Arthur W. Wright

English

Research Papers in Economics

ARTHUR W. WRIGHT
Avid watchers of Fox Network’s seri-
al “24” will have heard of terrorist 
“sleeper cells”, which lie dormant 
until a mastermind like Osama Bin 
Laden awakens them.  Sleeper prob-
lems of a different sort lie in wait 
for Connecticut and other states: 
sums they will someday have to pay   
today’s public employees in the form 
of pensions and other benefits, mainly 
health insurance.  For a long time, 
those “unfunded” liabilities have lain 
dormant.  Of late, though, their grow-
ing magnitude has compelled accoun-
tants and auditors to begin flagging 
them in public reports.
  How bad is this problem?  The 
total of the 50 states’ liabilities may 
look scary: as of mid-2006, nearly 
$2.5  trillion (in the same range as 
a year’s worth of Federal-government 
revenues) for state-employee pensions, 
and almost $400 billion for “other 
post-employment benefits” (OPEB).
  But things aren’t all that bleak for 
state-employee pensions, some 85% of 
which are already “funded” by finan-
cial assets in state-owned accounts.   
Bleaker, though smaller, are the OPEB 
liabilities, which are only 3% funded.   
Indeed, the dollars due on the other 
benefits exceed those on the pensions: 
$370 billion vs. $353 billion.
 But what about Connecticut?   
Bleak understates the case.  As of mid-
2006, our unfunded state-pension lia-
bility was $14.9 billion, about a year’s 
worth of State spending.  Compared 
with other states, we would have come 
in last, at 56% funded, were it not for 
West Virginia, one point lower (see 
chart).  On OPEB, things were even 
worse, by nearly half: the total liability 
was an estimated $21.7 billion, all of 
it unfunded.  In other words, as of 
mid-2006, Connecticut had not really 
begun to set aside current tax dollars to 
cover its future health-insurance com-
mitments to current State employees.   
There is some solace in having a lot of 
company—in OPEB, we’re at the bot-
tom nationally with 35 other states.
BIG WHOOP?
  But do future pension or health 
insurance liabilities really matter all 
that much?  Alas, the answer is yes, 
and the reason is that future State taxes 
matter.  The liabilities at issue here 
represent claims against future State 
revenues, which derive primarily from 
State taxes, which in turn will have to 
be levied against future incomes and 
asset values.
  In a real sense, Connecticut-today 
has already committed Connecticut-
tomorrow to collecting extra taxes, 
unless the latter opts to cut services—
education, economic development, 
social services—and the State jobs 
involved in providing them.
  True, future generations will have 
the benefit of rising per capita incomes 
from continued economic growth.  But 
should we be committing taxes on 
those future incomes to pay for State 
services consumed by the current gen-
10  THE CONNECTICUT ECONOMY  SPRING 2008
Connecticut-today has 
already committed 
Connecticut-tomorrow to 
collecting extra taxes.
Beware Those ‘Sleeper Taxes’
UNFUNDED PUBLIC RETIREE BENEFITS
0
5
10
15
20
25
30
35
40
State OPEBs
State Pensions
100%+
80-99%
60-79%
40-59%
10-39%
0-9%
No Data
PERCENT FUNDED ACROSS STATES
N
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SOURCE: Pew Center on the States, Promises with 
a Price (2007), pp. 18-40.  Data for FY 2006.SPRING 2008  THE CONNECTICUT ECONOMY  11 
eration?  Promised future payments 
to public employees are for work they 
perform today.  When tomorrow hap-
pens, the State will need to pay other 
employees to provide services to its 
then-current residents.
  And what if price increases for 
promised future payments outpace the 
growth of real incomes, as may well be 
the case for retirees’ health insurance?
  It gets worse.  Piling up a slug of 
future tax commitments may itself cut 
into future income growth.  Expected 
future taxes affect a state’s current debt 
rating, hence also its cost of borrow-
ing for capital projects such as roads, 
bridges, and airports that are key to a 
