Could a Federal Loan Program Help Fix Ailing State Public Pension Plans?
1654180 © Michael Smith | Dreamstime.com

Commentary

Could a Federal Loan Program Help Fix Ailing State Public Pension Plans?

Federal loans for states with failing pension systems would penalize states that have taken steps to address insolvency and are unlikely to fix the worst-off public pension plans.

Entering 2020, states were carrying over $1.2 trillion in public pension debt. For many of them, a day of financial reckoning was becoming increasingly inevitable. That reckoning may have come like a tidal wave with the economic shock that accompanied the COVID-19 pandemic and policy responses to it. Depending on investment return rates for the 2020 fiscal year, we estimate that total state pension debt could increase to between $1.5 trillion and $2 trillion.

In response to the growing pension debt and decreased revenues due to economic shutdowns, some state officials are using the financial downturn and coronavirus pandemic as justifications to call for federal taxpayer assistance to cover underfunded state public pension system’s shortfalls.

We have argued that a federal bailout of state pension plans is a bad idea for numerous reasons. But the calls for doing so continue. Repeatedly. Public pension bailouts could be considered as part of any additional stimulus bills Congress debates and passes in the coming months. Given the size and scope of the public pension debt problem, and thus the size of potential bailouts, it makes sense to dig deeper into the arguments for and against the federal government backfilling state pension plans.

Setting aside our disagreements with proposed pension bailouts, below we’ve outlined what we consider to be the best, most responsible approaches that have been floated in various public pension aid proposals—as their advocates, not Reason, are making them—along with what we deem to be the fatal flaws of these approaches.

Federal Aid Proposals

Many states find themselves in a tough financial position— with large pension debts and annual pension payment requirements that constitute a large percentage of employment costs.  As the current recession reduces revenues, to fund these pension payments states could look to:

  • Increase taxes. This is unwise for a number of reasons, and in an economic recession is likely to be unpopular and politically impossible.
  • Cut spending. This would be wise, but if governments were willing to cut spending in other areas in order to make needed pension payments, many states wouldn’t have the large pension debts they’re currently facing. Maybe some states will change in this crisis, but most states likely will not.
  • Borrow money. The most likely option for states would be to look to borrow the money needed in the form of a new wave of pension obligation bonds (POBs), through which public pension plan sponsors borrow funds on the municipal bond market to supplement their assets.

Like most pension reform advocates, the Pension Integrity Project at Reason Foundation has generally been skeptical of pension obligation bonds. Issuance of these securities essentially gambles that a public employee pension fund can take the borrowed money and earn investment returns that are greater than the interest and origination costs of the bonds.

When borrowing rates are relatively high, this is an especially risky bet. But in today’s environment of record-low interest rates, pension obligation bonds appear to be somewhat less dicey, prompting some municipal finance experts (even some usual POB skeptics) to suggest that the current moment provides a unique opportunity for their expanded use with fairly low risk.

That said, pension obligation bonds are not the most cost-effective borrowing mechanism available to U.S. public sector entities, and POB issuers often fail to rectify structural design issues, flawed assumptions, weak funding policies, and other problems within the pension system that caused the emergence of unfunded liabilities in the first place.

As a result, POB issuance has been followed by deterioration in funding levels in some places, and absent structural reform, the POB merely treats the symptom and not the disease. In the most extreme case, that of the Puerto Rico Employee Retirement System, pension obligation bonds contributed to the system’s insolvency, the commonwealth’s bankruptcy, and even benefit cuts for some retirees.

Further, POBs carry higher interest rates than federal debt and often have substantial origination fees. State and local governments would save substantial debt servicing costs by borrowing from the federal government or Federal Reserve at Treasury interest rates rather than issuing their own pension obligation bonds. Also, as long as the state or local government repays the federal loan, there would be no cost to federal taxpayers—the argument goes.

Hesitance at the pension obligation bond option has spurred an examination of options for federal financing of state budget shortfalls. In an April 26 Wall Street Journal op-ed, for example, American Enterprise Institute’s Andrew Biggs suggested such an intervention. Biggs wrote:

Congress may want to offer assistance, but it should come with strict conditions: Any state looking for a pension handout must either live by the stricter accounting rules federal law imposes on private pension plans or freeze its pension and shift all employees to defined-contribution retirement plans.

Essentially, Biggs’ suggestion is to use the carrot of federal assistance as an incentive for state (and local) pension plan sponsors to de-risk their public pension systems going forward, thereby improving long-term pension solvency.

