Many states have been underfunding the annual requirement for pensions in order to allegedly "balance" the state budgets over the past few years.
Those budget gimmicks are a cause for concern, according to a recent U.S. Government Accountability Office (GAO) report. The GAO makes it clear that without hefty cuts to government spending and serious reforms to government employee pension plans, states will face decades-long fiscal crises.
The recent GAO report stated that tax revenues as a percentage of gross domestic product will not return to the historical high reached in 2007 until 2058. Such a drastic gap indicates that states will not be able to tax their way out of the problem.
The GAO found two main drivers of the fiscal problems. First, rising health-related costs borne by state and local governments, especially those incurred by government employees and retirees, are putting pressure on state budgets. State and local Medicaid expenditures and employee-related costs will grow faster than the gross domestic product, the GAO said. It estimated health-related costs will grow from about 3.9 percent of GDP this year to 7.4 percent by 2060.
Second, unfunded government pension liabilities are continuing to grow rapidly. State pension funds use discount rates of seven percent, or more, to determine their future assets. There are two problems with this approach. First, it assumes that state legislatures are faithful in contributing the required funds each year. That is far from universal. Second, this calculation fails to consider the increased liabilities that state pension funds are incurring. Research by Moody's Investor's Services shows that even when the top 25 pension funds in the country were considered to be "on target" in their investment return over a 10 year period, they still suffered a $2 billion shortfall.
State Budget Solutions (SBS) found that if states were to adopt a fair market valuation of their pension funds, rather than the generous estimates they allow themselves, states would be in a collective $4.7 trillion hole.
GAO estimates that legislators and governors need to take action to increase revenue or cut expenditures by at least 18 percent and maintain it through 2060.
SBS has been issuing the same report on the fiscal future of states for years and urging the states to adopt major budget reform that focuses on outcome performance based budgeting rather than the current budget systems, which are based mainly on inputs and inflationary adjustments.
In the past it has been much easier for legislators and governors to focus on the next election and not rock the boat by cutting expenditures or raising taxes. However, the growth in unfunded pension liabilities, the rising cost of government health care, and the lowering of credit ratings will soon force action.
A commonsense solution is for governors and legislators to focus on outcome-based performance budgeting.
Bob Williams is the President of State Budget Solutions, a non-partisan organization dedicated to fiscal responsibility and pension reform.