Bankrupt Public Pensions, Part II

A June 5 posting on RI Policy Analysis links to a new Business Week article on the financially insolvent public pensions.

...the cost of retirement has continued its steady climb. According to the U.S. Census Bureau, major public pension plans paid out $78.5 billion in the 12 months ended Sept. 30, 2000. By the comparable period in 2004, that had grown to $117.8 billion, a 50% climb in five years. Beyond hiking taxes and cutting costs, governments have few ways to meet this bill...

...there's little relief in sight. Excluding federal workers, more than 14 million public servants and 6 million retirees are owed $2.37 trillion by more than 2,000 different states, cities, and agencies, according to recent studies. In 2003 alone, states and municipalities poured some $46.2 billion into these plans, according to the National Association of State Retirement Administrators, a 19% jump from the year before. Excluding federally funded programs, pensions went from 2.15% of all state and local spending in 2002 to approximately 2.44% in 2003. But the largest state and city funds were still short $278 billion in 2003 -- approximately 20% of state and municipal revenue excluding federal funds...

As much as states are throwing into pensions, they may owe even more. Despite a 2004 stock market rise that should narrow some of the gap, pension experts at Barclays Global Investors (BCS ) say that if public plans calculated their obligations using the more conservative math that private funds do, they would not be $278 billion under, but more than $700 billion in the red. "It's just ruining the financial picture for states and municipalities," says Matthew H. Scanlan, managing director of Barclays, one of the largest managers of pension-fund investments. "You're looking at a taxpayer bailout of this pension crisis at some point."

There's more bad news. One major category of cost isn't disclosed at all: how much retiree health care has been promised to public retirees. No one can estimate how much these promises will add up to, but they're sure to be in the tens of billions, and only some states seem to have put aside reserves for them, according to bond analysts. That's chilling, given how quickly medical costs are rising. After a pitched battle, the Governmental Accounting Standards Board (GASB), the independent accounting standards-setter for state and local governments, has finally begun to require states to disclose these liabilities. Numerous unions and state government representatives objected to the change, says GASB member Cynthia B. Green, "not because [unions and states] didn't think these were important, but because they thought once the governments did their studies and found what the price tag was, they would be concerned or, if not concerned, staggered." The requirement will be phased in beginning in late 2006.

If these costs aren't brought under control, rising taxes could prove unavoidable -- and a competitive problem for the states in the worst shape as well as for the country...companies -- and even citizens -- could end up moving to states in better fiscal shape. "You could see it turning into an economic desert in certain states," he warns. Combined with the national retirement issues surrounding Social Security, these plans contribute to a depressing outlook for U.S. competitiveness overall...

One reason for the drop [in pension funding levels] was unavoidable: The impact of the bear market of 2000-2002 on the value of these fund investments was severe. The other reason was just foolishness: a lathering on of billions of dollars worth of new promises to workers in flush days. It was a familiar mistake: Public-pension provisions are determined by elected officials, and civil servants vote. Legislators have a long history of making such expensive upgrades to already generous plans.

Some of these giveaways are truly spectacular. In 1998 the city of Houston instituted a deferred-retirement option plan, or DROP, that would allow workers to in effect take their retirement when they became eligible for it but continue to work at their salary. The retirement income was put in a side account where it earned an attractive rate of return, and the employee could later have his pension adjusted upward to a higher level. The DROP, along with other pension improvements, drove the city's pension plan down from 91%-funded in 2000 to just 60% two years later. Houston had gone from contributing 9.5% of payroll toward pensions to more than 32%. Joseph Esuchanko, a Michigan actuary brought in to study the problem, discovered that things would only get worse. According to his calculations, it was possible for employees to become millionaires thanks to the system...

...even bare-bones guaranteed retirements are increasingly rare in the rest of the economy. According to the Census Bureau, 90% of state and local workers have a defined-benefit pension with a guaranteed payout. But only 24% of people employed in the private sector have such plans. (Most public-sector employees contribute along with employers to their pensions, unlike private-sector workers.) And more of the companies that once offered these benefits -- places like Motorola, IBM, and Delta Air Lines -- are dropping them for new workers in favor of 401(k)s. Health-care coverage for retirees, a costly perk that companies have been shedding at lightning speed, also remains common in the public realm.