Under this concept, federal assistance would come in the form of a loan program that would require:

  • Ensuring that state and local governments pay back their loans in full; and
  • Ensuring that any loan is used effectively to finance a transformation into a sustainable public pension system, with governments implementing substantive pension reforms that ensure both near-term cash flow and long-term risk reduction.

The unusually low-interest rates government borrowers are now paying arguably offer a unique opportunity to tackle pension underfunding. Despite trillion-dollar annual budget deficits, the federal government is paying record-low interest rates. Global investors continue to find these low rates attractive because most other advanced economy sovereign debt is providing negative yields.

It seems likely that the U.S. Treasury could borrow even more money to help public pension systems reduce their unfunded liabilities if those systems—and the policymakers who ultimately govern them—are willing to reduce the risk of future unfunded liability accrual through transformational change. The current deflationary environment and ultra-low 30-year Treasury yields could allow states to use the federal government’s credit to better ensure pension solvency through the retirement and passing on of the baby boom generation. But to ensure that this remains a lending program rather than a subsidy to profligate state and local governments, strict borrowing covenants, which would need to be monitored and enforced on a regular basis, must accompany the loans.

A Conceptual Structure for Pension Bailouts

Continuing through the logic of a hypothetical federal pension loan concept, as its supporters have outlined— as a condition for leveraging federal borrowing and credit creation power, state and local governments would have to agree to a stringent set of reforms to public sector pension systems that would improve their long-term solvency by accelerating their movement toward full funding. At the outset, it is critical to emphasize that even most bailout supporters acknowledge this policy is ideally implemented only at a time when interest rates are very low and stock prices are not near peak levels, which is no longer the case as the stock market has recovered from the initial pandemic shock that occurred earlier in 2020.

One way to ensure compliance would be to make it automatic. States and most large local governments receive large amounts of federal funds, and the federal government could simply deduct principal and interest on the pension loans before remitting grant funds to a state or local government borrower, supporters of the loan argue. This concept is not new in U.S. public finance—some states effectively guarantee K-12 school bonds through the use of “aid intercepts,” and the state of Illinois passed a law in 2018 allowing the use of intercepts to require that local governments make their full actuarially determined contributions to their public pension systems. Medicaid transfers and state highway funds also offer two important federal fund transfer mechanisms that could potentially be leveraged.

Further, the federal government could impose certain requirements on borrowers that would greatly reduce the risk of further pension distress. Just as bank loans and municipal bonds often contain stipulations that require the obligor to meet requirements beyond paying in full and on time, supporters of the pension loans say the federal government could use covenants to promote pension system solvency. These could include:

  • Requiring any pension system receiving federal bond proceeds to collect and contribute no less than its full actuarially determined contributions (ADC) from employees and employers each year (though ramp-ups and corridors may be necessary for some particularly distressed public entities to ease their way into more-stringent funding regimes).
  • Requiring public pension systems participating in the federal borrowing program to follow rules on assumed rates of return modeled after those the Employee Retirement Income Security Act (ERISA) requires of private sector pension plans. ADCs are calculated based on actuarial methods and assumptions, which have resulted in underestimations of plan liabilities, and will likely continue to do so. For example, public pension systems usually discount their future benefit payments using their assumed rates of return—typically set at 7 percent or more. This contrasts with private plans that are obligated under ERISA to discount their liabilities at corporate bond rates, which are much lower, and is an obligation enforced by the Internal Revenue Service.
  • Requiring investment return assumptions targeting the 50 percent likelihood of 10-20 year forecasts rather than the traditional use of 20-30 year forecasts, which have led to systematic overestimation of returns.
  • Requiring a new set of standards to govern future cost-of-living adjustment (COLA) payments to beneficiaries in a way that protects any COLAs already earned and accrued, but offers sustainable, flexible benefit adjustments for the future to better protect taxpayers and employers from runaway costs (like those used in the Wisconsin Retirement System or the South Dakota Retirement System).
  • Requiring the use of the latest mortality tables in pension valuations, which would force pension plans to prepare for longer expected lifespans for retirees.
  • Requiring the use of shorter pension debt amortization (repayment) schedules. While these requirements would initially increase unfunded liabilities reported by each system, it is less likely that these liabilities would spike during the life of the federal loan.

Finally, the Federal Reserve or Treasury Department could require better disclosure from state and local borrowers that use such a program. Because the Securities and Exchange Commission (SEC) lacks the authority to regulate municipal bond issuers, their disclosure practices fall far short of the standards enforced in corporate securities markets. Whereas an SEC-regulated corporate bond issuer typically produces a quarterly financial report within 45 days of the end of its reporting period, the average municipal bond issuer reports annually and takes over six months to do so. Some issuers take years to file audited reports—bankrupt Puerto Rico being among them.

