Public Pensions and Illinois

Dean Baker has produced an interesting paper (hat tip: Felix Salmon) on the origins and severity of the crisis in public pensions. He finds, unsurprisingly, that the proximate cause of the problems that are causing an uproar in many state capitols is the decline of the stock market after the collapse of the housing bubble and the attendant financial crisis:

In sum, most states face pension shortfalls that are manageable, especially if the stock market does not face another sudden reversal. The major reason that shortfalls exist at all was the downturn in the stock market following the collapse of the housing bubble, not inadequate contributions to pension funds.

I have a number of reservations with respect to Dr. Baker’s findings. First, the problem states face with respect to public pensions is a cashflow problem. The problem may go away next year or it may continue for a decade; there’s no way to tell. If states borrow to meet these obligations, it will worsen their future fiscal situation since they will have not only the future pension obligations but the principal and interest to deal with as well.

Second, we have experienced the collapse of two bubbles over the period of the last fifteen years. Unless you’re predicting another bubble in the near term or claiming that the bubbles had little to do with stock earnings over the period in question, shouldn’t we assume that stock earnings will be significantly lower for the next fifteen years? That doesn’t seem to be the case in the paper.

Third, the year-on-year earnings from a stock portfolio aren’t based on 30 year averages. It’s the year-on-year earnings that determine how much money you’ll be able to disburse.

I might add that several analysts appear to take the paper as proof positive that structuring public employees’ pensions as defined benefits plans with the principal sums heavily invested in equities is superior to structuring them as defined contribution plans (however invested). Why doesn’t that argument apply to the Social Security system? I should mention that I am not a supporter of privatization of Social Security and I’m wary of plans for putting a substantial portion of its funds into equities whether privatized or not.

Finally, I’m concerned that his findings may not be robust. For example, Dr. Baker includes a length inventory of state pension obligations in Table 2. For the Illinois Teachers’ pension obligation Dr. Baker finds that the unfunded liability of this obligation amounts to .19% of the state’s future income. This determination is predicated on an assumption:

Of course, this estimate of the size of the shortfall will be overstated or understated if a state has growth that exceeds or falls behind the national average.

In other words rathers than making reasonable assumptions about growth on a state-by-state basis, Dr. Baker has assumed that all states will grow at a more or less uniform rate to draw his conclusion.

Consider this chart of Illinois gross state product from the University of Illinois:

or, in other words, Illinois’s growth is below that of the U. S. generally and it has fallen behind U. S. growth consistently over the period of the last 15 years. For Illinois, Dr. Baker’s paper is an Emily Litella moment: never mind.

Additionally, Illinois is the largest state in the worst shape with respect to its pensions. I don’t know that you can reasonably draw any conclusions without analyzing the financial prospects of each state on on an individual basis.


See also Josh Barro’s critique. It’s pretty hard to excerpt meaningfully but here’s a snippet:

To understand how the states got into their current sorry predicament, it is essential to examine the structural flaws in the state-pension edifice. There are two fundamental problems with the pension plans offered by state and local governments all across America: One is that, in many cases, the benefits are excessively costly, insofar as they are larger than is necessary to attract qualified talent to government work. The other is that, by guaranteeing annuity-like streams of income in retirement—regardless of whether the pension funds’ assets and market performance can support those payouts—such plans expose taxpayers to enormous risk. After all, those taxpayers are the ones who will be responsible for making up any shortages.

Both of these problems are driven by the structure of most public-employee retirement plans, which follow what is known as a defined-benefit model. As the name would suggest, a defined-benefit pension plan guarantees some fixed level of income to workers upon their retirement; benefits are determined by a formula that is typically based on the number of years worked and average earnings in several years leading up to retirement. (Under some defined-benefit plans, workers are also entitled to annual cost-of-living adjustments in retirement.)

In principle, defined-benefit pensions are designed to be pre-funded. Employers are supposed to set aside money during a worker’s career to pay for his benefits in retirement; in many cases, the employee is required to make some portion of the total contributions himself. The employer—in the case of public workers, the state—then invests these assets, mostly in equity investments (such as mutual funds or stocks) with a minority in fixed-income vehicles, such as bonds.

The key to defined-benefit plans, however, is that the employee’s benefit payments are not affected by the market performance of those assets. In this sense, defined-benefit plans are explicitly designed to shift investment risk from employees to employers. In the case of public pensions, if a plan misses its target investment return, state workers don’t see their benefit checks shrink: Instead, taxpayers hand over more of their earnings to the government, so that it can make good on its promises to public-sector retirees.

and Tyler Cowen’s:

Beware of the 30-year comparison I say. A lot of sums look small compared to thirty years’ worth of output.

6 comments… add one
  • While this doesn’t directly address your points, I wonder, with the number of listed stocks declining in the US, how can anyone really plan for retirement any more?

  • I think it’s pretty darned hard. One of the reasons that I support a Social Security system. I think that for most people there is simply no way to plan as far ahead as you’d need to.

    The other way to look at this, I suppose, is that people are retiring far too young. As I’ve mentioned occcasionally I’m an avid geneaological researcher. One thing I’ve noticed in my own family is that until very recently nobody ever retired. They were either in school, working, or dead.

  • PD Shaw Link

    If I understand the paper correctly, they are underplaying what I think is a large part of the problem. It’s not just that contributions have not been made, which over time would have returned the necessary income. I believe it’s that contributions are not made when the economy is down and they are made when budgets are less tight, which strikes me as a habit that will likely guarantee the worst returns. At the very least it’s more problematic than simply underfunding, but dollar-cost-averaging.

    If future budgets remain tight, then that problem will continue.

  • I’m not comfortable generalizing Illinois’s situation to that in other states but, equally, I’m not comfortable generalizing other states’ solutions to Illinois.

    Said another way I don’t think there’s one problem, i.e. state public pension shortfalls. I think there are 50 problems (maybe even more since some states have multiple funds funded differently). Some small to non-existent, some quite serious.

    Said another way, I think the paper is painfully inadequate. I don’t know whether he doesn’t understand the problem or is just professionally predisposed to gloss over the differences that characterize the problems in different states.

  • steve Link

    Two things. First, we should have public sector workers in defined contribution plans. That solves most of this. Secondly, we do well, as you note, to remember this when talk of privatizing SS comes around.


  • PD Shaw Link

    steve, the practical problem is that the ability to pay past uncontributed pension benefits depends upon the current system extending. Switching to a defined benefits plan would essentially mean the state has to start paying now into defined contribution plans and it can no longer rely on whatever contributions are being made by current employees to pay retired employees under the defined benefits plans. Did I explain that well?

    According to some commentors at OTB, many/most federal pensions have already switched from benefits to contribution, which I take is due to the feds greater resources. I wish that the stimulus package had provided the seed money for states to make the switch.

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