Managing Revenue Volatility
and Retirement Liabilities
in an Unpredictable World
By Chris McIsaac, GovInvest Pension Thought Leader
The economic disruptions brought on by the COVID-19 pandemic continue to pose challenges for public finance officials planning for an uncertain future. From managing underfunded pension liabilities in the face of short-term revenue volatility to planning for possible tax implications of long-term shifts in business operations, the need to support decision making with effective forward looking analytic tools is greater than ever. In the coming months GovInvest will publish a series of issue briefs, articles and case studies that explore these challenges and the steps policymakers are taking to prepare.
This Issue Brief is intended to set the stage for future commentary by discussing the historical trajectory and trends around revenue volatility and public pension funding, revisiting the recent experience of managing government budgets and pension plans during a global pandemic, and introducing the idea that technology can help policymakers better plan for and manage uncertainty moving forward.
Historical Revenue Volatility
Managing tax revenue volatility is one of the largest challenges that state and local governments face in crafting sustainable budgets. Unlike the federal government, these jurisdictions in almost all cases are required to align revenues and expenditures each year. Achieving balance can require significant adjustments to annual spending plans as actual revenue collections deviate from forecasts.
Policymakers do have some control over certain factors that influence the level of volatility—for example, imposing a relatively stable property tax versus a less predictable hotel lodging tax. However, states often limit the authority of local jurisdictions to use certain types of taxes. This being said, the larger factor impacting annual revenues are national economic trends and local industry dynamics.
The chart below from the National League of Cities illustrates these points, showing the year over year change in revenue across three major city tax sources—sales, income and property. Directionally, all three generally follow the national economic trends (falling during recessions and rising in periods of growth) while the timing and scale of the change varies by tax type.
COVID-19 Revenue Impacts
The COVID-19 pandemic has only exacerbated the longstanding challenges of managing tax revenue volatility. The pandemic’s arrival triggered a short but severe economic contraction in Q2 2020 that reduced overall year over year state and local government tax collections by approximately 15%. As entire sectors of the economy were largely shuttered, budgets crafted amid this uncertainty often forecasted additional revenue declines that in many cases did not materialize as the economy re-opened and federal stimulus dollars flowed. This resulted in overall revenue growth in both Q3 and Q4 2020, as shown in the chart below from the Government Accountability Office (GAO). It’s important to note, these overall numbers do not convey the very different experiences of individual jurisdictions depending on the nature of the local economy and tax structure.
The longer-term economic impacts of the pandemic remain highly uncertain but could prove even more consequential to public finances overall and exacerbating disparities across jurisdictions. For example, a permanent increase in the utilization of remote work could have negative implications on funding for public transit and sales and property tax revenue generated in commercial districts. On the other hand, rising residential property values further from city centers could bolster funding for suburban school districts and communities as residents seek larger homes better suited for remote work. Here again, the actual impacts are highly uncertain and likely to vary significantly across jurisdictions based on individual circumstances.
Pension and OPEB Costs Rising Steadily
Amid all this uncertainty, local policymakers also face rising budget pressures from underfunded pension plans and retiree healthcare costs (OPEB). A combination of historical investment underperformance, insufficient contributions and other demographic factors drove average local pension plan funding levels down from over 100% in 2000 to around 70% in 2020, causing the significant increases in actuarially required contributions shown in the chart below from the Center for Retirement Research at Boston College.
Similarly, for jurisdictions that follow the common practice of funding retiree health benefits on a “pay as you go basis” (as opposed to actuarial pre-funding of a pension system), annual budgets are directly exposed to the effects of rising healthcare costs. According to a Center for Medicare and Medicaid Services report that does not account for any COVID-19 impact, national health expenditures are projected to grow by 5.4% annually through 2028—more than one percentage point faster than the average annual growth rate for the overall economy.
COVID-19 Highlights Investment and Contribution Risks Facing Pensions
The economic effects of the COVID-19 pandemic highlight two of the biggest risk factors that impact unfunded pension liabilities—investment performance and contribution levels. On investments, the severe market contraction from early 2020 was followed by a swift rebound in asset prices that led to near record FY 21 returns for many pension funds. This will improve funding levels in the near term as those gains are recognized in plan reporting but could temper the outlook for future investment performance.
As referenced before, during that same period of extreme market volatility in early 2020 state and local governments were facing the prospects of severe revenue declines stemming from the lockdowns. This raised questions of meeting scheduled pension contribution requirements and risked adding to already significant unfunded liabilities, which would further drive up future contribution requirements. While the revenue outlook quickly improved from the early forecasts as economic activity resumed—and for some jurisdictions shifting all the way to budget surplus when accounting for federal stimulus—the experience highlighted the complications of managing long term liabilities and sticking to funding plans amid revenue volatility.
Technology to Support Planning and Decision Making
The challenge then moving forward is how to maintain pension funding discipline in the face of revenue shortfalls or even take advantage of opportunities to accelerate debt reduction during a period of surplus while balancing other budget priorities. Doing this effectively requires forward looking projections of revenue, pension, OPEB and labor costs that can help policymakers assess risks and tradeoffs and better manage future uncertainty. In future articles and cases studies, we will highlight examples of jurisdictions already using technology for this purpose and discuss some of the resources available for budget officials seeking to do the same in their state, city or county.
About the Author: Chris McIsaac is an experienced public policy consultant specializing in state and local pension, tax and budget policy. Previously, he managed state and local engagements for the Public Sector Retirement Systems Project at the Pew Charitable Trusts in Washington DC, served as an advisor to two Arizona governors, and published research on topics including pensions, tax policy and healthcare for the Arizona Chamber of Commerce Foundation.