Municipal disclosures continue to take the form of voluminous, opaque, and inconsistently formatted PDF files more than a decade after the SEC embraced a machine-readable reporting standard for corporate security issuers. More frequent, more timely, and more standardized disclosures would allow the Federal Reserve or Treasury to more effectively monitor state and local pension borrowers.

Working out the details of the loan provisions could be the responsibility of an appointed commission. Examples of relatively successful federal decision-making that were insulated from political pressures include the Base Realignment and Closure commissions of the 1990s and the Resolution Trust Corporation, which cleaned up the 1980s Savings and Loan crisis. There need not be haggling between governors and members of Congress if the program is professionally administered and properly insulated from the political process.

Finally, these stringent loan requirements are most likely too onerous for the states with the biggest pension system financial problems (like Illinois, Kentucky and New Jersey) because meeting these standards would require a far higher spike in contributions than many state and local officeholders could bear. Those states would likely have to find their own way to weather the consequences of decades of financial mismanagement.

There is a middle tier of pension systems that have been doing some things right since the Great Recession, yet they remained deeply underwater at the stock market peak during the last decade.

One example is the California Public Employees’ Retirement System (CalPERS), whose funded ratio increased from 61 percent to 70 percent between 2009 and 2019 while reducing its discount rate by 75 basis points over the period. CalPERS made only modest funding progress despite collecting its fully actuarially determined employer contributions each year. It also benefited from a 2012 reform that established more-modest funding formulas for new employees. CalPERS exemplifies a system that has been making incremental reforms but could use incentives to maintain and accelerate its progress.

The Failings of Even the Best-Designed Federal Bailout of State Pensions

There are some appealing aspects of the approach described above by those seeking loans and bailouts for public pension plans, but the pitfalls for taxpayers are many.

Fairness

One obvious disadvantage of federal loans is that they are sometimes not repaid, leaving federal taxpayers on the hook. In Puerto Rico, for example, some municipalities failed to make timely payments on U.S. Department of Agriculture loans.

Absent proper safeguards, a public pension system could still go bankrupt after borrowing from the federal government. In that undesired scenario, state or local governments would be torn between repaying their federal loan obligations or paying pension benefits earned by retired workers. It is likely that workers would be prioritized (as we have seen in Puerto Rico) and taxpayers would be obliged to take losses on the loans given to pension systems.

These concerns raise questions of basic fairness. While many state pension plans are in serious trouble—with massive debts and increasing doubts about the security of retirement benefits for workers, other states have managed their pension plans more responsibly. A federal bailout of the states that have managed their pension plans and budgets poorly would force federal taxpayers to shoulder the financial burden for problems they did not create and retirement benefits they will not receive.

Should a taxpayer in New Mexico, a state that just passed bipartisan pension reform legislation, pay for Illinois’ failure to properly fund its pension systems?

Similarly, why should the residents of states that have managed their pensions responsibly—like Wisconsin, South Dakota, and North Carolina—have to take the financial risk of backing federal loans to bail out irresponsible states? Doing so would also let those state policymakers who promised retirement benefits to workers without funding them—and the voters who elected them—to dodge the consequences of their decisions.

Even a federal bailout in the form of loans in exchange for pension reforms brings great financial risks to taxpayers.

This year’s recession comes after a decade of economic growth and robust investment returns during the longest continuous economic boom in modern history. While some states made progress on improving inaccurate actuarial assumptions and improving funding of their pension plans, others pursued a course of deliberate bad decisions and mismanagement, and overall pension plan finances experienced a lost decade.While all state pension plans, combined, went from having 63 cents saved for each dollar needed to cover long-term retirement liabilities in 2009 to 74 cents in 2019—and notably saw a more than 50 basis point average reduction in assumed rates of return over that time—some states still experienced degraded solvency.

Illinois, the epicenter of the recent calls for a federal bailout, is the poster child for the states that performed poorly. Illinois managed to fall from having 60 cents saved for each dollar needed to cover long-term retirement liabilities in 2006 to having just 40 cents for each dollar it needed for promised pension benefits in 2019. And, again, remember they did this during an economic boom.

Meanwhile, taxpayer groups, government worker unions, and lawmakers in states like Michigan, Arizona, Utah, New Mexico, Colorado, and Pennsylvania have been biting the bullet, compromising, and enacting politically difficult, but much-needed pension reforms to ensure secure retirement benefits and protect taxpayers from economic downturns. Those states did the right thing while Illinois, Kentucky, New Jersey, and many other states ran their pension plans further into the ground.

