The federal government may have run up a $1.3 trillion deficit in 2010, but that’s not the only government budget shortfall of note; a recent report from the Pew Center on the States found a $1 trillion funding gap in state pension retirement plans. Others have noted that this gap could be as large as $3 trillion.
Unfortunately, the problem doesn’t stop at state capitals in Wisconsin, Ohio or any of the other states in the news as policymakers debate the future of pensions. Cities and municipalities have also promised their public workers far more than they can afford to pay, with many cities facing pension shortfalls measured in billions of dollars.
This is exactly what’s happening in Texas cities like Dallas, Houston, Fort Worth and others — irresponsible behavior by city financial managers has created a yawning gap between pension promises and the funds available to pay them. Northwestern University professor Joshua Rauh estimates that each Dallas taxpayer will owe $12,856 per household to plug that hole; Houston taxpayers will owe $10,804 per household, and Fort Worth taxpayers will owe $7,212 per household.
The primary problem isn’t in overestimating future market return of pension accounts; it’s in underestimating the liabilities owed — the promised pension benefits. Cities in Texas and elsewhere regularly calculate their future pension liabilities using the assumed return on their pension investments. The problem is that these returns are volatile, risky and far from guaranteed.
That’s a lot to unpack, so let’s examine whether this makes sense by way of an analogy. Imagine that, tomorrow, you win the Texas Lotto — a $22 million jackpot, last I checked. If you’re the patient type, you can receive the entire sum in 25 annual payments; otherwise, you could choose a one-time payout worth $13.9 million. The immediate payout is less than the full lottery jackpot amount because it reflects the value of receiving future annual payments today; assuming a conservative 4.3 percent return, which the state of Texas does, that money would grow to the full $22 million over the next two-plus decades.
But say the state of Texas boosts their projected return rate; they think Texas Lotto winners can get a hearty 8.5 percent return over the next twenty-odd years, so they only pay out $9.7 million to the winners today. This would be a rip-off of, well, Texas-sized proportions; the savvy lottery winner would pass up the lump-sum payment, confident that future returns are not likely to be as large as the state’s prediction.
Lottery winners wouldn’t make that deal, but cities and municipalities across the country continue to engage in a similar financial sleight-of-hand with their pension funds. A large projected return gives the appearance of smooth financial sailing and lower required contributions. In reality, city leaders are gambling on large investment returns to make up for their decision to under fund the pension, and if they aren’t realized, it’s taxpayers who are stuck with the tab.
For the sake of all Texans, this insanity must stop. We must shift public employees to a more affordable retirement plan, similar to those in private sector, before the hole grows so large that cities in the Lone Star state can’t dig themselves out.
John W. Diamond is the Edward A. and Hermena Hancock Kelly Fellow in Public Finance at the Baker Institute and an adjunct professor of economics at Rice University.