$5 Trillion Price Tag for Public Pensions

As strapped state and local governments scramble for ways to balance their budgets, it's become very clear that it will be impossible for many to honor their pension promises to new employees and even current retirees. According to a recent economic study, the cost to fully fund these promises would cost taxpayers $5 trillion over a 30-year period, or nearly $1,400 a year in higher state and local taxes and fees for every household in the country.

Put another way, contributions to pay for public employees' retirement benefits now total 5.7 percent a year of all state and local taxes, fees, and other government charges. "Government contributions to state and local pension systems must rise to 14.1 percent" to produce fully funded pension systems, the study said, and it will take 30 years to get there.

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The magnitude of this challenge can be debated and, indeed, hinges on the future investment performance of retirement funds that can't be known today. Economists Robert Novy-Marx (University of Rochester) and Joshua D. Rauh (Stanford) based their price tag on a snapshot of the condition of state and local pensions in 2010. They then assumed economic growth in the states would average what it has been like over the past 10 years, assuming the continuation of present retirement rules. Finally, they factored in reasonable future investment gains in government retirement funds. Their $5 trillion answer is what it would take for governments to honor their retirement commitments and develop a system that was fully funded over the next 30 years.

They also studied other possible outcomes, including different combinations of the kinds of pension cutbacks that are already being tried in some states. The results were not encouraging for taxpayers. For example, in what they say has come to be known as a "soft freeze," some states are moving new employees out of guaranteed, defined-benefit pensions and into defined-contribution plans similar to private-sector 401(k) accounts. If all new state and local government employees were forced to use such defined-contribution plans, the study found, average household taxes would still rise by more than $1,200 a year.

[Read: State Pensions Could Be the Next Big Government Bailout.]

Adopting a much harsher "hard freeze" policy would stop all future benefit increases. No benefits would be revoked, but they would not grow over time to reflect an employee's rising salary or added years of service. Having frozen future pension liabilities, their study assumes states and localities would add a new defined-contribution plan and would need to make employer contributions into that plan. This approach would reduce annual taxpayer increases to $800--a figure still above what many taxpayers would tolerate.

The alternative strategy, of course, is to reduce the retirement promises made to public employees. And that is what most people expect will happen to state and local government pensions.

"Substantial revenue increases or spending cuts are required to pay for pension promises to public employees even if pension promises are frozen at today's levels," Novy-Marx and Rauh conclude.

Another reality is that not all state and local governments will deal with their respective pension challenges the same way. This will lead to different benefit levels and approaches, and will have correspondingly different impacts on taxpayers. The economists looked at scenarios where raising government revenues or current public services reduced a state's economic growth rate, including causing residents to relocate to states that were able to provide more attractive public services at lower costs. Average taxpayer burdens throughout the country would not change. But states facing the biggest pension-funding shortfalls would likely lose population and be forced to raise taxes even more on their remaining residents.

[Read: Just Like Social Security, the Pension System Needs Fixing.]

Here's a look at the authors' estimates of what it would take to close the pension funding gap in each state. Remember that these totals apply to payments required every year for the next 30 years.

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