Latest / The Fiscal Policy Podcast with Fexingo: Government Budgets, Stimulus, and Public Spending / The Hidden Cost of Public Pension Underfunding
Transcript
- Lucas: If walking through the economy with us has made something click, or if you just enjoy hearing two people debate the fine print of public finance, there is a way to keep this going ad-free. A couple of dollars a month is genuinely what keeps these shows on the air and the lights on in the studio. Luna: It really does add up when you think about it, especially for listeners who rely on this stuff for their own planning. You can find us at buy me a coffee dot com slash fexingo if you want to help out. Lucas: Exactly. It is low-key, sincere support that makes the difference. But let us get back to the books, because today we are looking at a number that is not on your grocery receipt but is definitely showing up in your tax bill. Luna: I am guessing this is about those pension liabilities that every mayor seems to be avoiding until election season. Lucas: Precisely. We have covered payroll and infrastructure before, but we have not dug into the math behind the promises governments make to their employees. Specifically, I want to talk about the gap between what a pension fund says it needs to grow and what it actually earns. Luna: So you are talking about the discount rate problem? Where the assumed return is higher than the realistic yield? Lucas: That is the core of it. Let us use the Chicago Teachers' Pension Fund as our anchor. It is one of the largest single-employer pension funds in the country, and it has been struggling with an unfunded liability that sits around twenty billion dollars. That is not a rounding error. Luna: Twenty billion is massive. How did they get into a hole that deep without anyone noticing for decades? Lucas: It starts with the actuarial assumption. For years, many state and local funds assumed they would earn seven percent annually. In the early nineties, that was plausible. Today, with interest rates where they are, earning seven percent consistently requires taking on risky assets like private equity or leveraged loans. Luna: But if the market doesn't deliver that seven percent, who pays the difference? The taxpayers, right? Lucas: Yes. If the fund earns five percent instead of seven, the contribution required from the city jumps significantly. The city then has to raise taxes or cut services elsewhere to cover that shortfall. It is a zero-sum game played over thirty years. Luna: This feels like a house mortgage. If your house appreciates slower than you thought, you still owe the same monthly payment. Lucas: A better analogy might be a credit card with compound interest. The longer you ignore the gap, the more expensive it becomes to fix. And here is the kicker: many municipalities smooth these contributions. They pay less in good years so they can pay even more in bad years, which creates a cliff edge. Luna: Cliff edges are dangerous for budgeting. Does this affect the broader economy, or is it just a local government problem? Lucas: It affects everything. When a city like Chicago or New York has to divert hundreds of millions toward pension payments, that is money not spent on road repairs, school supplies, or police staffing. It crowds out real investment. Luna: So the quality of life in urban areas drops because the budget is locked into past promises. Lucas: Exactly. And investors know this. You can see it in the municipal bond market. Bonds from underfunded jurisdictions often trade at wider spreads because buyers demand extra compensation for the risk that taxes will rise or services will degrade. Luna: I have noticed that some muni bonds are getting cheaper relative to treasuries. Is that related? Lucas: Partly. But also, liquidity is drying up in the muni market. However, the credit spread reflects the underlying fiscal stress. If a city is paying ten percent of its general fund just to service pension debt, it has very little flexibility left. Luna: Ten percent sounds high. What is the average across the country? Lucas: It varies wildly. Some healthy funds are under five percent. But in stressed states like Illinois or New Jersey, pension costs can consume fifteen to twenty percent of the general fund. That leaves almost nothing for discretionary spending. Luna: That is staggering. So the workers are getting paid, but the rest of the government is starving. Lucas: It is a structural imbalance. And it is not just about the money. It is about political will. Cutting benefits for current employees is a third rail. So politicians choose to kick the can down the road by extending the amortization period. Luna: Extending the period just lowers the annual payment now, but increases the total cost later, doesn't it? Lucas: Right. It is the financial equivalent of choosing a thirty-year mortgage instead of a fifteen-year one to lower the monthly bill. You end up paying way more interest over time. The total liability grows because you are spreading the pain over a longer timeline. Luna: So we are essentially borrowing from our future selves to pay for today's workforce stability. Lucas: That is a very accurate way to put it. And the worst part is that the beneficiaries of this delay are often the older workers who are close to retirement. The younger workers inherit the debt. Luna: This sounds like a recipe for intergenerational conflict. Are there any models that work better? Lucas: Some states have moved toward defined contribution plans, similar to a four-zero-one-k for the private sector. That shifts the risk from the government to the employee. It is politically unpopular, but it is financially honest. Luna: Honesty is expensive in politics. But it stops the lie from compounding. Lucas: It does. And for the listener, the takeaway is simple. When you look at your local tax ballot, look for the pension line item. If it is growing faster than inflation, something is wrong. Luna: Because you cannot fix a math problem with hope. You need a new formula. Lucas: Exactly. And until the formulas change, we will keep seeing these fiscal cliffs. It is a slow-moving crisis that everyone sees but no one wants to touch. Luna: Well, at least we are naming it. Maybe that helps voters ask the right questions next November. Lucas: Hopefully. Because the alternative is just watching the bill come due, and it is going to be a very large one.