Why the Federal Government Should Worry About State Pension Liabilities Josh Rauh, Kellogg School of Management May 19, 2010

Day of Reckoning Without policy changes, many state pension funds will run dry in years Assumptions consistent with recent past  Start with September 2009 assets  Assume 8% investment returns  Assume contributions and newly accrued benefits offset each other 2

When Will State Funds Run Out? Under these assumptions  Illinois in fiscal year 2018  7 states by end of fiscal year 2020  20 states by end of fiscal year 2025  31 states by end of fiscal year

Examples Illinois  Main 3 funds together run out in 2018  Benefits will be $14B annually in , $11B annually already promised today  Governor Quinn: FY2010 revenue of $28B Other examples  Connecticut and New Jersey (2019)  Louisiana (2020), Michigan (2023)  Ohio (2030), expected annual benefits during are 100% of 2008 revenue 4

All 50 States Combined 5

What Happens in a Run Out? Many state constitutions protect benefits Across states that run out by 2025, benefit payments after run outs will average  31% of 2008 revenues if plans frozen today  45% of 2008 revenues if plans continue to run Crisis  Taxpayers revolt  No buyers of state debt at auction  Retirees expecting checks 6

Scenarios Could happen sooner if  Workers start running for the exits  Taxpayers start moving  Contributions are deferred or not made  Investment returns are lower than 8% Could happen later if  States make fundamental reforms  Can borrow enough to fill the hole  Investment returns are higher than 8% 7

Role of Federal Government Washington will face massive political pressure to bail out affected states Consider recent bailout of banking sector, this one would be bigger Any tough talk that Washington won’t bail out states is not credible What can be done now? 8

Reforms For States Troubled states should 1.Close defined benefit (DB) plans to new workers. New workers must get BOTH:  a defined contribution (DC) plan like the federal Thrift Savings Program (TSP)  Social Security 2.After (1), issue debt for existing liabilities  Much cheaper and more feasible than it will be if the situation deteriorates  Makes existing worker pensions more secure 9

Proposed Federal Program Idea: help states borrow to fund pensions, on condition that states make the reforms New subsidized version of pension funding bonds, called Pension Security Bond (PSB) Give states 35% direct interest subsidy for PSBs for 15 years IF the state agrees to three specific austerity measures… 10

Conditions for Pension Security Bonds State must agree to 1.Close DB pension plans to new workers, not to start new DB plans for 30 years 2.Make exactly the annual Actuarially Required Contributions (ARC) for existing DB plan using the new PSBs 3.Include all new state workers for 30 years in Social Security plus a good DC plan, namely a Thrift Savings Plan spinoff set up by federal government 11

Estimated Cost of Federal Program Gross cost of tax subsidy for new PSBs around $250B  states to issue $1.0T in new debt over 15 years using 30yr bonds Gross savings from Social Security contributions by new workers >$175B  Diamond-Orszag calculations, reduced to use i.) state workers only; ii.) shorter horizon  Net cost of program is $75B… versus $1T+ chaotic bailout 12

Conclusion Plan offers benefits to numerous parties  Existing pensions become more secure  New workers get more than an empty promise  Avoids massive taxpayer-financed bailouts DC plans not perfect but immune to problems that are bankrupting states  State politicians can’t use pensions to borrow on horizons that extend beyond their careers Federal government should act today to get states to address these problems 13

Additional Slides

20 States Run Out by Average Benefit Over Five Years Following Run Out ($B) Ratio of Annual Benefits to 2008 Revenues Year Run Out (8% Returns) Promised by 2008 Projected as of Tax Revenue ($B) Promised by 2008 Projected as of 2008 ILLINOIS %43% CONNECTICUT %37% INDIANA %24% NEW JERSEY %47% HAWAII %34% LOUISIANA %39% OKLAHOMA %43% COLORADO %81% KANSAS %35% KENTUCKY %53% NEW HAMPSHIRE %45% ALABAMA %60% MICHIGAN %31% MINNESOTA %40% MISSISSIPPI %57% MARYLAND %38% PENNSYLVANIA %43% SOUTH CAROLINA %55% WEST VIRGINIA %26% MISSOURI %63%