Bankrupt Public Pensions: A Time Bomb That Will Explode

Two previous postings here and here discussed the perverse incentives that drive public sector behaviors. A more recent posting addressed further pension woes in the private sector. Marc has brought even more information forward about pension woes in his recent posting.

Misguided public sector incentives are particularly obvious when reviewing the status of public sector pensions across America, where public sector unions make outrageous demands and spineless politicians and bureaucrats cave into those demands – leaving working family and retiree taxpayers holding the bag.

On May 31, 2004, Fortune Magazine published an article entitled "The $366 Billion Outrage: All across America, state and city workers are retiring early with unthinkably rich pay packages. Guess who's paying for them? You are". Arguably one of the best writeups I have seen on this issue, here are some of its major points:

...the public pension morass is bigger, more wide ranging, and ultimately more costly than anything you've seen in the corporate world...

...public pensions are constitutionally guaranteed or protected in [41]...states...

...the result is a hole...that can only be filled...with either steep cuts in city services or [large] property tax increases or both…

The third option is to cut those lavish benefits. But that's easier said than done…

What’s happening...is just the beginning of a cascading problem. Pension plans covering the nation’s 16 million state and local government employees – about 12% of the entire workforce – are gobbling up increasingly large shares of budgets, setting the stage for bitterly fought battles among politicians, unions, and taxpayers. Collectively, the plans owe an incredible more in pension benefits to current and future retirees than the money stashed away to pay for them…

How on earth did it get to this point? You may have heard about the "perfect storm" – a lethal combination of a crashing stock market and record-low interest rates – that has hammered the pension plans (and share prices) of many of America’s largest corporations. Those same factors also wrecked havoc on the finances of state and local pension plans.

But when it comes to the government plans, you can add a few more poisonous elements to the mix: elected officials who were more than happy to dole out lush benefits to their heavily unionized employees during – and even after – the stock market bubble; a system that lets politicians push the costs for those increased benefits off on future generations of taxpayers; and a general public that simply wasn’t looking. "The public employee, no matter who you compare him to, has become the dominant sector of the labor force that is well pensioned and well benefited," says Dallas Salisbury, president of the Employee Benefit Research Institute. "And the real question is, At what point, vis-à-vis tax burden, does the nonpensioned public start to pay attention to that as voters?"...

Making the cash crunch even more severe is that in most cities and states, public pension costs are growing more rapidly than the tax base...

[Under defined-benefit pension plans,] the employer puts up all or most of the money...Unlike defined contribution plans, such as 401(k)'s, the nest eggs accumulated under a defined-benefit plan can't be demolished by a cratering stock market...

There's another crucial difference between the public and private sector plans: A corporation, under federal law, typically must start pumping money into its pension plan once the value of the plan's assets sinks below 80% of its liabilities. But there is no such law governing state and local plans - the decision to pump additional money into a pension plan lies with the individual discretion of state and local governments.

Thanks to this discretionary funding system, shortsighted politicians can simultaneously dole out rich pensions to their heavily unionized workforces (thereby presumably currying favor with a powerful group of voters and avoiding nasty strikes) and keep the rest of their constituents at bay by shoving the liability for those increased benefits onto future taxpayers...

There is another big trend at play here: the ever-widening divergence between the proportion of public and private sector workers who participate in a traditional pension plan. For private sector workers, the number has progressively slipped, from almost 40% at the beginning of 1980 to about 17% now...

The story is very different in the public sector, where traditional pension plans continued to flourish. Ninety percent of all state and local workers are currently covered by a defined-benefit plan, unchanged from a decade ago...

Only 9% of all private sector workers are now represented by a union, less than half the percentage of two decades ago. Meanwhile, the proportion of state and local workers with union representation has held steady over the same time, at about 43%...

...government pensions are generally much richer than those offered by corporations. The average public sector employee now collects an annual pension benefit of 60% after 30 years on the job or 75% if he is one of the one-fifth or so of workers who are not eligible to collect Social Security benefits. Of the corporate employers that still offer traditional pensions, the average benefit is equal to 45% of salary after 30 years...

Just as important, about 80% of government retirees receive pensions that are increased each year to keep pace with the cost of living, a feature which protects pensions against the effects of inflation and that can increase the value of a typical pension by hundreds of thousands of dollars over a person's retirement. But such inflation protection is nonexistent in corporate plans...

...then there are plans, like those in Houston and San Diego, that allow workers to draw both their salaries and pensions simultaneously...

Union officials say those greater benefits are part of a long-honored compact between governments and their workers. "Historically people deferred wages and traded them for retirement benefits," says Ferlauto [a union official]. "That's been the public service quid pro quo." But whether they are actually trading off wages anymore is anything but certain...

The stock market did, of course collapse, leaving public sector employee pension plans without nearly enough money to pay for promised benefit increases. Even more troubling is that many governments continued to sweeten pension plans long after the stock market bubble burst in 2000...

Thanks to the widespread constitutional and legal guarantees, politicans even attempting to reduce benefits can almost surely expect protracted court challenges...

So what's the answer to the pension morass? While changing benefits for existing employees is difficult, if not legally impossible, a handful of politicians have been attempting to at least reduce the amount of cash the plans siphon out of government budgets in the future...Governments will probably continue to offset rising pension costs by slashing services and, in the process, laying off workers...

Another alternative is for employees to contribute more to their pension plans. About 80% of all state and local plans require employees to make at least some contribution to their defined-benefit plan; the average payroll deduction is 5% of salary...But increasing that amount is a tough sell...Don't count on a booming stock market to come to the rescue...

…it’s looking as if the main responsibility for the public pension mess is going to rest squarely with taxpayers for the foreseeable future. [One union official] acknowledges that the situation might be creating some anger among workers in the private sector. "As more people are concentrated in positions that have no pension system at all, they look at some of these things with resentment," he says. "Hopefully some day they’ll all join unions, and they can negotiate better benefits for themselves."

Oh, that's a really intelligent comment there at the end of the article. Such a stunning grasp of basic economics.

And you wonder why it has never crossed the minds of public sector union officials to ask one simple question working families and retirees answer every day: Where is the money going to come from to pay for all of these outrageous contractual demands by public sector unions?