In a recent editorial, The Wall Street Journal reports on state and local pension liabilities as a percentage of state GDP and concludes that politicians have made excessive pension promises.
In fact, pension costs are going up, but the question is whether the rising costs are a result of benefit generosity or of underfunding.
The answer is underfunding.
Pension costs consist of two components: the normal cost, which is the value of benefits earned in a given year, and the amortization payment, which is the annual amount required to pay off the unfunded liability (a liability built up because of past underfunding and optimistic assumptions). The reason pension costs are rising is that the amortization payments are increasing. Normal costs are not increasing (see figure below). Calculating the normal cost using a consistent interest rate across time shows that the average normal cost has remained virtually unchanged at 11.9% of payrolls â that is, plans are not increasing benefit levels.
But even that constancy overstates the generosity of pensions for two reasons. First, the employerâs contribution to the normal cost is declining. At this point, the employer pays 5.6% of payroll, while the employee pays 6.2% (see below).
The second reason why the available normal cost data overstate benefits is that most state and local governments have cut back on benefits for new employees (see figure below). As new hires become an increasing share of the workforce, normal costs will decline.
In short, the generosity of benefits is not driving increased pension costs. If anything, benefit generosity has declined. The problem is that many governments have not made adequate contributions to fund their benefit promises (and their initial assumptions regarding the cost of benefits turned out to be optimistic).
In some cases, such as Connecticut, Illinois, and New Jersey, the current underfunding is now so severe that only some sort of âgrand bargainâ can resolve the pension problem. In many other situations, however, a serious funding commitment can ensure that the money will be there to pay promised benefits.
In any case, increasingly generous benefit promises are not the issue.