The Political Economy of Public Pension Funding

According to The Pew Center on the States, unfunded liabilities in state pension systems amounted to nearly half a trillion dollars even before the financial crisis hit in the fall of 2008. The subsequent collapse of the equity markets and the shrinkage in state tax revenues brought on by the recession only made these pension problems worse. Aggregate coverage of pension liabilities across all the states dropped from approximately 84 percent of liabilities before the recession to about 77 percent at the end of FY 2010.

In a project previously funded by RSF, economist Alicia Munnell and her team at the Center for Retirement Research at Boston College are assessing whether pension reforms, now underway in many states, will be adequate to meet future pension obligations. In this project, Princeton political scientist Nolan McCarty proposes to take up questions of a different kind about the pension crisis – namely, why did so many states underfund their pension promises during periods of economic growth and flush state budgets before the crisis, and how will states respond now that the financial crisis and the Great Recession have dramatically increased the severity of these problems.

McCarty argues that despite their ideological differences, both political parties have incentives to underfund pensions for state workers. To provide government services, state workers must be hired in competitive labor markets. To recruit state workers, the total compensation package offered must meet or exceed that of comparable private-sector jobs. By promising generous pension benefits without fully funding them, states can offer a competitive total compensation package to state workers while limiting the immediate effect on state budgets. If voters sufficiently discount the future taxes required to pay unfunded pension obligations (or if they pay little attention to them), politicians on both the left and right can soften painful fiscal tradeoffs by underfunding pension obligations. Republicans have the opportunity to reduce taxes without cutting government programs by shifting employee compensation from wages to unfunded pension obligations, while Democrats have the opportunity to increase government programs without increasing taxes by making unfunded pension commitments.

McCarty believes that the recession may have accelerated partisan polarization in state legislatures that has been rising over the past 40 years. The result might be a hardening of partisan positions and a deepening of the pension crisis. Alternatively, belated recognition of the severity of the crisis might lead to compromise and structural reforms that ensure greater funding and reduced liability. To examine these possibilities, McCarty proposes to develop an econometric model of annual state pension contributions and unfunded liabilities. Preliminary evidence suggests that the two parties are almost equally guilty of underfunding pensions. The model will be used to examine more specific questions: will states controlled by Republicans seek to rein in promises but underfund existing commitments? Will states controlled by Democrats continue to expand pension promises but increase contributions at an insufficient rate? And will ideological polarization between the parties and/or the influence of public-sector unions exacerbate these effects?