Ranking of State Finances Offers Insight on Public Pension Debt

How do public pensions affect states’ finances? A recent study by Eileen Norcross and Olivia Gonzalez at the Mercatus Center may provide informative insight into this question. The study ranks the 50 states by fiscal condition based on a comprehensive assessment of 14 financial metrics linked to five criteria: cash solvency, budget solvency, long-run solvency, service-level solvency, and trust fund solvency. The first two criteria are considered short-term measures of fiscal condition, while the last three criteria concern long-term fiscal performance.

Of the three long-term measures, the trust fund solvency is perhaps the most relevant indicator to evaluate how pensions and other post-employment benefits (OPEB) can affect a state’s finances. The measure is defined by combining three metrics:

(1) Total primary government debt/state personal income

(2) Unfunded pension liability/state personal income

(3) OPEB/state personal income

By directly incorporating pension liability and OPEB in its calculation, the trust fund solvency measure provides a more complete picture of a state’s ability to finance its long-term obligations than the long-run solvency measure, which covers only a portion of the pension liability and OPEB. It should also be noted that the trust fund solvency measure counts not only pension plans that states offer to their employees but also those plans that states administer but don’t directly contribute to, like municipal plans. The study’s rationale is that municipalities tend to ask for state aid when their state-administered/locally-funded plans face financial distress, which presents a “contingent liability” on the states.

Perhaps most importantly, the study uses market valued liabilities for pension plans instead of just taking a state’s reported accrued pension liabilities at face value with their own adopted discount rate. In the discussion of the trust fund solvency measure, the study gives a short but solid argument in favor of market valuation of pension liabilities, which uses a discount rate that reflects the risk of the plan’s liability rather than the expected returns on the plan’s assets:

First, according to economic theory, the value of the plan’s liability is independent of the value of the plan’s assets, much as the value of a homeowner’s mortgage is independent of the value of his or her personal savings. Economic theory holds that a stream of future cash flows (in this case, a stream of future pension benefit payments) should be valued based on the certainty and timing of those payments. State pension plans come with a legal guarantee of payment, but there is no guarantee that the plan’s assets will return 7.5 percent each year. GASB 27 implies that securing a promised stream of future benefits based on uncertain investment returns without any risk is possible.

Market valuation using a risk-free discount rate* shows that states’ pensions, and consequently states’ fiscal condition, are in much worse shape than the official numbers indicate. According to the data from the study, the average unfunded liability/state personal income ratio under market valuation is 30 percent, more than four times higher than the 7 percent ratio calculated under the GASB standards.

Table 1 and Table 2 below show the top and bottom 10 states in terms of trust fund solvency and general fiscal condition.

While there is no strong correlation between trust fund solvency and general fiscal condition, states at the bottom of the fiscal condition ranking tend to also rank low in trust fund solvency. States such as Illinois, Kentucky, Hawaii, California, New Jersey, and Connecticut have large unfunded pension liabilities relative to personal income and also have poor overall fiscal health.

The most interesting state in the rankings is perhaps Alaska, which ranks 1st in fiscal condition but 50th in trust fund solvency. A major reason is that the study assigns significantly larger weights to short-term solvency measures than to long-term ones. Specifically, cash and budget solvency criteria each receive a weight of 35 percent, while the three long-term criteria are each weighted only 10 percent. The rationale is that a state’s ability to meet immediate financial needs and to absorb negative financial shocks in the short run is probably more important than its long-term solvency. As a result, Alaska’s abundant liquid financial resources relative to near-term obligations greatly offset its poor trust fund solvency.

The fiscal condition ranking provides a valuable benchmark to evaluate states’ fiscal health, which concerns not only conventional government debts but also often-overlooked pension and OPEB liabilities.

Users of the ranking, however, should note two limitations. First, the ranking is only relative. Since an appropriate discount rate reveals that most states’ pensions are badly underfunded, even highly ranked states may have serious trouble meeting future pension commitments. Second, the overall fiscal condition ranking should not be viewed in isolation of the sub-rankings, as the low weights assigned to long-term solvency (a subjective methodological choice), including the trust fund solvency, may mask a state’s long-term financial problems.

*In principle a discount rate should reflect the risks of a plan’s liabilities, and as a proxy for this the authors applied a discount rate of 3.2 percent (15-year Treasury bond yield) to all liabilities on a fixed basis.