02.21.13 6:59 PM ET
Don't Bail Out the States
The state of Illinois faces the worst pension fund shortfall in the nation. Terrifying as are the state's unfunded liabilities, however, it also counts one imposing asset: an Illinois president in the White House. Will President Obama say "yes" when Illinois comes asking? Not if he listens to Brett Joshpe at Forbes.com:
While bailouts of various private entities in the financial sector may have been necessary, if not extremely unseemly, to prevent a global economic meltdown, different considerations apply in the case of public sector pensions that demand federal forbearance. Any bailout, of course, presents a moral hazard, but there are particular reasons why public pension bailouts would create unacceptably perverse incentives.
First, they would implicitly encourage states to keep spending and doling out entitlements, as doing so is popular for politicians, even if unsustainable. This is especially the case in more liberal-leaning states where public sector unions dominate.
If states and municipalities know that benefits are backed by the full faith and credit of the federal government, then there is simply no incentive to cut back and to end the political patronage that is destroying our nation’s finances. This will create little Fannie’s and Freddie’s that fear no liability knowing their obligations ultimately could transfer onto Uncle Sam’s balance sheet.
Similarly, the moral hazard inherent in public pension bailouts not only will encourage politicians to offer excessive benefits, but it will invite plan sponsors to underfund their plans. This frees public funds to be used for other purposes, i.e. more spending. So, the possibility of bailouts conveniently incentivizes states to promise benefits and but then spend on things having nothing to do with benefits. There is a word for that. It’s called Greece.
Finally, knowing that the feds will bail out broken pensions will free sponsors and their portfolio managers to take excessive risk in the hopes of realizing higher returns. Modern portfolio theory dictates that to reap higher returns, investors must assume greater risk. The more pension funds are underfunded, the greater returns that are necessary to close the liability gap, and the greater risk they must take. It becomes easier to pursue such returns and justify higher risk knowing that a bailout could result.