Latest / The Fiscal Policy Podcast with Fexingo: Government Budgets, Stimulus, and Public Spending / How Government Pension Liabilities Create Hidden Debt
Transcript
- Lucas: So here's a number that should stop anyone who follows government budgeting: state pension funds in the U.S. are collectively underfunded by about one point four trillion dollars. That's not a projection—that's the current gap between what states have promised and what they've actually set aside. Luna: One point four trillion? That's larger than the entire GDP of Canada. And it's state-level—so not even counting federal pensions or Social Security. Lucas: Right. And while we're talking about promises and numbers that feel abstract, it's a good moment to mention that this show stays ad-free because listeners like you choose to support it. If you want to keep hearing conversations that go past the headlines, consider throwing a couple bucks in the jar: buy me a coffee dot com slash fexingo. It genuinely makes a difference. Luna: Absolutely. No ads, no sponsor pressure—just people who care about how public money actually works. That's worth preserving. Lucas: Alright, so back to that one point four trillion. The real story is how that gap gets calculated—and why it might actually be much larger. Most public pension funds assume they'll earn an average annual return of around 7 percent on their investments. If you lower that to a more realistic 5 percent—which is closer to what many private funds use—the underfunding jumps by another several hundred billion. Luna: So the number itself is political. The assumed return rate is basically a dial that states can turn to make the problem look smaller. Lucas: Exactly. And it's not just an accounting trick—it has real consequences. Illinois is the poster child here. Their pension funds are less than 45 percent funded, and the state spends about a quarter of its general fund revenue just on pension contributions. That money isn't going to schools, roads, or public safety—it's going to past promises. Luna: And Illinois isn't alone. New Jersey, Kentucky, Connecticut—they're all in the same boat. The Pew Charitable Trusts tracks this, and the number of states with funded ratios below 60 percent has been growing. Lucas: What's fascinating is how this debt is invisible to most taxpayers. When a state issues a bond for a new bridge, that's a visible liability. But a pension promise doesn't show up on the balance sheet the same way—it's an off-book obligation until it comes due. And when it does come due, it crowds out everything else. Luna: Some states have tried to borrow their way out. They issue pension obligation bonds—essentially taking on new debt to invest in the stock market, hoping returns beat the interest rate. Lucas: And that strategy has a mixed track record. Illinois did it in 2003, issued ten billion dollars in pension bonds, and for a while it helped. But then the market dipped, and the state was left with both the bond payments and the same underfunding gap. It's a gamble, not a solution. Luna: So what would an actual fix look like? Is it even possible without huge tax hikes or benefit cuts? Lucas: The honest answer is: it depends on the state. For a state like Illinois, the math is brutal. To fully fund pensions over 30 years, they'd have to increase contributions by roughly two to three billion dollars a year—on top of what they're already spending. That's either a significant tax increase or massive cuts elsewhere. Other states have more breathing room. But the underlying issue is structural: the promised benefits are more generous than the revenue streams can support. Luna: And the discount rate assumption is key. If a state assumes 7 percent returns but actually gets 5 percent, the gap grows automatically. Some states have started lowering their assumed rates proactively—California dropped from 7.5 to 7 percent a few years ago—but that's still above what many economists consider realistic. Lucas: One of the better proposals out there is to require states to use a risk-free rate—like the yield on a ten-year Treasury—for discounting pension liabilities. That would make the underfunding transparent and comparable across states. Currently Illinois's funded ratio is 44 percent; under a risk-free rate, it would be closer to 30 percent. That's a huge difference in perceived health. Luna: So transparency might force action. If voters see that their state's pension debt is larger than its bonded debt, they might demand reform. Lucas: Exactly. And that's why the debate over pension accounting standards is so important. The Governmental Accounting Standards Board — GASB — sets the rules, and they've been slowly tightening them. But they still allow that 7 percent assumption. Until that changes, the true size of the liability stays hidden. Luna: You mentioned Illinois a few times. What's the human impact there? Beyond the budget numbers. Lucas: Illinois has one of the lowest credit ratings of any state—just above junk status. That means when it borrows for infrastructure, it pays a higher interest rate. Every extra basis point on a bond issuance is money that could have gone to schools or roads. Plus, the state has deferred maintenance on highways and buildings because the pension payments eat up cash. The state's own comptroller has said the pension burden is the single biggest threat to Illinois's fiscal future. Luna: And it's not just retirees. It's current employees who worry their benefits might be cut, and younger workers who question whether the pension system will even exist when they retire. Lucas: Right. Some states have moved to hybrid or defined-contribution plans for new hires, like 401-style accounts. That shifts the risk from the state to the employee. But it doesn't fix the existing unfunded liability for current retirees—that has to be paid somehow. Luna: So it's a generational issue. The decisions made decades ago are coming due right as demographics are shifting—more retirees, fewer workers paying in. Lucas: And that's the real fiscal time bomb. The one point four trillion is a snapshot, but the trend is worsening. As interest rates stay higher, pension funds earn less on bonds and the assumed return becomes harder to achieve. A 7 percent return in a world where ten-year Treasuries yield 4 percent is a stretch. It forces funds into riskier assets—private equity, venture capital—which can backfire. Luna: I've seen analyses suggesting that if you mark pension liabilities to market using a risk-free rate, the total unfunded liability for state and local governments could be closer to four to six trillion dollars. That's staggering. Lucas: And that number isn't hypothetical. The Federal Reserve's own Financial Accounts of the United States show state and local government net pension liabilities at around two point five trillion as of last year. That's measured using the discount rates states actually use. So even with the optimistic assumptions, it's already huge. Luna: So what's the path forward? Is there any state that's actually fixing this? Lucas: A few have made progress. Rhode Island, for example, reformed its system in 2011—cut benefits for future service, raised retirement ages, and created a hybrid plan. Its funded ratio has improved from about 50 percent to over 60 percent. But that required tough political choices and lawsuits from unions. It's not easy. Luna: And those reforms only apply to new benefits, not the accrued ones. The legacy debt remains. Lucas: Exactly. That's why some economists argue that the only realistic solution for deeply underfunded states is a combination of higher taxes and modest benefit adjustments for current retirees—usually through cost of living modifications, not outright cuts. But that's politically radioactive. Luna: And that's the tension: we're asking taxpayers today to pay for benefits earned by public workers decades ago, many of whom have already retired. It feels unfair from both sides. Lucas: It is unfair—but it's the math we're stuck with. The longer a state waits, the more expensive the catch-up becomes. Illinois's required contribution has more than doubled in the last decade. At some point, the state runs out of fiscal room, and then we see service cuts, tax hikes, or both. Luna: Which brings us back to the core fiscal policy question: what do we owe to the past versus what we invest in the future? Pensions are a promise, and breaking promises has costs too—legal, reputational, human. Lucas: And that's really the takeaway. The one point four trillion dollar gap isn't just a number on a spreadsheet. It's a constraint on every future budget decision. States that ignore it are effectively borrowing from future generations—and those loans come due with interest. Luna: So maybe the most important step is just making the true size of the liability visible. If voters and lawmakers can't see it, they can't fix it. Lucas: Agreed. And in a world of tight budgets and big promises, that kind of transparency is the first step toward fiscal reality.