The Flexibility We Need to Budget for the Unknowable

Analysis of long-term government commitments such as pensions is important, but overly rigid funding rules are a formula for intergenerational conflict.
by | July 31, 2013
 

As health-care and other costs of caring for an aging nation surge, pressures are intensifying to make policymakers accountable for the long-term budget implications of the decisions they are making today. At the federal level, this has principally taken the form of long-term models suggesting that budget deficits will explode to over 20 percent of GDP over the next several decades absent policy changes.

As an analytic tool, any responsible government should employ long-term projections. If exercised judiciously, they can help policymakers address incipient fiscal pressures before they turn into a wrenching fiscal crisis in several decades. They can enable governments to phase in painful changes gradually.

However, at the state and local level, these long-term fiscal forecasts too often have been transformed from analytic tools into rigid decision rules that mandate the provision of certain levels of funding to long-term commitments such as public employees' pensions. These approaches include the use of advance funding reserves, the funding for which may be automatic, requiring no annual decision.

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The advance funding of commitments on balance sheets has been adopted by accounting and bond-market communities alike as a litmus test of good financial management and budgeting. But there are important tradeoffs raised by these budgetary decision rules that should be carefully weighed by policymakers.

Anchoring budgetary choices to necessarily uncertain long-term budget projections is inherently problematic. Long-term fiscal estimates are highly sensitive to modest changes in assumptions. Relatively small changes in future rates of return for defined-benefit pension plans -- retirement liabilities minus the expected return on assets -- translate into very large differences in annual contributions that governments must deposit in pension funds. In recent years, total state- and local-government pension liabilities have been estimated between $660 billion and $3.2 trillion -- a range based largely on varying assumptions about discount rates.

These ranges, in fact, are entirely appropriate and should be presented to policymakers when determining how much of today's resources should be set aside. Yet the formulaic requirement to budget for long-term pension liability through advance funding dictates that a precise estimate -- however flawed -- be used by lawmaking bodies.

Locking in funding for one fiscal commitment many years in advance reduces the flexibility that state and local officials will need to address other longer-term costs, such as health-care and infrastructure needs. Advance funding, in effect, elevates one set of claims above others in budgeting.

Pensions may in fact warrant advanced funding, since in most states these commitments have a contractual nature as deferred compensation. Some have suggested that state and local governments go beyond pensions to also set aside reserves for future payments for health-care coverage for retirees. Yet, unlike pensions, health care is not a guaranteed commitment but a subsidy that can and most likely will be modified due to factors such as changes in the economy and federal health reform. Moreover, as difficult it is to predict long-term pension-funding requirements, health-care costs are even more uncertain.

Let me be clear about the argument here. Long-term state and local pension and retirement health-care commitments -- as well as those for funding the non-federal share of Medicaid -- are growing and will increasingly crowd out other state and local needs. State and local leaders should take actions to either reform these commitments to avoid having them crowd out other critical priorities or to raise taxes to provide sufficient revenues for their future cost growth.

Advance funding need not be the tool to do so, however. State and local disclosure of these costs in financial statements and other documents can go a long way toward building the public support necessary to take on these fiscal challenges. Unlike the federal government, bond markets hold state and local finances hostage for escalating costs, exacting interest rate premiums when budgets are deemed to be unsustainable. These disclosures and sanctions are enough to ensure that bondholders get paid without the provision of advance-funding reserves.

The challenge of balancing between the two competing budgetary commandments of funding past commitments and providing for current needs has already reared its head in contemporary budget debates. In some cases, state and local governments are finding ways to trim commitments to their retirees to free up funding for current and emerging needs. At the most extreme, bankrupt governments in Central Falls, R.I., and San Bernardino, Calif., have placed pensions of existing retirees on the chopping block to enable servicing of debt payments for bondholders. On the other hand, at the federal level, the burden of financing pensions and health-care costs has trumped the financing of discretionary appropriations for such areas as schools and infrastructure. The budget sequesters and caps are scheduled to reduce discretionary spending to record low levels over the next 10 years while age-based entitlements largely escape the budgetary ax.

Let us go forward and use long-term analysis and estimates to jump-start a healthy debate over the fiscal future at all levels of government. This may well entail using advance funding to reflect the obligation to recognize certain legal commitments on future resources, such as defined-pension benefits. But we need to be careful to protect the flexibility of future generations to set their own priorities as well.

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