State leaders know recessions come along regularly, but many of them choose to pretend it’s not true, spending like an economic boom will never end and failing to prepare for inevitable economic downturns. A federal pension bailout would only encourage more fiscally irresponsible behavior from politicians. If states begin to think they or their pension systems are too big to fail, they will likely become profligate spenders.

No Track Record of Success

Examples of federal loans to states are very rare. The federal government does have a program that allows states to borrow to cover shortfalls in their unemployment trust funds. We are not at all confident that Congress, in the midst of a massive public health and economic crisis, can carefully and with due deliberation craft a more complex loan program for states that would work well and protect taxpayers. The transparency and accountability issues with the  $2 trillion Coronavirus Aid, Relief, and Economic Security (CARES) Act reveals a host of problems even though bailout programs are old hat for Congress. For example, major problems have cropped up with the airline bailouts. The lack of oversight of the CARES Act’s emergency funding for public transit is disturbing. But most damning is the utter failure to implement the overall CARES Act accountability measures that were included to reassure taxpayers the money would be used well.

How can taxpayers possibly expect members of Congress to design effective criteria for a first-of-its-kind state pension loan program—and implement it effectively in ways that ensure that federal taxpayers are paid back and made whole—when they can’t do so for seemingly standard stimulus measures?

The likelihood of an effectively designed and implemented program seems even more unlikely when you consider the wide range of retirement plan structures out there such as defined benefit, defined contribution, cash balance, hybrids, with or without automatic COLAs. These pension plans also have vastly different investment strategies and assumed rates of returns, different structures for annual contributions by employees and employers, and very different structures for deciding annual payments.

Could Congress design a set of terms, strings and conditions that would cover all those varying state pension plans effectively, and even if they could, would state legislators rush to embrace one-size-fits-all retirement plan design guidelines and mandates? It seems likely there would be perverse incentives for some states and unfairly harsh limitations on others.

Advocates might say there is little risk to taxpayers if states pay the loans back. But, that’s a big “if,” since states have no track record of using federal loans well or of paying them back. This could be because the federal government has no innate incentive to force states to become fiscally responsible, and the states know it. This is a massive proposed experiment, that would force taxpayers in states that have been fiscally responsible to take on the risk, via the federal government, of loans to fiscally irresponsible states. Such a pension bailout would be fundamentally unfair and unwise.

Incentivizing Financial Irresponsibility

States with pension plans in deep financial trouble got that way through many years of mistakes and wishful thinking—hoping for the best and planning for the best, rather than hoping for the best but planning for the worst. By doing so they avoided making necessary payments into the pension plans. It seems unlikely that a short-term infusion of cash in the form of a federal loan—in exchange for making pension reforms—would look more attractive to lawmakers than the ability to keep kicking the cost can down the road, especially if the strings attached to the loan are designed to stop them from being financially irresponsible.

Additionally, implementing those fiscal restraint strings would come at a steep political cost for state lawmakers since government workers would need to be asked to make higher pension contributions to fully fund the pension systems going forward. The inevitable legislative negotiation process between governors, Congress, and the administration would result in designing a loan program that is designed for meeting the short-term political goals of those in the room by providing immediate funding.

Pensions, however, are a long-term policy matter. Reforms to pension plans can take years to bear fruit. A short-term loan program would be ill-suited to motivating meaningful long-term reforms.

It also seems likely that some states, once a federal bailout loan was repaid, would revert to their entrenched bad habits of financial irresponsibility— resulting in the growth of unfunded pension liabilities all over again. Moreover, fiscally responsible states with hard-earned rainy day savings would not only fail to qualify for the program but would also end up paying for their less responsible peer states, which ends up punishing them for their fiscal accountability and creating incentives to abandon it.

A federal loan bailout would only have a chance of working if it could overcome those incentives, as well as the long-running tendency of many states to make bad pension finance decisions. It’s a long shot at best.

Moreover, arguing that Congress properly comprehends the bad pension decisions that many states make and could craft requirements to avoid them as conditions of a loan program, is laughable given the size of the national debt and federal budget deficits. The financial mismanagement of the federal government in recent decades is, unfortunately, the stuff of legend.

Beyond the debt, deficits, and fact that we cannot simply borrow unlimited funds forever, the track record of dire policy consequences for states that have been bailed out by the federal government in the past should serve as a cautionary tale.

The timeline of the required reforms is another quandary that raises a ton of questions, including:

Could states undo the reforms as soon as the loans are paid off? Indeed, do the onerous fiscal restraint strings incentivize states to default on loan repayment?

Again, how would the federal government enforce state-level pension reforms once the loans have been made since many of the proposed conditions involve ongoing operational decisions or reversible design decisions?

