping shortfalls in notorious jurisdictions like Illinois/Chicago, New Jersey and Connecticut, taxpayers in some red states are badly exposed. A few of those states are credited with reforms (such as Oklahoma and Arizona), but those willing to put more realistic contribution levels in place, or substitute 401(k)-style retirement plans, are the exception. Even rarer are attempts to eliminate double-dipping by individuals who leave one ranking position in the public sector for another in a different jurisdiction. It’s common, for example, for police and fire jobs to qualify for a full pension after 20 years.
“If anyone is operating under the assumption that red states tend to be better funded than blue states, they are likely to be surprised,” says Zachary Christensen of the Reason Foundation’s Pension Integrity Project. “We’ve done a lot of research on that presupposition internally, and we haven’t found any statistically significant difference in funding depending on political alignment.” For example, South Carolina, solidly red politically, shows up badly in arrears in Reason’s latest map of state funding ratios, as does Kentucky, which leans Republican despite having a Democratic governor. The South has other trouble spots. Even dependably Republican Indiana has barely two-thirds of its obligations covered, according to Reason.
In states that have kept pension affairs in order, or where state coffers are full from years of economic growth or pandemic aid, there is temptation to add to payrolls (Texas, until 2020) or boost salaries (Georgia), thereby fueling future obligations. Others plan to hand current surplus funds back in the form of gimmicky inflation credits or tax cuts, such as on gasoline, even when costs are mounting down the road. (Newly reelected Democratic Gov. Gretchen Whitmer in Michigan is a dual threat: With a now-compliant legislature, she’s going to exempt pension income from tax, reversing a GOP initiative of 12 years earlier.)
Explaining the Shortfalls
Why these funding gaps? Pensions grow increasingly unfunded when they rely on unrealistic rates of return from their investments, which go into stocks, bonds, real estate and various “alternative” strategies including hedge funds and private equity. To the extent that these bets pay off, beneficiaries (really, taxpayers in the public case) must contribute less going in. Especially after years of bullish returns, there’s every political incentive to expect, say, 8% annually when 6% is historically optimistic. The difference can amount to many billions of dollars.
Indeed, pensions generally were battered in 2022 by bearish markets and benefit cost-of-living adjustments. Oklahoma’s plan was down for the year and 21 percentage points short of its assumed rate of return for the fiscal year; the Alabama and Georgia teachers’ plans were in a similar boat. It doesn’t help when politicians and pressure groups of various stripes try to screen disfavored companies or industries out of the state funds’ portfolios, regardless of their financial prospects. This can happen in blue states to demand “sustainability” or “diversity,” or, as in Texas, to blacklist investment firms frowning on fossil fuels.
A fiduciary’s imperative is to cover the benefit claims. For its part, South Carolina made corrective funding moves in 2017 but punted in the most recent legislative session. Republicans in Kentucky attempted to rein in benefits in 2018 but were overruled in court; in 2021, they overrode new Democratic Gov. Andy Beshear’s veto to install a partial 401(k)-type plan for teachers. As with all borrowing, the failure to fund pensions adequately now creates an interest expense that compounds mightily (in normal times).
Fixing a Stubborn Challenge
The experience of another red state, North Dakota, shows both the stubbornness of the problem and the high bar for winning genuine reform. In 2021, the Reason pension team spelled out the nature and extent of an underfunding crisis of the state’s Public Employees Retirement System that manifested in the early 2000s. The causes were the usual: unrealistically high expected rates of investment return and unduly low contributions to the fund for the workers. A concerted legislative campaign finally came to fruition late last year and, with help from Reason to sell the reform ideas, seems headed for approval. But this is in a statehouse with highly unusual GOP dominance and hence, less resistance from union and other public-sector interests that are largely blue stalwarts. Nationwide, the picture is much different. Only in four other states (West Virginia and Wyoming, for the GOP, and Hawaii and Rhode Island, for Democrats) is there a partisan skewing of such degree.
A bullet-proof majority doesn’t always lead legislators to do the right thing, but partisan warfare frequently can get in the way. It’s easier to fight other, sexier battles and let this one slide. “Big picture, it is hard to get policymakers motivated to correct something when it is possible to kick the negative consequences down the road,” says Reason’s Christensen. “Effective pension reform requires fixing outdated plans AND dedicating significant amounts of additional public funds to pay down expensive debt.”
Just as galloping entitlements at the federal level are crowding out future fiscal choices for Congress, so are these “hidden” state obligations going to constrain the legislatures, whichever party controls them. One possible out, against which ALEC’s report warns, are “pension obligation bonds,” a twist on the familiar municipal indebtedness play but with no actual asset in the balance.
Societal aging is a broader problem for governments around the world. A new study from S&P Global finds that, as pension burdens mount, more than half of the 81 nations studied are on track to have their credit rating fall to “speculative grade” by 2060. A constitutional republic ought to be better positioned to manage its actuarial affairs, but the U.S. practice is increasingly one of hope now and pay later.
Worst case, the irresponsibilities of America’s states and localities will become one more federal bailout. But reformers are hopeful that a shared interest in reliably backing up promises, together with appreciation of the hard-math reality, can force needed changes in the present. Once more, Christensen of Reason: “It’s a lot easier to wade through the politics when you make it about the numbers.”