The Senate Majority Leader, Mitch McConnell of Kentucky recently raised the possibility of allowing states to go bankrupt.  Current law does not permit states and territories from seeking bankruptcy protection.  This issue came to national attention well before the recent pandemic crisis when Puerto Rico’s financial problems reached the United States Supreme Court.  While getting out from under large pension liabilities may be an alluring possibility for some states, most if not all  will resist bankruptcy with every tactic possible since  it would result in at least a partial loss of sovereignty.  Bankruptcy is handled through the federal court system and results in the appointment of a trustee or receiver to manage the financial affairs of the bankrupt entity.  No state would enjoy a federal official looking over its shoulder while  sorting through its budget, looking for potential ways to raise revenue or cut program expenses.  Budgeting and taxation lay at the heart of state sovereignty.  Who can forget the lesson of “no taxation without representation!” in American history?  Should this discussion go any further, Congress would probably need to amend bankruptcy law to make it more palatable to the state governments and citizens by limiting the authority of the trustee or receivers in bankruptcy.

On the other hand, bankruptcy of smaller governmental units is allowed.  The number of these bankruptcies are very small compared to the number of private entities declaring bankruptcies, but are becoming more common.  The City of Detroit has so far been the largest governmental entity to declare bankruptcy. Orange County and Stockton, California are other large municipalities that have taken that route also.  However, the increasing depopulation of “Blue States” and their cities could result in more crises in the future. Governmental entities declare bankruptcy under Chapter 9 of the Bankruptcy Code, a method for these political subdivisions  to reorganize similar to Chapter 11 for other entities.

What things should someone watch out for when discussing potential municipal insolvency?  One of the myriad issues facing states and localities is  unfunded defined benefit plans.  Pension accounting is one of the most mysterious pieces of generally accepted accounting principles and is being deemphasized in the United States  as the number of pension plan participants in the private sector continues to decline. (That is a topic for another article.)  Unfunded pension liabilities remain a huge problem for states and political subdivisions though. The U. S. Pension Tracker at Stanford University  believes state and local government pension plans are underfunded by nearly six trillion dollars.  That is right—not  six billion—but six trillion dollars.  Let’s assume for the sake of argument there are 250 million taxpayers in the United States, both personal and corporate.   This pension deficit represents approximately $24,000 per taxpayer.  The ability of states and political subdivisions to raise this type of money or to even have the political willpower to raise this amount of money is in serious doubt.

 An allied issue is the rate of return governmental entities assume for their pension plans. The higher the assumed return, the less the entity needs to fund. Conversely, the lower the assumed return the higher the annual contribution to the pension plan must be. The Pew Charitable Trust[1] estimates the median rate of return assumed by public pension funds in 2017 was approximately 7.42%.  It also estimates this will almost certainly drop due to lower interest rates in the next decade, not to mention the recent turmoil in the stock market.  It was not that long ago when pension plans were using an 8% return assumption.  One risk is the pressure on plan trustees to maintain a high rate of return will force them to invest in riskier assets, further compounding the problem if there is a general decline in these value.  For instance, a pension plan may invest in alternative assets (other than stocks and bonds) such as real estate.  Should the value of real estate fall such plans risk even more underfunding.

  In short, as returns on pension plans decrease, and the demographics change (i.e. an older workforce, called the Silver Tsunami) state and public subdivisions will face increased financial pressure.  Where will these entities come up with the money to pay its pension obligations?  We all know there is only one place where that can come from. The other alternative, reducing pension benefits is not only politically costly, but possibly illegal.  Only time will tell if the ticking time bomb of public pensions will explode into more municipal bankruptcies.

[1] https://www.pewtrusts.org/en/research-and-analysis/issue-briefs/2019/12/state-pension-funds-reduce-assumed-rates-of-return