Could a U.S. Debt Default Be a Good Thing For Public Pensions?
Currently, there’s no clear end in sight for the political fight over the federal debt ceiling. As weeks of negotiation have passed, a government default isn’t out of the realm of possibility. While this may not be the most obvious question in the debt ceiling debate, it’s one worth asking.
If the debt ceiling isn’t increased this could have direct implications for federal employee pensions. Government salaries would temporarily stop. This includes contributions to those employees’ supplemental defined contribution plans. Federal retiree payments will likely pause as well.
But would would the implications be for state and local pension plans?
The most immediate effect of a federal default on state and local pension funds would be financial market turmoil. Pension funds hold trillions of dollars in a broad range of investments. This includes publicly traded equities, government bonds, and other vehicles. Because of these investments, state and local pension funds are particularly exposed to financial market volatility. Any downturn in stock markets or turmoil in bond markets would negatively affect pension funds.
But there are other effects from federal government default that pension fund stakeholders should keep in mind:
- Governments Might Delay Pension Contributions
- A federal default would likely mean an increase in borrowing costs. This will impact everyone in the country, including states, municipalities, and school districts.
- A default because of a debt ceiling breach would also likely mean a delay in federal government payments to states. School districts can expect delays in the delivery of federal funds for school districts. This may lead to serious budget crunches for those ending their fiscal years on June 30.
- In either case, states or municipalities may attempt to relieve budgetary pressure. Delaying contributions into their own pension funds is one of the ways they may do that.
- Unfunded Liabilities Might Increase
- While it’s not entirely known how markets might react to a federal government default, we know that it won’t be good. In theory, increased borrowing rates could mean higher bond yields and better returns on fixed income. But that likely wouldn’t balance out losses on public equities or other asset classes.
- Ultimately, if financial markets go into a tailspin because of a default, this will put downward pressure on pension fund assets. And all else equal that will mean an increase in unfunded liabilities. (Particularly for pension funds who measure their assets and liabilities on June 30 each year.)
- Costs for Public Employees Might Increase
- Any increase in unfunded liabilities will mean a need to increase contribution rates.
- Depending on the state, contribution rate increases might mean higher contribution rates. This means government employers and/or pension plan members may see their contribution rates rise. Some states automatically increase member contribution rates when costs rise.
- If unfunded liability increases are large, and require cost increases, states will need to balance costs. Some states may do that by reducing retiree inflation adjustments.
In short, there are serious implications for public pension funds should the federal government fail to reach a deal on the debt ceiling. And the potential upside of higher bond and fixed income returns is negligible relative to to the threat of global financial market turmoil. So the answer to the question at the top is, no, a default would not be good for public pensions. Not only would a default be bad for pension funds, it could dramatically exacerbate pension funding gaps that would take states decades to fix.