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Our Unfunded Pensions Bomb Is Ticking


Taxpayers Face Potential Whammy When Governments’ Promises Come Due



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Underfunded state pensions are the multitrillion-dollar debt you’ve probably never heard of. Warren Buffett, Berkshire Hathaway’s chairman, has warned that state funding for pensions is “woefully inadequate.” This shortfall in defined-benefit pension plans will have to be made up by taxpayers, bondholders and state pensioners.

Underfunded state pensions are the multitrillion-dollar debt you’ve probably never heard of. Warren Buffett, Berkshire Hathaway’s chairman, has warned that state funding for pensions is “woefully inadequate.” This shortfall in defined-benefit pension plans will have to be made up by taxpayers, bondholders and state pensioners.

Under a defined-benefit pension plan, retirees are guaranteed a fixed amount each year. Employers are supposed to set aside enough assets to cover the amounts they owe current and future retirees. Unfortunately, state and municipal governments have put aside vastly less than they need to cover future retirees’ benefits.
   
To see why this has happened,
consider a hypothetical negotiation between a self-interested mayor and a union negotiator ably representing government employees.
   
The union negotiator starts by saying, “My members have contributed heavily to your campaign, so please give them a huge salary increase.”
   
The politician responds, “I’d like to help you out, but to give most government employees a mammoth raise, I would have to raise taxes, cut existing spending or borrow money, and all of these options would cost me votes.”  
   
The negotiator considers this for a minute, then replies, “OK, don’t give us anything now, but get the government to make a legally binding promise to give my members greatly increased retirement benefits in the far future, long after you leave office.
   
“Or, like some government employees in California can do, allow my members to retire at age 50 and then for the rest of their lives receive a pension that will be close to what they earned the year before they retired.”
   
The politician then counters by saying: “That’s a good idea in theory. But under our accounting rules, I have to put aside enough money today to cover future pension expenses.”  
   
But the negotiator defeats this objection, saying, “Just assert that the assets you have already put aside for pensions will somehow be invested in a way that earns them a spectacularly high return — high enough to cover your new obligations to my members.
   
“With this assumption, you can give my members something they will be extremely grateful for without you needing to raise any additional revenues today. And if anyone ever accuses you of being fiscally irresponsible, just tell them that teachers, police officers and firefighters deserve a first-class retirement.”  
   
This true-to-life story explains why, according to some estimates, state and municipal pension plans would need at least another $3 trillion in assets today to cover the expected future retiree benefits. This $3 trillion is going to come from somewhere, the most likely place being from taxpayers.
   
Consequently, many of you will, over the next two decades, face higher state and local taxes to help pay for defined-benefit pensions. Taxpayers, however, might balk at paying higher rates to bail out state employees’ pension plans.   
   
Employee unions have anticipated that future tax revenues might not be enough to cover state and local pension plans, so they cleverly made pension obligations “senior” to bond debt, meaning that a government must pay off its pensioners before it repays bondholders. Underfunded pensions, therefore, pose a default risk to state and local bondholders, since a desperate state or municipality must halt bond repayment before it deprives civil servant retirees of their legally guaranteed benefits.
   
Still, the defined-benefit pension burden might be so crushing for local governments that a few default on their bonds and renege on their pension promises.
   
If California defaults on its debt, it will likely be to escape some of its pension obligations.
   
Along with Social Security and Medicare obligations, underfunded government pension plans represent massive liabilities that U.S. taxpayers owe to those who have or will soon retire.
   
Unless our economy experiences much greater than normal economic growth over the next few decades, our politicians will either have to impose growth-crushing levels of taxation on working Americans or anger senior citizens by giving retirees far less than they have been promised.


James D. Miller is an associate professor of economics at Smith College in Northampton, Mass. His latest book is Singularity Rising: Sur­viv­ing and Thriving in a Smarter, Richer and More Dang­erous World (BenBella Books), on sale in October.


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