In a New York Times editorial, Richard Riordan and Tim Rutten propose a national plan to address the pension crisis facing state and local governments. As the authors remark, this plan bears a number of similarities to a plan I proposed in 2010 in a piece in the Economists’ Voice with Robert Novy-Marx, and then again in short form in the New York Times Room for Debate Blog.

There are some important differences, however, between the Riordan-Ruttan plan and our own.

First of all, I agree that some form of federal intervention to stem the state and local pension tsunami is desirable and necessary. Otherwise our cities indeed face the bleak future described in the op-ed: long emergency response times, unfilled potholes, and cash-starved public services of all kinds, as taxpayer resources will be increasingly diverted to pay for public sector pensions. Furthermore, the prospect of more municipal bankruptcies could undermine investor confidence in the municipal bond market and restrict this vital source of capital for states and cities.

Given this state of affairs, I think some kind of carrot-and-stick approach from the Federal government is absolutely appropriate. In an ideal world, we would all tell Washington to “just say no” to any state or local government bailouts. If Congress could make a credible commitment to that policy, then states would on their own have the incentive to reform their own finances and stop running up of massive unfunded liabilities.

The reality today, however, is that Washington cannot credibly commit not to bail states out. As a result, in expectation Federal taxpayers face a huge and ongoing cost associated with the likelihood of a multi-trillion dollar bailout of these systems. Is there some chance this bailout can be avoided? Possibly. But there is a very large chance that it will not be avoided.

A bailout could take many (undesirable) forms, including Federal Reserve purchases of muni bonds (they did it with mortgage backed securities so why not) or direct aid to the most profligate of state governments. And of course cities and states know of this possibility now and are behaving accordingly. Talk about moral hazard.

The main similarity between our plan and the Riordan-Rutter plan is the carrot-and-stick approach. In both plans, the federal government would offer the states and cities some support in the issuance of new bonds to cover pension liabilities (the carrot). And in both plans, a state or city could only access this support if they implemented serious reforms to their pension systems that would stop the accrual of new unfunded liabilities (the stick).

The one point of departure, and it is an important one, is that in the Riordan-Ritter plan, the carrot is larger, as in their plan the program would “essentially serve as an insurance agency,” with participants paying fees, and the federal government guaranteeing repayment on the bonds.

In our plan, there is no new national insurance agency and no federal guarantee for the bonds. The federal support for the bonds in our plan is simply a tax advantage.

Under current law, bonds floated by states to fund pensions are fully taxable. As a result, issuing debt to fund pension plans is considerably more expensive than issuing regular tax-exempt municipal bonds.

In our plan, the tax subsidies for the Pension Security Bonds (as we call them) would work like Build America Bonds, with the federal government paying 35 percent of coupon payments directly to the state. Only the amount of the contribution deemed required by actuaries will be tax deductible, so as to prevent states from overfunding plans, and to bring the bonds to the market gradually over 15 years.

The fact that no new insurance liabilities are created under our plan makes its total cost much easier to know and to estimate ahead of time. Net of the offset to federal finances that would happen as new public sector employees are introduced to Social Security (one of the key requirements of our plan), we estimated the net cost of our plan at $75 billion.

I would have to think a national insurance agency for state and local government plans would ultimately cost far more than that. States would not implement the reforms to take up the federal guarantees, let alone be willing to pay the premiums, unless they viewed the guarantees as quite valuable.

Of course, the larger carrot in the Riordan-Rutter plan is also accompanied by a heavier stick. I particularly like the aspect of their plan that would require a national standard to address the wishful actuarial accounting which assumes returns of 7¾% or 8% on assets, as well as the specification that the pension changes should apply to current workers.

Our plan for Pension Security Bonds would cost in the tens of billions of dollars. But it would be an important step in stopping the crisis facing public sector pension systems from taking trillions of dollars out of the pockets of federal taxpayers in the event of a bailout.

overlay image