Changing actuarial assumptions would change the actuarial valuations of the pension plans, including how much debt they have and what annual payments should be. Is that to be done before or after the loans are calculated?

Does the federal government trust the states’ actuaries to run the new numbers, or do they hire their own actuaries to do it?

How much would all of that cost?

There are a lot of questions, but not a lot of good answers that would fully protect taxpayers.

An Oversight Nightmare 

But let’s leave those questions and other concerns aside and charitably assume appropriate conditions for federal loans could be crafted—What would prevent states from immediately underfunding or even withdrawing funds from their pension plans with the prospect of these federal bailout loans in the offing? Or why wouldn’t they temporarily change actuarial assumptions to make their pension plans appear to be more underfunded so they could get more federal bailout cash?

To avoid shenanigans, the loan program would need to obtain a verified and independent actuarial evaluation of every plan in every state seeking a loan. The federal agency providing the loans would have to look at the structure and elements of each plan and design loan conditions for each one. States would certainly dispute the actuarial analyses and the necessity or design of specific loan conditions. Suffice it to say, even if this could be done, it would take considerable time and a lot of work by a lot by federal bureaucrats. At the same time, it would tie-up state officials negotiating and lobbying for favorable loan conditions rather than focusing on making good financial decisions and legislating reforms to their pension plans that would put them back on a realistic path to solvency.

In our work on pension reform, we have learned that every state pension plan is unique and solutions need to be specially tailored. Is the federal government going to build a team of experts to come up with reforms for each individual state plan as a condition of a loan? Or would a team evaluate reforms proposed by each state? It’s unlikely either would work.

The proposed federal loan program offers several specific requirements intended to transform the state pension plans getting the loans to keep them on the proper financial straight and narrow. Unfortunately, it is not clear any of those requirements would work either.

The federal government could also consider withholding payments from federal grants or funds that normally flow to each state, such as Medicaid transfers or state highway funds. But this approach immediately raises issues. Medicaid funds are allocated on a formula designed to meet concrete needs for health care services. Transportation funds are largely, though by no means entirely, an allocation back to states of user fees paid in the form of fuel taxes and are supposed to be dedicated to transportation purposes. The same can be said of most other flows of federal funds to the states—they are spoken for and only paid to the states to accomplish long agreed-upon goals in providing certain services. And it seems very unlikely that powerful members of Congress would allow the federal government to withhold their state’s funds. For example, would Senate Majority Leader Mitch McConnell (R-KY) simply stand by while Kentucky saw its federal transportation dollars withheld to pay for one of these proposed loans?

The political incentives, especially in election years, suggest the president and other elected officials would also be motivated to intervene to ensure key states with lots of electoral votes kept getting their federal transportation and Medicaid money—even if they stopped making the loan payments. Politicians certainly wouldn’t want to be blamed for a state losing billions in highway or health care funding.

If the federal government followed through on threats to withhold any of these streams of funds as repayment for the pension bailout loans, it would be tantamount to them telling the states which program areas to cut to shift funds to pensions. That’s bound to have blunt-instrument ramifications, and frankly, it’s the states who need to learn to prioritize and figure out where to make spending cuts so they can afford to fund their pension plans.

Other specific suggestions include requiring any pension plan that got a loan to make the full actuarily determined payment into its pension plan each year. In other words, the plan can have a loan now if it promises to make proper payments in the future—like it failed to do in the past. And what is the enforcement mechanism if it doesn’t?  Would the federal government charge it penalty payments, creating an even greater incentive for states to walk away? What incentive do they have to enforce these paternal requirements? If the states fail to pay, what consequence is there to the federal government?

Not much.

And if there isn’t a good enforcement mechanism, it seems likely many states would borrow from the federal government to fully fund their plans then stop all payments into them so they could shift that spending to other priorities, essentially rebuilding the debt they have chosen to build up over recent decades, but having bought a lot of time with the federal bailout.

The Alternative Is Responsibility

All in all, federal loans would be unlikely to help states make long-term reforms to their pension systems or solve their funding problems. Instead of rewarding governors and state legislators for holding their hats out and asking for bailouts, Congress should refer them to the states that have worked hard to reform their public pension plans and get them onto sustainable paths. There are good pension models to follow and good tools to use for states that want to reverse course on declining pension solvency and embrace reform. And all state and local pension plans should always be planning ahead for the next economic downturn.

Stay in Touch with Our Pension Experts

Reason Foundation’s Pension Integrity Project has helped policymakers in states like Arizona, Colorado, Michigan, and Montana implement substantive pension reforms. Our monthly newsletter highlights the latest actuarial analysis and policy insights from our team.

This field is for validation purposes and should be left unchanged.