The looming $78 trillion pension crisis

French pensioners protests benefit cuts.
French pensioners protests benefit cuts.
Image: Jean-Paul Pelissier/Reuters
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The hot policy debate of the moment among economists and politicians is whether debt matters. Debt doves are mostly right; the current deficits most nations are running probably won’t blow their finances out of the water. However, there’s another, hidden source of debt that might:  government pension obligations. As pension liabilities grow and populations age, the payments governments owe current and past employees threaten to crowd out other spending for things like schools and roads, and could make even reasonable debt levels unsustainable.

Pension problems

Pensions with defined benefits still make up a significant share of many retirees’ income. Even as corporate pensions have become rarer in the US and UK—replaced by defined contribution plans like 401(K)s—defined benefits plans still exist, for local public sector workers and the 59 million Americans who receive Social Security each month. Most European governments also continue to offer defined benefits to their citizens after they retire. Pensions are already a big part of state spending globally. In Brazil, one third of tax revenues go to pension benefits (paywall), and the share is growing elsewhere. The figure below illustrates how much pensions take up of GDP in industrial countries.

There are two ways to pay for pensions. One is pre-funding, where contributions are made on behalf of workers, invested for many years, and then used to pay their benefits when they retire. If too little money is saved or the investments don’t pay-off, the pension fund becomes insolvent. When that happens, payments to retirees are cut or tax payers bail out the fund.

The other funding method is pay-as-you-go, like Social Security, where today’s workers pay the benefits of retirees. This can go wrong if there are too few workers to finance retirees or if other budget pressures—schools, roads, debt repayment—reduce the tax dollars available to pay into the fund. Pensions of both types risk insolvency because many pre-funded pensions are underfunded and as the population ages, there are fewer workers paying into the pension fund, while retirees need more income because they’re living longer.

The hidden debt bomb

These trends are why pension spending is expected to grow. A report from Citibank estimates governments around the world are short $78 trillion to pay their pension promises. The worry is that governments must one day finance this shortfall. And when they do it will crowd out other social spending and there will be less money available to service other forms of debt.

Pensions normally aren’t the sole reason government runs out of money and can’t pay their debts, but they are often a major factor. There are generally three stake holders in any debt crisis: bond holders, pensioners, and the citizens who depend on government services. Municipal services, like public safety and schools, are normally the first things cut, but while firefighters and teachers might not get paid, pensions will be. Debt crises can come down to a stand-off between bond holders and pensioners, and pensioners normally win—taking modest cuts compared to bond holders. That’s because pensions are different than other forms of government spending: They’re on-going entitlements to society’s most vulnerable, sympathetic, and politically organized citizens. Increasing a pension benefit requires years of benefit payments and bearing the risk people live longer. Yet when governments calculate their debt burdens, pension obligations are normally not included, even though they are effectively senior to other forms of debt.

America’s public pensions

In the US,  most of the shortfall comes from pre-funded pensions for government workers in state and municipalities. Pensions are short, by some estimates, more than $3 trillion (about the same size as all outstanding municipal debt).

The state of Illinois contributes 11% of its revenue to fund pensions, and its fund is still severely under funded. Local governments underfund pensions in part because they use questionable accounting standards to estimate their liabilities. Instead of valuing their liabilities by using the returns of a treasury bonds as a discount rate (pdf), which is the financial industry’s standard for a low-risk asset, they use the expected return on their asset portfolio. The higher the rate of returns they use, the less they appear to owe. Stanford economist Josh Rauh estimates if Illinois used the correct standards it would be contributing 23% of its revenue. The problem is worse at the local level, where the city of Chicago contributes 23% of tax revenue to pensions and should be contributing 46%. Several other large cities should be paying well over 20% into pensions, too. The accounting standards also allow short-sighted politicians and union leaders to ignore the looming threat of underfunded pensions.

Underfunding pensions may seem harmless now because most pension funds still have considerable assets. But local services are already being impacted and pension obligations are one big reason why teacher pay is so low.

Shoddy accounting standards also create an incentive to take on more risk so pensions fund can claim a higher expected return. This may explain why in the last few years public pension funds have invested more in private equity funds, which lock up their money for years. The funds claims high returns but can’t be objectively valued, because private equity doesn’t trade in public markets. If many of these investments don’t pay off what they claim, public pensions could be in significantly worse shape.

The European situation

The Citibank report claims the situation in Europe is even worse. Most European pensions offered by the state are unfunded, or current tax dollars go toward paying elderly pensions. European pensions tend to be generous, replacing up to 70% of salary, and the average retirement age is 63 (compared to 67 in the US). But as the European population ages, those benefits won’t be sustainable without large cuts to other services. According to Citibank there are 42 retirees for every 100 workers in Europe, a ratio that will rise to 65 per 100 by 2060. It’s no wonder that despite generous promises, a majority of Europeans fear they won’t have enough money when they retire.

How will it end?

Pension benefits, unlike other forms of debt, are rarely cut. The elderly have the time to organize and the political clout to protect their interests. They also are sympathetic: They’ve worked most of their lives under the promise they’ll be paid during retirement. Many are too old or sick to go back to work, and often the pension benefits, while large in aggregate, are small for individuals. The average state pension in America is less than $40,000 and many beneficiaries don’t qualify for Social Security. Further, state and city pension benefits in the US are often guaranteed by state constitutions, precluding cuts.

If benefits are trimmed, it’s normally through increasing the retirement age, thereby reducing the lifetime payout per retiree. But given the varying nature of work, that burden falls unequally on different workers and some economists and politicians argue that because some people in strenuous jobs can’t work longer, no one should have to. In Europe, even modest increases to the retirement age have resulted in violent protests. And the dirty secret is that while increasing retirement ages would help, it’s often still not enough to close the gap.

This leaves pressure on governments to do something else. Governments may issue more debt to make up the difference, or cut services to younger citizens. But eventually bond holders could get fed up with the possibility of the government reneging on promises to them, and demand a higher yield on their bonds. Interest rates could increase, requiring bigger cuts in services as governments make higher debt payments. The more debt we issue now, either for bonds or pensions, means less flexibility to deal with whatever the future brings. The best way to prepare is to save more, hope for the best, and elect politicians who will take pensions seriously.