The Hidden Costs of Underfunded Pensions

• In Event: Disclosure and Financial Reporting

Abstract

Underfunded state and local pension plans are a critical public policy issue. In the extreme, they can lead to bankruptcy and loss of crucial public services. Moreover, the legal avenues through which governments may reduce unfunded pension obligations have been reduced as a result of recent court battles in Illinois and New Jersey. Assessing the funded status of defined-benefit plans is not an exact science, but it is clear that some defined-benefit, public-sector plans are so underfunded as to precipitate a crisis. While the most visible effects of underfunded pensions are financial stress and potential bankruptcy, there are less visible costs and risks that can also degrade the economic health of a community, even where underfunding is not so extreme as to precipitate a crisis.
This paper explores several hidden costs and risks of underfunded pensions. These include lower credit ratings and higher borrowing costs; increased current expenditures; reduced property values; weakening of interperiod equity; and the temptation to adopt high-risk strategies such as pension obligation bonds. This paper contributes to public discussion regarding defined-benefit pensions by encouraging stakeholders to consider the more hidden costs and risks of underfunded pensions, even when the funding level does not precipitate an immediate crisis.

Authors

• Larita J Killian, Indiana University - Purdue University - Columbus

• Dagney Faulk, Ball State University