Latest / The Fiscal Policy Podcast with Fexingo: Government Budgets, Stimulus, and Public Spending / How the Federal Governments Unfunded Pension Liability Works as a Stealth Tax
Transcript
- Lucas: The federal government owes its current and former employees roughly two-point-four trillion dollars in pension benefits that it hasn't set aside money for. That number doesn't show up in the national debt as we normally talk about it — but it's a real obligation, and it's growing. Luna: Two-point-four trillion? That's more than the entire GDP of Canada. How does that work — is this like a corporate pension plan that's underfunded? Lucas: It's structurally similar, but the accounting is completely different. For civilian federal employees hired after 1983 — that's the Federal Employees Retirement System, or FERS — the government and employees both contribute to a defined-benefit pension. But on the military side, which is the bigger piece, there's almost no pre-funding. The military's retirement system is pay as you go: benefits are paid out of current revenue each year. Luna: And that creates a liability that's not backed by a pool of assets, the way a private-sector plan would have a trust fund invested in stocks and bonds. Lucas: Exactly. In the private sector, if a pension is underfunded, the Pension Benefit Guaranty Corporation can step in, and the company has to make catch-up contributions. The federal government regulates itself. Its trust funds are bookkeeping entries — Treasury securities that represent a claim on future tax revenue, not actual cash or marketable assets. Luna: So when the government says the military retirement trust fund has, say, five hundred billion dollars, that's basically an IOU from one part of the government to another? Lucas: Correct. The Congressional Budget Office and the Government Accountability Office have both flagged this. The military pension system's unfunded liability — the difference between promised benefits and the assets in the trust fund — was about one-point-two trillion at last estimate. For civilian FERS, it's another six hundred billion. Then there's the older Civil Service Retirement System, which is more funded but still has a gap. Add those up and you're well north of two trillion. Luna: And this isn't including Social Security, which has its own trust fund issues. This is just the direct federal employee and military retirement systems. Lucas: Right. Social Security is a separate universal program. This is specifically the pension promise made to about two-point-eight million civilian retirees and one-point-five million military retirees, plus active workers who will eventually claim benefits. And unlike Social Security, where the trust fund is projected to run out in the early 2030s, the federal pension trust funds are legally required to be 'sufficient' — but sufficiency is defined by the government's own accounting. Luna: So the government can essentially decide what assumptions it uses to calculate the liability. If they assume a higher discount rate, the liability looks smaller. Lower the rate, it balloons. Lucas: That's the key flaw. The Treasury sets the discount rate based on the yield on long-term Treasury bonds, which is always low right now. But the risk profile of a pension promise is different from a sovereign bond. In the private sector, the discount rate for pension liabilities is based on high-quality corporate bond yields, which are higher. The government effectively uses a lower rate, which actually increases the liability — it's more conservative in that sense — but then it doesn't fund the liability anyway. Luna: It sounds like a worst of both worlds situation. The government projects a higher liability because of the lower discount rate, but still doesn't set aside the money. Lucas: That's the contradiction. The Office of Personnel Management publishes annual reports showing the actuarial deficit. For the military, the deficit as a percentage of payroll has been running around 60 percent. But the government doesn't make annual contributions to close that gap. It just pays the benefits as they come due and calls it a day. Luna: Which means future taxpayers are on the hook for benefits that current employees are earning right now. That's the stealth tax part. Lucas: Exactly. When a military member serves twenty years and retires at, say, age forty, they start collecting a pension that could pay out for forty-plus years. The cost of those benefits is mostly recognized decades after the service was performed. The government doesn't set aside any of the current year's salary cost to invest for that future obligation. Luna: What about the civilian side? I know FERS has employee contributions — I think it's 4.4 percent of pay for newer hires — and the agency contributes too. Lucas: That's right. For FERS, employees contribute a percentage of salary, and the employing agency contributes an amount that's supposed to cover the normal cost of the pension. But the agency contribution goes into the trust fund, which holds those Treasury IOUs. The trust fund is not invested in the market. So the returns are whatever the Treasury pays on its own securities, which is very low. Over decades, that means the trust fund grows more slowly than if it were invested in a diversified portfolio. Luna: There's been a proposal to invest federal pension trust funds in a mix of stocks and bonds, like the Thrift Savings Plan does for individual accounts. But I think that's been controversial because of the risk and the potential for political interference. Lucas: The Federal Retirement Thrift Investment Board has argued for