Potential Federal Roles in Dealing with State and Local Pension Problems

Douglas J. Elliott

State and local pension funds across America struggle financially. The aggregate state pension deficit ranges from $0.7 trillion to $2.5 trillion or more, depending on how one calculates the value in today’s dollars of future pension payments. Pension deficits at localities add as much as another half trillion dollars. Whatever the true figure, this is a big problem — funding this deficit immediately could require two year’s worth of state and local tax revenue, or more. Put another way, the higher estimates for the deficit are about the same size as the total amount states and localities have borrowed from the bond markets. (A primer on state and local pensions and their funding is available here.)

The magnitude and difficulty of these pension problems raise several interlinked questions, which this paper will address:

  • Should the federal government intervene?
  • What could it do to help?
  • What key principles should guide any federal action in this area?
  • In practice, would political constraints allow federal intervention?

There are reasonable arguments for a range of views and this paper tries to objectively present the different viewpoints and the positives and negatives of the potential policy options. In the end, the author personally believes that most states and localities do face very serious pension problems that need to be dealt with over the long-term. Some of them face such severe problems that near-term action is vital. However, it does not appear appropriate, for a variety of reasons, for the federal government to provide financial aid to the states, even through loans or guarantees. Rather, Washington should push states and localities to face up to the issues and strongly encourage, or possibly even require, substantially better and more uniform reporting, including the use of less aggressive accounting techniques.

Federal financial assistance is not warranted, because the problems are tractable without federal money and such aid would raise major fairness issues. The pension deficits vary considerably in size and, unlike with natural catastrophes, the most severely damaged states bear major responsibility for creating their own difficulties. In addition, there is a real danger that assistance would end up encouraging future irresponsibility, even if major restrictions were attached to the money.

Some of the proposed options are presented by supporters as nearly costless to the federal taxpayer. If we knew this to be true, such choices would almost certainly be worthwhile. However, they invariably are made to appear costless by implicitly or explicitly assuming that the worst case will not occur. This is not a safe assumption and the federal government should not be in the business of guaranteeing against all unlikely harmful events simply because there is a low probability of loss. Financial markets charge substantial sums to take such risks precisely because sometimes less probable events do actually occur and they can be very costly. We recently saw with Fannie Mae and Freddie Mac that years of providing a “costless” implicit federal guarantee of seemingly safe institutions came home to roost with losses to the taxpayers that are likely to mount to hundreds of billions of dollars.

The author is also not inclined to support proposals for a new section of the federal bankruptcy code to govern insolvencies of states, because there will almost certainly be substantial costs while the benefits are much less clear. The interest rates that markets charge states would inevitably rise if such a mechanism were created, since it would make it more likely in practice that states would default on their obligations. Although this cost increase would hit weaker states the hardest, it would likely fall on all states to some extent, since the rules of the game would be seen as different, and less attractive to investors. On the other side, it is not clear that states would actually find themselves in a substantially better position to deal with their financial problems. In particular, it is not obvious that a revised bankruptcy law would really provide new options that do not already exist for the states, for reasons explained below. However, there is a great deal of legal complexity in regard to this and there is still some room for a convincing case to be made for the new bankruptcy code.

Whether or not the author’s opinions are correct, it is also improbable as a matter of practical politics that federal aid will be offered, for a variety of reasons explored below. It would therefore be dangerous for any of the parties involved in resolving the financial and pension problems of states and localities to assume that Santa Claus will arrive with bags of federal cash. Unfortunately, such a false hope appears to be one factor delaying needed adjustments in some of the states.