Kicking pension problems into the future is popular with politicians, enabling them to make promises and let voters worry later about borrowing costs.
But large, unfunded state pension liabilities are a costly problem—and the cost is already reflected in current bond prices, research by Chicago Booth PhD candidate Chuck Boyer suggests. “The public pension funding crisis is not merely about future insolvency,” he writes. “Future obligations are having an effect on debt spreads right now.”
To many Americans, it may seem unimaginable that states would fail to fully pay pensions promised to teachers, firefighters, and other public-service workers. It has been almost 90 years since the last state default: during the Great Depression, Arkansas owed over $160 million to debt payments, which was nearly half of the state’s annual revenue (and equivalent to roughly $3 billion in 2019 dollars). The debt was restructured and “debtholders were eventually made whole,” Boyer writes in recounting this history.
However, pension obligations are mounting in many states, and officials are struggling to cut costs and raise taxes to pay what is owed. And he argues that the effects can be seen in the $3.8 trillion capital market for US municipal bonds, which includes bonds issued by 50,000 state and local governments.
When a company defaults, there is a clear legal framework for who gets paid back first. This isn’t the case for states, however, as there is no such legal structure, nor much precedent. The markets’ expectations, then, are built into bond prices. Bondholders, wary of how a default could play out, demand a premium.
Using annual fiscal reports released by state governments, Boyer looked at the ratio of unfunded pension liabilities to GDP from 2002 to 2016 and estimates that every 1-standard-deviation increase is associated with a 27–32 basis-point increase in bond spreads over the Treasury rate, up to a fifth of the average total spread. Unfunded pensions cost US states more than $2 billion in lost bond-issuance proceeds in 2016, he calculates, adding that he considers that a conservative estimate.
But the penalty that a state would essentially pay in the form of higher spreads varies from state to state, providing some indication of how the market thinks a default could play out. States where pensioners have more legal protections and their unions have more bargaining power (and maybe higher public support) are paying higher borrowing costs. In these areas, debtholders see a higher risk of default—perhaps assuming states would take care of pensioners before bondholders, who are mostly high-net-worth and retail investors.
Boyer looked specifically at Illinois, where pension reimbursements are protected by the state constitution. In 2013, the state passed reform legislation that would have reduced the state’s pension liabilities by $160 billion by extending retirement ages and capping the amount of someone’s salary that could be used to calculate pension benefits. After the law passed, the state’s bond spreads fell by an average 12 basis points more than other states’ bond spreads. But in 2015, the Illinois Supreme Court overturned that legislation, and spreads shot up. In 2016, the State of Illinois issued $28 billion in general-obligation bonds to raise $3 billion. Had the state moved to fully fund its pensions, its bond spreads would have improved by 79 basis points, writes Boyer, and the state would have raised an additional $280 million.
He also argues that the pension problem has a larger effect on bonds with longer maturities, a clue that unfunded liabilities are most likely to affect state solvency 10–20 years down the road. But already, unfunded pensions are increasing states’ borrowing costs, compounding fiscal problems.