Preparing for a rainy day

Eileen Norcross, Sheila Weinberg  |  June 10, 2020

By Eileen Norcross, Senior Research Fellow at Mercatus, and Sheila Weinberg, founder & CEO fo Truth in Accounting

Economic shocks like the one we’re facing right now, by definition, do not give much notice. And while the emergence of COVID-19 and the extended lockdown was not on any state legislature’s or governor’s radar at the start of this year, the economic disruptions of the last several decades should have given states an incentive to be fiscally prepared.

Indeed, in the last 25 years alone, states have had to navigate the effects of the Asian financial crisis, 9/11, the 2008 financial crisis and the housing bubble, and now a global pandemic. In other words, governments should expect economic disruptions to occur, even if they don’t know what form such disruptions will take.

In the coming months, state and local governments will confront significant revenue losses as they slowly rebound from this latest, pandemic-related, shock. According to estimates by Truth in Accounting, total projected revenue losses for states between March 2020 and July 2021 are expected to total $347 billion. For some, the losses represent over one-third of annual operating budgets, including New Jersey (-$14 billion), Illinois (-$16 billion), and New York (-$32 billion).

With ongoing uncertainty about the virus’s effects on public health still driving decisions over how and when people return to offices, entertainment, schools, and shopping districts, the continued economic effects will be hard to predict.

There are no silver bullets to fix the COVID-19 shock. Federal bailouts and transfers may temporarily plug budgetary holes. But they are unsustainable and come with unintended consequences, including additional federal debt, decreased accountability for state spending, and a disincentive to reform poor fiscal practices. It is likely that states will face diminished revenues for at least two years. But not all states will experience the same degree of damage. States’ budgetary resiliency also depends on the strength of their pre-crisis fiscal foundations.

While all states have fiscal rules meant to provide some degree of stability over business cycles, build up a financial buffer, and encourage prudence in good times and bad, the effectiveness of those rules varies greatly. Improving and reforming fiscal rules and practices must be part of states’ responses to this latest challenge because one thing is certain: there will be another disruption in the future.

Firm fiscal foundations can help mitigate the need for mid-crisis budgetary triage. There are three major areas for states to consider.

Keep one set of books

In recent years states have implemented new Government Accounting Standards Board (GASB) guidelines that require them to report all of their long-term liabilities on their balance sheets. Previously, states’ true financial conditions were overstated because hundreds of billions of dollars of unfunded pension and other retirement obligations remained “off-the-books.” As a result of the new standards, states now prepare their government-wide financial statements using the types of rules that are in place in the private sector. Under these accrual accounting rules, only revenues earned are included, and expenses are reported when incurred, not when paid.

The GASB guidelines are improvements, but more work remains to be done. In addition to the government-wide statements, state financial reports include a separate set of books, called fund statements. These include account balances and activities for major funds, including state general funds. These statements only report inflows, including loan proceeds, and outflowsonly checks written. For example, only the amount a state chooses to pay into its pension systems is included, not the pension costs incurred. The publishing of two sets of books leads to confusion, which some government officials use to their advantage.

For example, in August 2019 Illinois Comptroller Susana Mendoza issued a press release stating that the state had cut its deficit in half in fiscal 2018. The state’s general fund statement did report a $6.8 billion reduction, in large part because of a $6 billion debt refinancing scheme. But the comptroller’s press release failed to mention the reality of Illinois finances as presented on the government-wide statements. When all of the state’s earned revenues and incurred expenses were included, Illinois’ financial condition for the year had actually worsened by $3.7 billion.

Removing pension risk

Since the recession of 2008, analysts have warned that public sector pensions are exposed to an inappropriate level of investment risk. Public pensions are intended (statutorily and in some cases, constitutionally) to be guaranteed payments for employees in retirement. Historically, public pension assets were invested in lower-risk bonds. This reflected the idea that guaranteed payments to workers should be invested in assets with guaranteed returns.

