It is hard to imagine a more stupid or more dangerous way of making decisions than by putting those decisions in the hands of people who pay no price for being wrong.
– Thomas Sowell

With a few exceptions here and there, crises in government funding don't simply arrive on the doorstep unannounced. Their progress toward the eventual Bang! moment is there for all the world to see. What final misdeed triggers the ultimate phase of the crisis is less predictable, but the root cause is almost always the same: debt. And whether that debt is actually borrowed or is merely promised to the populace, when the market becomes worried that the ability of the government to fund its promises is suspect, then the end is near. Last week we began a series on what I think is an impending crisis in the unfunded pension liabilities of state and local governments in the United States.

To talk about the situation using the word crisis can seem a little hyperbolic. The problems are distributed throughout the country, yet not every city or state has significant unfunded pension liabilities. And even those that do can muddle through for very long time before a smoldering problem explodes into an actual crisis. Think Detroit. You could see the crisis building for years and years in the media before it finally reached the breaking point. And Detroit was not the first city to go bankrupt, though it has been the largest. But unless significant action is taken to alleviate the problem of debt, we are going to see even larger cities and then whole states enter a crisis period. And as we will see from the data, we are not talking insignificant states. This week we continue our series on the unfunded liabilities of states and cities. Note: this letter will print a little longer than most, as there are lots of charts and graphs.

As we discussed in last week's letter on state pensions, official estimates of accrued liabilities understate funding shortfalls by conveniently assuming unrealistic investment returns into perpetuity. While official estimates report state-level unfunded liabilities across all 50 states at only $1 trillion today, the unfunded liability burden jumps to over $4 trillion if we discount those liabilities at more reasonable expected rates of return.

In case you were wondering, the $4.1 trillion funding shortfall includes only state-run pensions, meaning that funding gaps at local levels of government are not included. We went to great lengths this past week to calculate the total pension gap at both state and local levels across all fifty states, but we were told the data does not exist – at least not in one place.

Many cities and counties invest their funds with state pension plans rather than managing them separately, but the best estimate I could get was that if you included all the separately managed city and county pensions, it might increase the total amount by anywhere from 10 to 20%.

Even without another $500 billion to $1 trillion in unfunded pension liabilities, the implications of this gaping hole in the available pension research are truly mind-blowing, considering that, in extreme cases such as we are seeing in Detroit, local unfunded liabilities may become obligations of the states for purely political reasons. So we are stuck looking at the problem from a state-run-pension perspective, knowing that the actual shortfall could be even larger. If anyone knows of better sources for this data, I would really appreciate hearing about them.

The Aggregate or the Particular?

It may be tempting to look at aggregate pension shortfalls at the national level, but these shortfalls really amount to a state-by-state issue that will ultimately force troubled states to (1) increase taxes, (2) cut public services, and/or (3) reduce retirement benefits for current and already retired public employees. Cities and counties like Detroit (or Chicago?) that manage their own pensions and are underfunded will confront the same set of choices.

Making matters even more complicated, not all states can legally cut public employee retirement benefits. Illinois, Alaska, Louisiana, Hawaii, Michigan, Arizona, and New York (shown in red below) all have clauses in their state constitutions that protect public employee defined-benefit pension plans. While most states can reduce pensions to address their budget deficits, these seven must first amend their state constitutions. As you can see, several of these states are at the bottom of the pack in terms of funding ratios, but Illinois is the most vulnerable. (Funding ratios use the more conservative model suggested by Moody's and GASB, as we talked about last week.)

At only 24% funded, according to Moody's new methodology, Illinois is the single-most underfunded state in the union – the worst of an entire basket of bad apples. This week will focus primarily on Illinois, but we will cast our eye around the country in coming weeks.

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