The Political Economy of Underfunded Municipal Pension Plans

The purpose of this paper is to provide an explanation of the political and economic determinants of underfunding of municipal pension funds. We develop a new dynamic politico-economic model within an overlapping generations framework. The key insight of the model is that underfunding can result in equilibrium even if individuals are fully informed, perfectly rational, and forward looking, and policies are capitalized in housing or land prices. Funding policies matter if housing also serves as collateral for households that are potentially credit constrained. The model suggests that differences in funding levels are systematically related to differences in economic fundamentals such as wage levels, the size of the public sector in a city, and the compensation of public sector workers measured by the current wage and retirement benefi ts. Finally, our analysis has some important policy implications. A policy intervention that mandates higher funding rates for municipalities than those adopted in equilibrium improves household welfare.