state’s competitive position.  Similarly, 
business decisions about locating new 
facilities or even staying in a state 
depend on “sleeper” as well as current 
taxes.  
  Sound financial practice dictates 
“funding” at least a high proportion 
of the future payments promised to 
public employees in return for their 
present-day work.  “Funding” means 
setting aside enough extra tax dollars 
today to cover the promises of future 
benefits paid to current workers.
  So Connecticut has its work cut 
out.
CONNECTICUT’S PUBLIC-
EMPLOYEE PENSION LIABILITIES 
  Let’s begin with State pension lia-
bilities.  The line graph below (taken 
from the Comprehensive Annual 
Financial Report, or CAFR, published 
each fiscal year by State Comptroller 
Nancy Wyman), shows the funding 
status of the four largest State retire-
ment programs between fiscal years 
1998 and 2006.  (The only other pro-
gram, for Probate Judges, is essentially 
fully funded and has been self-sustain-
ing since FY 2000.)
  The chart shows that three of the 
four programs were substantially under-
funded as of mid-2006.  Moreover, in 
the two largest funds—state employ-
ees and teachers—the funded ratio 
deteriorated over the 8-year span.  (So 
did the funded ratio for municipal 
employees, but as of mid-2006 it was 
still slightly overfunded.)  
 Was that deterioration due to 
gross negligence, or to something more 
benign such as mistaken assumptions?   
Arguably, “negligence” applies to the 
teachers’ pensions, and “mistaken 
assumptions” to state employees.
  The key here is what actuaries call 
the “annual (or actuarially) required 
contribution” (ARC), the amount that 
must be set aside annually to fully fund 
a liability over a given number of years.   
For a given unfunded “accrued actu-
arial liability” (AAL), the ARC will be 
smaller, (a) the higher the funded ratio 
is to begin with; (b) the higher the 
assumed rate of return on the financial 
assets in the fund; or (c) the longer is 
the “amortization period” for eliminat-
ing unfunded liability.
 Every year from 1998 through 
2006, the State contributed 100% of 
the ARCs for the judicial and munici-
pal retirement systems.  Further, only 
in 1998 was the State’s contribution 
below 100% to the state employee 
system.  Contributions to the teachers 
system, though, fell short of the ARC 
in every year but 2006; little wonder, 
then, that its “funded ratio” fell by 
nearly 11 percentage points over the 
period.  Doubtless, that helped spur 
budget officials at the Office of Policy 
and Management (OPM) to ramp 
up contributions to the teachers sys-
tem (including commitments of $100-
200 million per year from budget 
surpluses) beginning in fiscal 2006.   
Further, 2007 saw a successful push by 
State Treasurer Denise Nappier to bol-
ster the funding of teachers’ pensions 
through the Pension Obligation Bond 
Act, Public Act 07-186.
  Note, however, that funding pen-
sion obligations by issuing State bonds 
simply changes the form of the liabil-
ity, not its size.  But it is not just a ruse: 
The case for bond-funding of pension 
liabilities is that state governments can 
usually borrow at lower rates than they 
can earn on the financial investments 
bought to fund the pension liabilities.   
The maneuver does, of course, add risk 
to a state’s financial position, and could 
therefore adversely affect the state’s 
debt rating, which could raise its bor-
rowing costs, which…
 But how can the funded ratio 
for the state employees system have 
dropped by nearly 6 points, if the 
ARC was 100% in eight of nine years?   
It must be that one or more of the 
assumptions used to calculate the ARC 
were wrong.  Perhaps the expected 
rate-of-return assumptions were con-
servatively low in 1998-2001 but too 
liberal later on.  In any case, the 
string of five straight declines in the 
funded ratio, 2002-2006, calls for new 
assumptions—or new actuaries (and in 
30%
60%
90%
120%
150% Municipal
Judicial
Teachers
State Empls.
2006 2004 2002 2000 1998
“FUNDED RATIOS”,
MAJOR STATE PENSION PROGRAMS
%
 
