The looming shortfall in public pension costs

Robert Novy-Marx is an assistant professor of finance at the University of Rochester’s Simon Graduate School of Business. Joshua Rauh is a professor of finance at the Stanford Graduate School of Business and a senior fellow at the Hoover Institution.

How much will the underfunded pension benefits of government employees cost taxpayers? The answer is usually given in trillions of dollars, and the implications of such figures are difficult for most people to comprehend. These calculations also generally reflect only legacy liabilities — what would be owed if pensions were frozen today. Yet with each passing day, the problem grows as states fail to set aside sufficient funds to cover the benefits public employees are earning.

In a recent paper, we bring the problem closer to home. We studied how much additional money would have to be devoted annually to state and local pension systems to achieve full funding in 30 years, a standard period over which governments target fully funded pensions. Or, to put a finer point on it, we researched: How much will your taxes have to increase?

We found that, on average, a tax increase of $1,385 per U.S. household per year would be required, starting immediately and growing with the size of the public sector. An alternative would be public-sector budget cuts of a similar magnitude, or a combination of tax increases and cuts adding up to this amount.

For some states these numbers are much higher. New York taxpayers would need to contribute more than $2,250 per household per year over the next 30 years. In Oregon, the amount is $2,140; in Ohio, it is $2,051; in New Jersey, $2,000. California ($1,994), Minnesota ($1,928) and Illinois ($1,907) are not far behind.

Most states have traditional defined-benefit pension systems, which guarantee a certain payment upon retirement. In the past 10 years a handful of states have added defined-contribution elements, in which workers share in the market risk of their pension investments, as most private-sector workers do through IRAs or 401(k) plans.

Most of these modifications, however, affect only new hires. Under legislation Virginia passed in April, for example, new employees will have about 40 percent of their defined-benefit pensions replaced by small 401(k)-style plans. As a result, Virginia’s annual household burden of $1,066 will fall around 20 percent. Virginia’s load will remain heavier than that of Maryland, which is in better shape than all but 12 states but nonetheless requires an additional $818 per household each year. Even Indiana, the state in the best condition, would need to increase contributions by $329 per household each year to meet its pension obligations.

These finding were calculated assuming that states invest somewhat cautiously and achieve annual returns of 2 percent above the rate of inflation. But even if states continue to make massive bets that the stock market will bail them out, and if the market were to perform as well over the next 30 years as it did over the past half-century (an unprecedented bull market), the required per-U.S. household tax increase would still amount to $756 per year.

And, of course, the returns could be much worse.

Another way of stating the result is that contributions toward public-employee retirement would have to immediately rise to 14.1 percent of every dollar that state and local governments take in for taxes and fees for services (up from 5.7 percent), including such things as state university tuition and motor vehicle fees. If pensions are to be balanced using taxes only, government contributions would have to jump to 22.6 percent of tax revenue, from 9.1 percent in 2009, the most recent available data.