State and local government pensions tout their ability to couple generous, guaranteed benefits for public employees with low and stable contributions from taxpayers. In reality, the risks that public pensions pose to taxpayers and government budgets have multiplied by a factor of 10 over the past four decades. While elected officials—including a number of Democratic mayors—are pushing for reforms, even they may not be aware of how much pension risk government budgets are truly bearing.
State and local governments contribute to public employee pension plans on the expectation that they will receive high and steady returns on the plans’ investments. Public plans generally assume annual returns of around 8 percent and calculate their required contributions on the assumption that they will receive these returns going forward.
But pension investments are risky. If actual returns fall short of the assumed rate, the sponsor must make larger catch-up contributions in future years. These catch-up contributions—referred to as amortization payments, as they pay off unfunded liabilities generated when investment returns fall short—increase pensions’ burden on government budgets. This is particularly true because investment returns tend to be correlated with the state of the economy. This means that a plan often will need to increase its pension contributions in bad economic times, precisely when tax revenues are lowest and the call on tax revenues for other purposes are greatest.
If contributions rise too high, governments may even skip making them. This alleviates the immediate budgetary burden but obviously only worsens the problem for the future. This is especially problematic because the future payments must also include interest at the 8 percent rate that plans assume for their investments. Public plans have seen both higher required contributions and skipped payments over the past decade.
What many elected officials do not understand is how much these risks have grown.