There have been a lot of reports the last few years detailing the level of underfunding in state and local government pension funds. Most of these focus on how much money taxpayers will need to come up with in the future to make up the shortfalls. But lately there’s been another focus. Some argue that the underfunding means at least some governments are likely to default on their bonds instead of raising taxes enough to pay the pensions. This piece from Charles Schwab & Co. takes an evenhanded look at the issue and concludes only a few governments are likely to take such a drastic step. Investors can protect themselves by staying with the highest-rated local government bonds.
Overall, 74% of state plans and 57% of local government plans have made changes—such as reducing benefits or increasing contributions—to their pensions since the financial crisis2. The most common reform is to reduce the cost-of-living adjustment (COLA) for retirees, which in turn reduces the projected liability. Steps like these can free up money for debt service, because the state or local government can scale back current contributions for future pension obligations.
Reducing benefits can be difficult, because most states have legal protections that apply to pension benefits for current employees and retirees, but these protections are not uniform among states. For example, Illinois’ state constitution says that pension benefits “shall not be diminished or impaired,” which has limited the state’s ability to address their large liability. Texas, on the other hand, has less strict protections for state-administered plans3, making it easier to address their liability. No state, according the Center for Retirement Research at Boston College, protects benefits for future employees—meaning that new employees may not be offered a pension plan but instead a defined-contribution retirement plan, similar to a 401(k), where the burden to fund the employee’s retirement is mostly the employee’s responsibility.