This article appeared in Bridge on May 2, it is being posted here with the authors’ permission.
We still don’t know how COVID-19 will alter human lives and institutions over the long term, but government finances may feel the effects of the pandemic for a long time. Part of this results from fiscal policies that defer today’s hardships to the future. The pandemic’s effects on local pension funding, especially, will be felt for years, but not necessarily right now.
Public pension funds are supposed to be prefunded. That is, when employees are working and earn their pensions, their employers set aside enough money to pay for the promised benefits. Those contributions are invested, the money grows, and then it is used to meet the monthly obligations due to retirees. The state constitution deems that pension benefits earned by employees are contractual obligations and prohibits them from being cut or eliminated.
Several risks can affect a pension system’s future financial condition. These risks center around assumptions pension system managers make about future economic trends which they use to set employer contribution levels. Chief among these is investment risk, which is the risk that projected returns will differ from actual returns. The pandemic caused the value of investments held by local government pension systems to drop, along with the stock market. This will create a gap between what governments have saved and what they owe their retirees. Eventually, these shortfalls are reflected as liabilities that have to be made up.
Local governments were already carrying pension debt even before the recent market declines. The median local pension plan only has saved enough to pay for 69% of what employees have earned, and local governments would need a combined $8.3 billion to pay for the difference according to the state’s retirement reporting site.
Many local governments also promise their employees other post-employment benefits in the form of health insurance. These governments use the same funding strategy: Set aside money today to pay for future expenses (in this case, insurance premiums for retirees). As with pensions, they were behind on OPEB funding before the market losses. According to the state, the median city had saved just 13% of the expected costs as of last year; collectively, all local governments would need another $5.8 billion to prefund these benefits.
When pension and OPEB obligations are underfunded, costs get deferred to the future. Employees already provided their services but some of the costs of compensating them must be paid by future taxpayers. Governments must allocate additional future revenues toward these costs, making fewer resources available for public services down the line.
There is no legal or constitutional requirement to offer these benefits, and some governments have transitioned to 401(k)-style benefits and health care savings plans, which prevent this kind of underfunding. Even so, many local governments still offer traditional pension plans, and they are responsible for operating them and fulfilling benefit obligations until the last beneficiary has died.
Governments will still struggle to pay for the market losses their pension plans have incurred in the pandemic. But the increased costs of new pension liabilities will not happen soon.
That’s because pension funding mechanics defer recognizing losses (and gains) and even then, spread the pain over a number of years to make the required annual payments manageable.
For instance, the nonprofit Municipal Employees’ Retirement System, which manages pension funds for over 700 local governments, has still not recognized the market gains in 2019, let alone 2020’s recent losses. Recent market declines will not even affect local government finances if markets recover by year-end and meet their assumed 7.35% growth, though local government managers shouldn’t adopt this Pollyannaish view.
If there are losses, it will still take some time before it affects local governments.
Those losses will also be recognized over five years, which is intended to prevent large one-year swings in pension contributions due to volatile market returns. And it’s good that MERS recently shortened its smoothing policy from ten years to five years.
But, when the increased payments do hit, the pandemic’s effects will be felt by budgets already harmed by the recession. Local government revenues — especially in the form of state revenue-sharing payments that rely on the sales and fuel taxes — will have taken a hit. Increased pension obligations will further strain budgets, though with luck, the pandemic will be over by the time pension systems require more cash.
But knowing that future pension payments will be higher, and that governments are obligated to make those payments, provides some clarity to a future fiscal picture currently clouded by the pandemic. The virus’ effect on local government finances, like a lot of its other effects, will be smaller if the pandemic is shorter.
Craig Thiel is Research Director at Citizens Research Council
James M. Hohman is Director of Fiscal Policy at Mackinac Center for Public Policy