Public Employee Pensions and Municipal Insolvency

Abstract This paper studies how municipal governments jointly manage spending, credit market borrowing, and a public employee pension system. I model governments as levered investors who must meet non-defaultable pension obligations and may value government spending more than citizens. I quantify the model using data on California cities, including a new record of fiscal emergencies, tax increases required to maintain essential city services. After the financial crisis depleted pension funds, cities engaged in excessive risk-taking: the fiscal emergency option encouraged gambling for resurrection that kept cities vulnerable to shocks well into the recovery. To correct this problem, a savings requirement works better than a restriction on risk-taking or a pension funding requirement. The policy experiments emphasize that effective policies need to target the combined pension and bond finances, as policies that only target one, such as a pension funding requirement, are undermined by endogenous changes to the other.