Understanding Public Pension Debt

Iowa has a long history of strong public sector financial management, and low public debt.  Often #1 and always ranking in the top tier of states in terms of lowest public debt as a percent of gross state product, Iowans are notoriously frugal when it comes to their tolerance for public indebtedness.(1)

There’s a reason for Iowa’s standing.  Under state law, debt that is backed by the “full faith and credit” of the government faces a high bar on the terms under which it can be issued.  Constitutional debt limitations; notice requirements; requirements for extraordinary majority votes in public referenda; many safeguards are in place to limit the extent to which Iowa governments can obligate future taxpayers.

Public debt is also limited to certain purposes, primarily capital projects where the life (and benefits) of the asset matches the period over which the payments are extended.

According to the Iowa State Treasurer, state and local governments in Iowa had $14.4 billion in outstanding obligations in 2012.(2)

But that’s only half the story.  For all the limits and safeguards on public debt, there is yet another source of public debt that receives little, if any, public scrutiny.  This debt is incurred automatically, sometimes even by intentional inaction.

Public pension debt is money owed to defined benefit public pension systems as a result of past underfunding or the use of assumptions that turned out to be wrong.  It is debt in every sense of the word.  It obligates future taxpayers for long periods of time (usually 30 years); it carries an interest expense (the longer the payments are deferred, the higher the cost to make up ground); and it is essentially backed by the full faith and credit of the government, i.e. benefit payouts are guaranteed.  The debt payments have a crowding-out impact on state and local budgets.

In addition to its lack of transparency, what’s different about pension debt is it is covering past operating expense, not the capital expense of a long-lived asset.  Pension debt is the cost associated with past work by government employees, a benefit earned for those years’ work, but not fully funded.  We’re asking Iowans 30 years from now to pay for a benefit associated with work that occurred last year, and in years before that.  Basically we’re borrowing from future generations to cover current and past operating expenses.

Iowa’s public pension debt has ballooned in recent years.  Once a marginal (or non-existent) addition to total outstanding obligations, public pension debt is now as much as the sum of all other public debt and is certainly much more than the sum of all general obligation debt.

Self-reported public pension debt (termed “unfunded actuarial liability” or UAL) in Iowa totals around  $6.7 billion.  Using a modestly lower assumption about the rate of return on investments, a shorter amortization period, and market-based valuation of assets (vs. smoothing), Moody’s estimates the state-only share of IPERS’ UAL to be 2.1 times higher than its reported value.  If the same holds true for all other public pension debt, the total is likely to be around $14 billion, equivalent to all other public debt in Iowa.  Many would argue the debt is much higher than even Moody’s suggests, though no one has suggested that pension debt could be any lower than what is self-reported.

The possibility of placing a large debt burden on taxpayers without their knowledge is a fundamental feature of defined benefit plans.  That’s because future benefit payouts are guaranteed, while the necessary investment earnings are not.  While our current debt is already substantial, it can grow still more to the extent that market returns do not average 7.5 percent per year in the future or if other assumptions are not met.

In order to check the risk of pension debt ballooning out of control, the vast majority of private sector retirement plans and some state plans have already shifted to alternative plan structures such as defined contribution, a hybrid, or some combination.  Paying down some of Iowa’s pension debt faster than currently planned can save interest expense, but it does nothing to prevent the debt from growing in the future.  For true reform, Iowa should consider some of these options.

A recent report by Barron’s Financial Weekly showed Iowan ranking second best nationally in terms of management of tax-supported debt and unfunded public employee pensions.(3)  That’s great, but rather than patting ourselves on the back we ought to be asking why our public debt has doubled over the past few years, and what we’re going to do to limit its growth in the future

(1) See Gross Public Debt as a Percentage of Gross State Product, by State, for years 1957 to present.

(2) Iowa Treasurer’s Office, Outstanding Obligations Report, 2012.

(3) Barron’s Financial Weekly, August 27, 2013, Cover Story, “Munis on the Mend” by Andrew Bary.  Or see http://webreprints.djreprints.com/47683.pdf

 

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