something like that for years. But opponents say it would give the government too much ownership in private companies and could lead to cronyism. The most recent attempt was in 2020, and it didn't go anywhere. Luna: Let me ask about one more piece: the military pension reform from 2018 that blended the old system with a defined-contribution component. Did that help with the unfunded liability? Lucas: The Blended Retirement System, which started in 2018, reduces the defined-benefit multiplier for new entrants and adds a matching contribution to the Thrift Savings Plan. Over the long term, it will lower the government's liability per service member. But the legacy liability — the promises already made to current retirees and those who stay under the old system — still has to be paid. The unfunded liability for the old system is estimated at about one-point-one trillion. The new system doesn't erase that. Luna: So we're essentially in a situation where for the next forty years, the military pension payments will be high because of the old system, and the government hasn't saved for them. That's going to put pressure on either taxes or other spending. Lucas: The CBO projects that military retirement payments will grow from about sixty-six billion this year to over one hundred billion by 2045, in nominal terms. That's not the biggest driver of the federal budget, but it's not trivial. And it's a fixed obligation — unlike discretionary spending, which Congress can cut, these benefits are statutory. Luna: So when a politician promises to protect federal pensions, they're essentially promising to keep the current structure, which pushes costs onto future taxpayers. Lucas: Exactly. And that's the stealth tax part. Every dollar paid in pension benefits to a current retiree is a dollar that either comes from current taxes or borrowed from future taxpayers. It's a real burden, just not one that appears on the standard debt clock. Luna: It makes you think about how much of our fiscal debate is about visible debt and how much is about these hidden liabilities. Lucas: That's a good point. And it's a subject we keep coming back to on this show largely because listeners find it valuable. I'll just say, a small group of listeners supports the show directly through buy me a coffee dot com slash fexingo, and that's what lets us keep these episodes ad-free. If you get something out of understanding how the government's fiscal machinery actually works, that's a way to help keep it going. Luna: Yeah, it's a straightforward way to support the kind of deep-dive we try to do. And now back to those pension liabilities — because there's one more twist I want to get into. Lucas: Sure. What's that? Luna: The fact that the government borrows money to pay the pension benefits, and that borrowing itself adds to the national debt. So there's a double-counting issue: the liability exists in the trust fund, and the debt used to pay the benefits adds to the publicly held debt. Lucas: That's a subtle but crucial point. When the Treasury issues debt to raise cash to pay military pensions, that increases the debt held by the public. Meanwhile, the trust fund holds a Treasury bond of equal amount — but that bond is a claim on future taxes, not a real asset. So the net financial position of the government is worse than either number alone suggests. The official debt doesn't include the trust fund's liability, but the trust fund's assets are not real resources. Luna: It's like having two columns in a ledger: one shows a loan to yourself, the other shows an IOU from yourself. Net out, you're just in debt. Lucas: Exactly. And that's why many fiscal experts argue for reporting the government's total obligations on a more comprehensive basis, including the net present value of future pension benefits minus future contributions. The Peter G. Peterson Foundation does an annual 'fiscal summit' report that puts the total federal unfunded liability, including Social Security and Medicare, at over one hundred trillion dollars. The federal employee pensions are a smaller but significant part of that. Luna: One hundred trillion is a number that's hard to wrap your head around. But if you break it down, it's basically the current generation promising itself consumption that future generations will have to pay for. Lucas: That's the core insight. And understanding that structure helps you evaluate any pension reform proposal. If a candidate says 'we can protect pensions without cutting benefits or raising taxes,' ask them how. Because the math doesn't work unless you change the assumptions or the funding mechanism. Luna: Or unless you invest the trust funds in higher-return assets, which is what some state pension funds do. But that comes with its own risks. Lucas: Right. The federal government's current approach is to understate the risk by assuming the trust fund earns a low, safe return, but then not actually funding it. It's a strange mix of conservatism and recklessness. Luna: So what's the bottom line for the listener? How should we think about the two-point-four trillion dollar number? Lucas: I think the bottom line is that this is a real claim on future resources, not an accounting trick. It will require either higher taxes, lower spending elsewhere, or reduced benefits for future retirees. The longer we wait to address it, the more expensive it becomes. And the first step is just to acknowledge that the liability is there — even if it doesn't appear on the standard debt report. Luna: Which is why we spend episodes like this pulling back the curtain. Thanks, Lucas. Lucas: Thanks, Luna. We'll keep watching those CBO reports.