Four trillion dollars. That is the shortfall of state and local government pension funds across the United States—the amount of money these governments have committed to workers but lack the funds to cover. According to Joshua Rauh, an associate professor of finance at the Kellogg School of Management, that massive number represents “hidden debt,” a means by which governments can run up debt off the balance sheet, bypassing balanced-budget laws. And it could spell big trouble in the years ahead.

In two recent papers, Rauh and Robert Novy-Marx, an assistant professor at the University of Rochester, show that these pensions are dangerously underfunded, that they are based on faulty economic assumptions, and that the impact to taxpayers could be significant. Ultimately, Rauh says, it could result in people leaving cities in order to avoid the fallout.

Questionable Logic at Fault
According to Rauh, the huge discrepancy between state and local government pension assets and liabilities comes from what is essentially bad accounting. The Governmental Accounting Standards Board (GASB), a nongovernmental group that sets guiding principles, allows these governments to measure the cost of providing pension benefits using expected returns on the assets in pension funds. They are allowed to say, in other words, that because a particular portfolio has historically delivered an 8 percent return, it will always deliver 8 percent. Under that questionable logic, you could assume that a mutual fund you bought in 1982 would have the same return for the next 30 years, and you could reduce the stated value of your debts accordingly.

“In the mid-’90s,” Rauh says, “the GASB legitimized this accounting that governments had been practicing for years. It’s very different from what would be done in the private sector, and very different from what logic says you should be able to do.”

It is also, Rauh says, a self-perpetuating cycle. “What short-sighted politicians want is to be able to spend money now that you don’t have to collect in tax revenues now. These problems have been put off into the future.”

Back in 2007, when Rauh and Novy-Marx first began work on a paper titled “Public Pension Promises: How Big Are They and What Are They Worth?”, equity markets were close to all-time highs. State and local governments claimed their pension systems were fully funded. “We looked and said, in fact they are assuming that the success that these funds have had, that the equity markets have had, over the last 30 years is just going to continue indefinitely. They’re assuming that every dollar in the pension fund is going to continue to grow without risk at 8 percent.”

Subsequently, of course, the financial crisis hit—and these same pensions lost $1 trillion in assets. Rauh and Novy-Marx are not the first to point out that government accounting differs from private-sector accounting. But they are the first to precisely measure it. Government reports, Rauh says, are “opaque and not standardized.”

“One thing you want to know is the outflows. What has been promised every year in the future? That seems like something that any taxpayer should have the right to know. But they’re not required to disclose that.” So Rauh and Novy-Marx set out to reverse-engineer these cash flows and then to “stress-test the assumptions,” to discover what happens when they re-evaluated cash flows using real discount rates that account for risk in the markets. The answer—that $4 trillion figure—should, Rauh says, be a cause for concern.

Analyzing the Numbers
In another recent paper, “The Revenue Demands of Public Employee Pension Promises,” Novy-Marx and Rauh calculated the cost to taxpayers of the unfunded liabilities. “People have trouble thinking in trillions,” Rauh says. “What does a trillion dollars really mean?” If you divide $4 trillion by the number of households in the United States, 150 million, it works out to $26,000 per household. But even that figure is hard to interpret, because it only reflects the present value.

So the researchers went further, to calculate the impact of that number on households in terms of increased taxes or decreased spending each year. On average, across the country, fully funding promised pensions could result in a tax hike of nearly $1,400 per household, every year.

Of course, the real amount would vary greatly by geography. As they write in the paper, “Taxpayers may leave the states that are the most burdened by the legacy liabilities and look for places with lower taxes and better public services.” Rauh plans to research these impacts.

If Chicago, for instance, faces a “day of reckoning” with its pensions and has to pay them out, residents might move to the suburbs to avoid paying higher taxes and facing cuts in services as the city struggles to meet its obligations. “That’s something that we expect to happen as state and local governments try to deal with these problems,” Rauh says. As people leave these areas, that only compounds the problem by reducing the tax base—leading to even greater tax increases for those who stay.

So what is the solution? The first thing, Rauh says, is to stop the problem from getting any worse. “If you have a friend who calls you up and says, ‘I have $100,000 in credit card debt, what can I do?,’ the first thing is to tell them to stop increasing the debt.” While there is no easy or pleasant solution, starting to pay down or renegotiate the debt is essential. “But it has to be recognized what the value of the debt is, what the value of the promises are. Then,” Rauh says, “we can think about how we can pay for it.”

Further reading:
Joshua Rauh blogs about this and related topics at Everything Finance.

Related reading on Kellogg Insight

Pensions in Peril: The funding status of state-sponsored pension plans

Today’s Rising One-percenters: The growing gap between the very rich and everyone