But as bond yields dropped over the 1990s and 2000s, pension plans gradually adopted investment strategies that included a higher proportion of stocks, in effect “chasing returns.” By the eve of the last recession, state and local pension plans held an average of 70 percent of portfolio assets in higher-risk equities, alternatives, commodities, and real estate—a share that increased to 74 percent by 2018. This approach bakes in greater risk and volatility into pension portfolios, with the bad years delivering investment losses and deeper funding gaps that states must eventually find a way to close.

The actuarial practices that many public plans use reinforce the illusion that greater investment risk makes plans more affordable to governments. It’s an assumption that leads some governments to promise more benefits to workers during boom years without recognizing the true costs. In other cases, boom years give the appearance of plan overfunding, leading some governments to skip annual contributions. In market downturns these paper gains quickly evaporate and reveal the gap between what has been promised to workers and what has been set aside to fund the payments.

Instead of chasing risky investments, state and local governments should adopt a life-cycle fund approach to funding pension benefits. With this approach, investment funds are automatically converted to lower-risk instruments as individuals in the plan approach retirement. As the American Enterprise Institute’s Andrew Biggs shows, the age-based portfolio approach means that pension benefits paid in the near term would be funded with a relatively safer portfolio mix of 85 percent bonds and 15 percent equities. Benefits to be paid to younger employees several decades into the future would adopt a wealth-generating strategy and invest in a portfolio consisting of 90 percent equities and 10 percent bonds.

Rainy day funds that don’t leak

All but two states have put in place measures to help manage their finances during business cycle swings. With budget stabilization funds, or rainy day funds, states set aside money to cover budget gaps during downturns. Economists David T. Mitchell and Dean Stansel find that over the last decade, some states have managed to build up sizable reserves to meet the current crisis. For example, Wyoming, Alaska, North Dakota, and New Mexico each have enough funds to cover 25 percent of annual spending. However, several other states have little to nothing set aside, including Illinois, Kansas, New Jersey, New York, and Pennsylvania.

The performance of these rainy day funds has varied, depending on how they are designed and managed. Rules that require automatic deposits and clearly specify withdrawal conditions set up these funds for success. This approach enables states to ride out shocks by consistently building up reserves and drawing them down only for true emergencies. In particular, states should direct revenue windfalls from boom years to cover revenue shortfalls during recessions.

In addition, states should build rainy day fund reserves to meet likely revenue needs based on their experience with past recessions, which provides a target for how much revenue should be set aside to weather average downturns. Relying on a mathematical rule that requires contributions to meet that targeted amount disciplines saving and limits the temptation of policymakers to use surplus revenues on increased spending. Withdrawals from rainy day funds should also be clearly specified, again to prevent their use to cover spending increases.

At the same time, rules should not be so punishing as to discourage withdrawals during a crisis. As The Pew Charitable Trusts notes, some state rules are so strict as to make the funds nearly inaccessible. For example, regardless of economic conditions, Mississippi legislators may only withdraw $50 million annually from the state’s rainy day fund. That is, they are capped in terms of how much they can access during an emergency. Other states require the funds to be replenished quickly, discouraging withdrawals and making them ill-suited for use in deep or long-lasting recessionary periods.

Fiscal realism is the key

What states do during the years of economic expansion greatly affects how well they can endure recessions: rapid spending increases, large tax cuts, and the size of the rainy day fund all determine fiscal resiliency. In addition, accounting rules that encourage risk taking or obscure the full cost of spending only contribute to a false sense of fiscal health, leaving governments ill-prepared to meet spending commitments and make informed choices.

Funding pensions and employee health benefits while maintaining sufficient reserves for recessions need not be an impossible tradeoff. Secure fiscal foundations can be built with a consistent commitment to accurate accounting for liabilities, minimizing pension investment risk, and rules for rainy day funds that direct windfalls to buffer budgets during downturns.

This article first appeared on the Bridge at the Mercatus Center. 

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