How Should We Measure and Define Public Pension “Trouble”?

Based on the steady stream of headlines rolling in from across the country, we appear to be fast approaching – or in some situations have already entered into – a full-blown public pension crisis.  “Not so fast, my friends,” argues a Lee Corso from the world of public pension research:

“The good news is that the total costs for long-term commitments – pensions, OPEBs and debt service – appear to be under control in many jurisdictions.  However for a handful (emphasis ours) of states, cities and counties, these costs are an extraordinarily high percentage of own source revenue.

Will Pensions and OPEBs Break State and Local Budgets?” Center for Retirement Research (CRR) at Boston College, 2016

That’s a huge dose of unconventional wisdom.  The fact that it comes from an independent scholarly organization (not a public retirement association or an advocacy group dressed in research camouflage) makes this analysis worth digging into a little deeper.

The report examines whether a state is really “in trouble” with respect to its funding its long-term obligations (which includes general debt and other post employment benefits or “OPEB” as well as pensions).  The test used is the claim these long term payment obligations have on state own source revenues.  If required debt, OPEB and pension payments consume 15% of state own source revenue, the state is considered “in trouble.” If those required payments exceed 25% of state own source revenue the situation is “untenable.”  (Just how those thresholds are derived is a bit of a mystery.  A J.P Morgan research paper cited in the study which established these benchmarks states “while these are qualitative judgments, a ratio of 15% or less indicates to me a state that’s in good shape.”)

Calculating required debt payments is straightforward – they equal the actual payments.  Calculating required OPEB and pension payments gets into the weeds of how future pension benefit payments are discounted and whether underfunding is being made up over a reasonable period of time.  The researchers used a conservative – at least with respect to what public plans use – discount rate of 6% and the 30-year payback period public pension plans commonly use.

According to the CRR investigators, only 15 states exceed the 15% “in trouble” threshold for all long-term obligations.  Minnesota looks particularly stellar.  “Required payments” to service debt, OPEB and pension costs all together comprise a mere 5.3% of state own sources revenues in 2014 – nowhere near the trouble zone.  The pension piece of this obligation is a little over half of that total, comprising only 3.0% of Minnesota state government’s own source revenue in 2014.

So what’s the problem?

Well, there are a few technical issues to quibble about.  These estimates don't reflect the large investment shortfalls of 2015 and 2016.  The 30-year payback period for unfunded liabilities is still very accommodating and far exceeds the average remaining service life of a current public employee, which should be the basis for amortizing these liabilities.  (Governing Magazine’s then-pension expert recommended a maximum 20-year period when the Governmental Accounting Standards Board was revisiting public pension accounting standards a few years ago).  And while a 6% discount rate is certainly more conservative than what is employed today, a strong case can be made it is still far too aggressive given where risk free interest rates currently are.  Address all these issues and the Minnesota’s “required payments” calculation would certainly be much higher.

But the major problem is the difference between the “required” and “actual” payments and the opportunity cost to government it represents.  Even though the study indicates Minnesota state government should pay 3.0% of its own source revenue to fully fund its public pension obligations, it only pays 0.9%.  That difference represents roughly $590 million in state revenues in 2014. 

So what should Minnesota lawmakers do to find an extra $590 million or so each year?  According to Department of Revenue data from the November 2015 forecast, a 5-6% surtax on all income tax bills would do it.  Or how about another 1.5 percentage point increase in the state sales tax rate to 8.375%?  Or maybe we should just pay for it out of the state’s budget reserve, effectively draining it in about 3 years?

Perhaps we should cut spending instead.  $590 million is 2.8% of the state’s general fund budget for FY 2017 – the current fiscal year.  Should we cut 2.8% across the board, or should we target the cuts?  A $590 million cut in property tax aids and credits spending (think local government aid and your property tax refund) is about a 35% whack.   How about a 6-7% reduction in K-12 education spending?  Or maybe some of those long overdue infrastructure improvements need to be put on hold for a while longer.

You get the point.  With a $77 billion all-funds budget for 2016-17, the state of Minnesota can theoretically “afford” most anything it wants – including managing larger long-term debt obligations.  But government spending is fundamentally about priorities and choices and the use of scarce resources.  “Pension trouble” isn’t defined through the lens of acceptable debt capacity.  Rather, it’s defined by the implications paying for these obligations in a fiscally responsible way have for the quality and delivery of public services taxpayers expect from government and the tax prices they must pay for them.