It has long been accepted as truth that government workers get good benefits and job security in lieu of high salaries, but over the years the gap between public and private employee paychecks seems to have narrowed. It's hard to come by perfect comparisons, since government numbers for the private sector include lower-wage industries like retailing, which pull down the averages, but overall, public-sector workers look to be getting a pretty good deal. In 2004 average salary for a public worker was $49,275 compared with $34,461 for everyone else, according to the Employee Benefit Research Institute (EBRI).

Even white-collar workers are better off in the public sphere. According to the U.S. Labor Dept., state and local government managers and professional staff earned $42.87 an hour last year, while their private-sector counterparts earned $41.52. One big reason: government workers get $2.62 an hour in retirement benefits; everyone else gets $1.63.

States pay more for public retirees too. According to the EBRI, the average public-plan retiree got $16,188 a year in 2003, far more than the $7,200 their private company counterparts could expect. One reason for that big split is that some public retirees do not get Social Security. But that too is changing. Since 1983 most public workers have been part of that system too, so in the future the disparity could well widen. All in all, EBRI concludes, state and local government wage and salary costs are 40% higher than the private sector's; its employee benefit costs are 60% higher...

This tendency to dole out goodies in fat times is the core moral hazard of public-pension plans. Politicians like to reward voters when they can, and public workers vote..."That was the mirage of cost-free benefits," says S&P's Young. "Nobody pays, nobody gets hurt."...

But states have also voluntarily heightened their own exposure to this risk. Rosalind M. Hewsenian, managing director of Wilshire Associates, says the biggest cause of the sharp drop in funding levels at public plans over the past few years was a drop in employer funding and a reliance instead on investment gains to make up the difference...

Elected officials are hesitant to ask the rest of their voters to pay for these promises through higher taxes. One primary reason: Outside of government workers, very few employees have these kinds of deals anymore. "Our people at 55 years of age can get 75% to 80% of their salary [as pension], and it's a pretty nice salary," says Illinois State Representative Robert S. Molaro, a member of a commission convened by the governor to make recommendations for fixing the pension system. "It will be hard for us to go to the taxpayers and ask them to pay for our pensions with benefits you in the private sector couldn't even dream of."

Given this divide, it's reasonable to wonder why there hasn't been more debate about these plans already. They've been protected from scrutiny for a number of reasons. The public-pension systems lack the regulatory system governing corporate pension plans. Corporations have to disclose timely, detailed information about their pensions to investors and the SEC. Rating agencies focus on them, too. In combination, these groups can pressure companies to be more conservative in their fund management. Devereaux A. Clifford, managing director of pension consultants Greenwich Associates, says it was pressure from these watchdogs that forced corporations to lower unrealistic investment return assumptions, from 8.9% in 2002 to 8.3% in 2004.

The public world has far less scrutiny. Nor do these plans have an equivalent to the Pension Benefit Guaranty Corp., the government-sponsored insurer of corporate plans. They have to conform to the funding requirements or accounting demands of the Employee Retirement Income Security Act, the federal law passed in 1974 to monitor private pensions. And public fund reporting lags corporate reporting by at least six months. Important factors like the performance and cost of bonds issued to cover pension obligations are even harder to suss out.

That's bad news. Understanding the depth of these retiree problems seems especially important for state and local governments because of their limited financial options. Unlike the federal government, which can always print money, and private companies, which might sell more widgets and make more profits to fund their pensions, and whose pensions are guaranteed by a government-backed insurer, local government basically has only one way of meeting those promises: your taxes. Public-pension experts note that these obligations must be paid. Public-sector retirement benefits are generally guaranteed by state constitution...

The more likely answer is the most painful: Taxes will keep going up and benefits will be cut for future public employees. Both are unpopular. The debate is just starting to be heard.

ADDITIONAL INFORMATION:

Bankrupt public pensions, related issues with public sector unions, and the misguided incentives that exist in public sector taxation have been discussed previously on Anchor Rising:

Misguided Incentives Drive Public Sector Taxation
If You Won't Deal With Economic Reality, Then It Will Deal With You
Underfunding Pensions, Public and Private, can Hurt Taxpayers
Bankrupt Public Pensions: A Time Bomb That Will Explode
Why Truly Free Markets & Timely, Transparent Information Are Needed to Protect the Freedom of American Citizens
RI Public Pension Problems
The Cocoon in which Entitled State Employees Live
The Union's Solution for the Future: Get More People in Unions