This commentary originally appeared in Forbes on July 22, 2016
Decades of generous pension increases made to government employees by politicians are looming larger on state and local government balance sheets across America.
Days ago, Ted Eliopoulos, head of the California Public Employees’ Retirement System (CalPERS), announced that he earned 0.61 percent in the prior year on a $300-billion-dollar investment fund—California’s worst year since the stock market meltdown in 2009. CalPERS expects to earn 7.5 percent annually on its investments. Last year, the nation’s largest state and local pension fund returned 2.5 percent; the year before, 1 percent. CalPERS’ 20-year return now comes in at 7.03 percent and will likely drop further.
Why should you care what CalPERS or your home state counterpart makes on its investments? Simple: if you’re a taxpayer, you’re on the hook to make good on the promises politicians have made with the government employee unions that helped elect them.
When CalPERS belatedly and prudently lowered its expected rate of return from 7.75 percent to 7.5 percent in 2012, the state of California was hit with an extra $167 million annually to make up for the reduced expectation of investment income. Local governments, including school districts, where hit with even larger costs. Instructively, CalPERS leaders wanted to further reduce expectations of future earnings, to 7.25 percent, but school districts and other government entities pushed back, saying such a move to reflect economic reality would hit their budgets even harder—instead, best to kick the can down the road.
Under pressure to boost earnings, state pension fund managers may increasingly turn to riskier investments. For instance, CalPERS had almost $30 billion invested in private equity funds which provided its strongest long-term return at 14.4 percent over five years. But, high returns mean high risk and, in the case of government pension funds, taxpayers are liable to make up any shortfall in pension obligations due to investment losses.
While CalPERS’ pension investment earnings were declining in 2012, a parallel debate arose over imposing a $9 billion “millionaire’s tax” over seven years, ostensibly to fund schools. Proposition 30, a November 2012 ballot initiative, was primarily funded by labor unions, with the powerful California Teacher Association alone chipping in $11.4 million of the $67.1 million spent to support passage. The initiative was sold as being “for the children” but its real purpose was to boost government support for badly underfunded teachers’ pensions. The ballot measure passed with 55.4 percent, but had it failed, teacher layoffs were threatened as school districts would have had to cut current employees to pay for past employees’ pensions to the tune of $2 billion per year.
Nationally, the state and local government pension shortfall is estimated at $4.8 trillion, according to the U.S. Pension Tracker at the Stanford Institute for Economic Policy Research, run by Joe Nation, PhD, my former colleague in the California State Assembly. This equates to $41,219 per household, a sum that will come due in the form of higher taxes over the next 30 years as government workers retire—unless investment returns pick up or government services are cut significantly to pay for pension promises.
The three states with the largest potential government pension problem are Alaska, Illinois and California. The three states that have been the most prudent in not over-promising and under-funding government pensions are North Carolina, Indiana, and Tennessee.
Converting a state’s underfunded pension liability into the tax hikes, or spending cuts, needed to meet legal obligations over a 30-year period brings a distant, theoretical fiscal challenge home to taxpayers. Starting with a state’s current state and local tax receipts, then comparing those to the yearly sum needed to pay for pension obligations over the next three decades, we see that Illinois is in the worst shape in the nation, needing a 17.9 percent increase in taxes at the state and local level for 30 years, absent other spending cuts, significant reforms in its government employee pension system, or a consistent improvement in annual investment earnings. New Mexico follows with a 17.3 percent tax increase needed to cover unfunded pension obligations. California risks the third-highest tax hike at 16.1 percent. Nevada is close behind at 16.0 percent.
The national heat map below shows how much state and local taxes would have to be increased over current collections as a share of state income to adequately fund promised government pensions. The next heat map shows total state and local tax obligations, assuming pensions are adequately funded over the next 30 years, with the ten-highest-taxed states and five-lowest taxed states called out.
Without pension system reform, government increasingly risks being seen by taxpayers as little more than a public employee pension system collection agency, demanding tax money to pay for well-heeled government retirees while returning less and less in services.
Chuck DeVore is Vice President of National Initiatives at the Texas Public Policy Foundation. He was a California Assemblyman and is a Lt. Colonel in the U.S. Army Retired Reserve.