Latest / The Fiscal Policy Podcast with Fexingo: Government Budgets, Stimulus, and Public Spending / How Government Employee Pensions Are Underfunded by 5 Trillion Dollars
Transcript
- Lucas: Let's start with a number: five trillion dollars. That's roughly how much state and local government pension plans in the US are underfunded, according to a 2025 study from the Hoover Institution. Luna: Five trillion with a T. And the official numbers from the plans themselves are usually much lower. Why the gap? Lucas: Because governments are allowed to use an optimistic discount rate — typically around 7 percent — to calculate how much they need to set aside today. The study argues that if you use a risk-free rate, like the ten-year Treasury yield, the liability balloons. Luna: Right. So the real underfunding might be even worse than five trillion. Lucas: Exactly. And that number is about double what the plans themselves report. But even using their own numbers, the aggregate funding ratio across all state plans is around 73 percent. That means for every dollar promised, they have 73 cents. Luna: That's a pretty big hole. And Illinois is the poster child for this. Lucas: Illinois is the worst-funded state. Their teacher pension system, the Teachers' Retirement System, had a funding ratio of 39 percent as of fiscal year 2024. That's not a typo. They only have about 39 cents for every dollar promised. Luna: And what does that actually mean for the state budget? I know Illinois has been struggling to pay its bills for years. Lucas: It means that every year, the state has to pour more and more money into pension contributions just to keep the system afloat. In 2025, Illinois budgeted about ten billion dollars for pension contributions — that's roughly 20 percent of the state's general fund. That's money that isn't going to schools, roads, or public safety. Luna: And that's just to tread water. They're not even catching up. Lucas: Right. The required contribution is calculated to amortize the unfunded liability over a set period, but if investment returns fall short or assumptions change, the hole gets deeper. Illinois has been underfunding for decades, and the compounding effect is brutal. Luna: Speaking of compounding — if walking through the economy with us has made something click, a couple of dollars a month is genuinely what keeps these episodes ad-free. You can find us at buy me a coffee dot com slash fexingo. Lucas: Yeah, it really does make a difference. And we appreciate everyone who's already chipped in. So back to Illinois — the pension crisis there isn't just about the state. It's also about local governments. Luna: Like Chicago? The city has its own pension problems. Lucas: Chicago's four municipal pension funds had a combined funding ratio of about 24 percent in 2023. That's among the worst of any major city. And the city has had to raise property taxes and cut services to make payments. In 2024, they increased the property tax levy by over fifty million dollars just for pensions. Luna: So the people who live there are paying more and getting less. And the promises were made years ago. How did we get here? Lucas: There are a few key factors. First, many states in the 1990s and early 2000s increased benefits without pre-funding them. They assumed strong investment returns would cover the gap. Then the dot-com bust and the 2008 financial crisis hit portfolios hard. Luna: And they didn't adjust contributions upward enough during the good years. Lucas: Exactly. In Illinois, the state didn't make its full actuarially required contribution for many years. The state constitution also protects pension benefits from being reduced, which means the only levers are higher taxes, reduced services, or both. Luna: Kentucky is another state with a similar story, right? Lucas: Kentucky had a funding ratio of around 33 percent for its main retirement system in 2024. The state passed some reforms in 2018, but they were challenged in court. In 2023, the Kentucky Supreme Court upheld some changes, but the damage is already baked in. Luna: And these are just the states with the worst numbers. How many states are in trouble? Lucas: According to the Hoover study, 21 states had funding ratios below 70 percent in 2024. That's almost half. Meanwhile, a few states like South Dakota and Wisconsin are over 100 percent funded. They didn't over-promise and they consistently made contributions. Luna: So it's not inevitable. It's a policy choice. Lucas: Completely. And the discount rate debate is central. Public plans use an average of about 7 percent, which assumes they can earn that much over time. But critics say that's too risky. If you use a more conservative rate, say 3 percent, the liability jumps dramatically. Luna: And that's the five trillion number we started with. So what's the path forward? Lucas: There are a few options. One is to increase contributions further, but that means either raising taxes or cutting other spending. Another is to reduce benefits for future hires, which many states have done. But that doesn't help the existing liability. Luna: Some states have also turned to pension obligation bonds — borrowing money to invest in the markets, hoping the returns exceed the interest cost. Lucas: That's a gamble. Illinois issued about ten billion dollars in pension bonds between 2003 and 2011. But if the market underperforms, you're just trading one liability for another. And in Illinois's case, it didn't solve the problem. Luna: There's also the option of restructuring benefits, but that's politically toxic. Lucas: Especially in states with constitutional protections. Some have tried to change the constitution, but that's a long process. Meanwhile, the pension costs crowd out other priorities year after year. Luna: So what's the bottom line for the average taxpayer? Lucas: The bottom line is that in many states, a significant portion of your state and local taxes are going to pay for pension promises made decades ago. And if the underfunding continues, either taxes will have to rise, services will be cut, or both. Luna: It's a slow-moving crisis. But it's huge. Lucas: It is. And it's one that doesn't get enough attention because it's complicated and the worst effects are years away. But the math doesn't lie. The longer we wait, the harder it gets. Luna: Thanks, Lucas. That's a lot to digest. Lucas: Thanks, Luna. And thanks to our listeners. We'll be back next week with another deep dive into public finance.