Art Woolf: Why Vermont has a compounded pension problem

Clarification: As of June 30, 2016, the average pension for all persons receiving retirement from the teachers pension system was $19,259. The $50,000 figure in this column is used only as an example.

Our elected officials work hard to balance the state’s budget each year and are usually successful. That’s despite the fact that Vermont is the only state in the nation that is not required, by statute or by the state’s constitution, to balance its budget. Unfortunately, despite an ostensibly balanced budget, this year’s budget is not really balanced and it hasn’t been for a long time.

That’s because a balanced budget looks only at revenues and expenditures in the current budgetary year and ignores future commitments.  That is a problem, and a big problem, because of the promises our elected officials have made to current state workers and to teachers in every school district in the state.  We have promised to provide pensions and health care benefits when they retire but haven’t put away enough money to pay for those future expenditures. 

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It’s a lot easier for policymakers to promise someone $1,000 to be paid 30 years from now than to pay them $1,000 — or even $500 today.  Any current payments have to come from taxpayers today while $1,000 three decades from now comes from future taxpayers, and future voters.

Unlike nearly every other worker in Vermont, teachers and state employees have a defined benefit pension, which means the state guarantees them a fixed monthly payment for their lifetime.  Nearly all other Vermonters have a pension determined by the market value what they have contributed into their pension fund. Over time, that increases due to the magic of compound interest, which Albert Einstein is alleged to have said is the most powerful force in the universe. But unlike state employee and teacher pensions, there’s no guarantee of what that monthly payment will be. The guarantee to public employees means there is no risk to them of not getting the exact monthly payment. All the financial risk is on the backs of future Vermont taxpayers.

Suppose the state of Vermont makes a deal with a state employee or teacher to pay her a $50,000 pension in 30 years. (I’ll simplify and assume the pension is only for one year.)  How much does it cost the state?  It depends on two factors: When the state starts putting money into a fund to pay that $50,000 and what kind of return the investment gets. If the state waits 30 years it’s going cost taxpayers $50,000 in 2047. If it puts $5,000 into a pension fund today and it grows by 7.95 percent per year it will increase to $50,000 in 30 years. But where can you get a 7.95 percent return?  I don’t know, but that’s the rate the state assumes it can earn on the funds it puts aside for future retirees.   

There’s a good case to be made for assuming a lower rate of return.  Even if the $5,000 grows by 6.95 percent — only one percentage point less — it increases to only $38,000 in 30 years so future taxpayers will be on the hook for the remaining $12,000.  If that $5,000 grows by 4 percent per year, the pension fund would only have $16,000 in 30 years.  If returns average 4 percent per year for the next 30 years, the state would have to put aside $15,000 today — not $5,000 —i n order to generate $50,000 in 30 years.  The growth rate you assume makes a huge difference.

That, in a nutshell, is the state’s pension problem, and it’s made worse because the state also has promised to pay for health care costs for those retirees. Even with a 7.95 percent rate of return, it is still underfunding its annual contributions. 

How much is the shortfall? The amount that the liabilities — the pension promises — exceeds the actual amount that needs to be in the fund by $1.8 billion for pensions and another $1.8 billion for health care.  If the investment returns on those funds are less than 7.95 percent, that $3.6 billion shortfall will be even worse. 

The good news — if you can call it good — is that every state faces this problem.  The bad news is that, according to a study by a Stanford University economist, the magnitude of Vermont’s problem puts it among the bottom third of the states.

The solutions are not easy.  The best would be to change the pension plan for new teachers and state employees to make it like the rest of us have.  Alternatively, the state could use a more realistic assumption of what the returns to the funds are likely to be.  That would mean the state will have to put a lot more money — approximately $50 million — into the funds each year, which means higher taxes or less money for everything else.

Art Woolf is associate professor of economics at the University of Vermont.