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SOURCE: Connecticut State Comptroller, CAFR, FY 2006, p. 86.
(continued on page 14)14  THE CONNECTICUT ECONOMY  SPRING 2008
Hartford, of all places, the Insurance 
Capital).
 In fiscal 2006, the State of 
Connecticut scored 100% of the ARCs 
in all four of its major State public pen-
sion systems.  The tab was a bit more 
than a billion dollars, according to the 
Pew Center On the States (PCOS—see 
the source of the first graph above), out 
of General Fund expenditures of about 
$15 billion.
  Turns out that’s just for openers.  
CONNECTICUT’S O.P.E.B. BLUES  
  Pension obligations present fairly 
well-defined targets.  In contrast, “other 
post-employment benefits” (OPEB), of 
which health insurance obligations are 
by far the biggest component, are beset 
by uncertainties: future cost increases, 
the fate of the Medicare program, 
and what (if anything) a Democratic 
administration in Washington come 
2009 might do about the nation’s 
broader health care problem.  (See 
Dennis Heffley and Raymond Salani’s 
piece on page 15.)  One certainty, of 
course, is that this and other health-
care-driven spending programs will 
command a steadily rising share of 
State outlays.
  At the moment, the Government 
Accounting Standards Board (GASB) 
requires only that state governments 
report their unfunded non-pension 
retiree liabilities.  According to its 
November 2007 Fiscal Accountability 
Report to the General Assembly (p. 51), 
OPM expects the GASB to add a fund-
ing requirement shortly.
  Judging by the data OPM cites, it 
will be none too soon.  But beginning 
to fund OPEB liabilities, on top of 
sustaining the funding effort on pub-
lic pensions, will put a large dent in 
Connecticut’s annual budgets.
  The first graph below shows that, 
effective with the end of fiscal year 
2006, the Nutmeg State ranked 8th 
among the 50 states in total OPEB 
liabilities, with $21.1 billion; PCOS 
puts the figure at $21.7 billion.  Tiny 
Connecticut is the smallest state, by 
population, in the highest ten.  
  Per capita (see the second graph), 
Connecticut ranked even worse, in 
3rd place at $6,020 per person, behind 
Alaska ($7,047) and New Jersey 
($6,877).  For perspective, the median 
for state per capita unfunded OPEB 
in the U.S. is all of $1,581.  It may 
be some comfort—albeit cold—that 
Connecticut (and New Jersey) at 
least rank 1st (and 2nd) in per capita 
income.
  Alaska deserves an A for effort to 
fund OPEB liabilities, with a funded 
ratio of 65% through FY 2006, accord-
ing to PCOS.  But the only other 
state in the top ten, on a per capita 
basis, to have made any significant 
effort is Kentucky, with a 10% funded 
ratio through FY 2006; Delaware had 
managed just 1%.  The rest: nada, 
beyond token payments in FY 2006; 
in Connecticut’s case, $393 million, 
about a quarter of what PCOS esti-
mated was an ARC of $1.6 billion 
per year.  The full payment would 
have amounted to more than 10% of 
Connecticut’s budgeted expenditures 
for that year.
  The arithmetic is compelling: $1 
billion a year to fund State pensions, 
and another $1.6 billion to fund State 
OPEBs, makes $2.6 billion a year.  I 
make that to be 15.2%, or more than 
1/7 of the “enacted” budget for next 
fiscal year, 2008-2009.
“IT COULDN’T HAVE HAPPENED 
AT A WORSE TIME”?
  Is there ever a “good time” to put a 
15% bite on State budgeted spending?   
If it has to happen, better that it be 
during a spell of State budget surplus-
es.  Indeed, in December 2006 State 
Comptroller Nancy Wyman proposed 
creating a trust fund for up to a third 
of the health-insurance tab for today’s 
State employees after they retire, using 
funds from then-projected and future 
State fiscal surpluses.
 And OPM has recommended 
assigning a top priority for budget 
surpluses to the reduction of unfunded 
liabilities for OPEB liabilities along 
with state employees’ and teachers’ 
pensions—but only after the budget-
reserve (or “rainy-day”) fund reached 
10% of net General Fund appropria-
tions (see p. 74 in the OPM source for 
the two graphs).  Unfortunately, the 
10% target is proving elusive.  Looks 
like funding the State’s huge public-
retiree benefits obligations may be fac-
ing…well, a rainy day.
  Feelin’ the budget blues yet?  The 
OPM’s projected budgets for fiscal 
2009-2010 through 2011-2012 show 
deficits totaling $1.3 billion over the 
three years.  A gamblin’ man might 
well bet against Connecticut being able 
to make much progress toward raising 
the funded ratios on its pension and 
OPEB obligations over the next five 
years.  In fact, I (a non-gamblin’ man) 
would bet that those ratios will get 
worse before they get better.
  If only we’d taken fuller advantage 
of the good times, when they were in 
full swing, to upgrade and maintain 
the State’s efforts to reduce its unfund-
ed public-retiree liabilities.
BEWARE THOSE SLEEPER TAXES (continued from page 11)
0
10
20
30
40
50
60
70
80
GA AL CT MI MD NC TX NY NJ CA
TOTAL UNFUNDED O.P.E.B. 
LIABILITIES
0
1,000
2,000
3,000
4,000
5,000
6,000
7,000
8,000
KY ME DE MD WV AL HI CT NJ AK
PER CAPITA UNFUNDED O.P.E.B. 
LIABILITIES
SOURCE: Credit Suisse, per Connecticut OPM, Fiscal 
Accountability Report, 11/15/07, p. 51. 
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Beware Those 'Sleeper Taxes': Unfunded Public Retiree Benefits

http://cteconomy.uconn.edu/articles/AW_S2008.pdf

Beware Those 'Sleeper Taxes': Unfunded Public Retiree Benefits

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