Public-sector pensions: State of war

AMERICANS ARE USED to debates on the financial health of their Social Security system at the national level, but many will have been caught unawares by a pensions crisis in their state and municipal governments. Already one small city—Prichard, Alabama—is unable to pay its pensioners. The crisis has exposed the potential conflict between public-sector workers who still enjoy DB pensions and private-sector workers who get less generous DC pensions—and at the same time have to fund the benefits being paid in the public sector through their taxes. Years of underfunding mean that more contributions to public-sector plans are needed, and soon. But since most states have balanced-budget requirements, such contributions can come only from higher taxes or cuts in services.

Reform of public-sector pensions is inherently difficult. The biggest liability is promises made to existing employees. Court decisions have suggested that these promises cannot be withdrawn; states may not even be able to limit the future accrual of pension rights by existing workers. In California the Little Hoover commission, which in February reported to Jerry Brown, the state’s governor, concluded that courts had protected employees’ pension rights “as structured on their first day of work”.

It seems odd that private-sector employers can restructure their pension plans and public-sector employers cannot. The best that local governments can do is change the system for new employees, a process that will take decades to bear significant fruit, or to increase employees’ contributions. Even that amounts to a pay cut, creating the potential for dispute with the unions. In Wisconsin unions have swallowed higher contributions but balked at attempts to restrict their bargaining rights.

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Related topics

• Jerry Brown
• Social Security
• California
• Pensions

Putting off the evil day

The funding crisis in public-sector pensions is, in large part, the result of post-dated cheques written by politicians in the past. As Roger Lowenstein, a journalist, recounts in his book “While America Aged”, there has been a “devil’s pact” in which politicians granted benefits to unions without funding those promises properly.

A classic illustration comes from San Diego, California. In 2002 the funding ratio (the proportion of pension liabilities covered by assets) of the city’s pension scheme dropped close to 82.3%, a level that should have triggered a rise in the contribution to make up the shortfall. That would have required a tax increase. To avoid this, the city did a deal with the unions whereby it would raise future benefits in return for not having to lift contributions. In other words, faced with a hole in the fund, the authorities dug deeper.

In theory, states and municipalities are required to make an actuarially determined contribution to their pension funds each year. In practice, some have failed to make such contributions in the face of budget pressures (New Jersey is a repeat offender). That means they are implicitly relying either on the investment portfolio to bail out the fund or on future taxpayers to contribute even more to make up the shortfall. But the stockmarket has stagnated since 2000 and state coffers have been bare.

The bill is now coming due. The Little Hoover commission estimates that contributions to California’s public-sector pension funds will have to rise by 40-80% in five years’ time and stay at those levels for decades. In Los Angeles, total retirement costs (including health care) already make up 18% of the city’s budget, a share that is set to rise to 37% by 2015. In New York, the Manhattan Institute reckons that the taxpayer’s contribution to the teachers’ fund will have to rise from $900m now to $4.5 billion by fiscal 2015-16.

Voters are furious, and have been outraged even more by two related issues. One is the lavish pensions paid to retired city and state executives; in California, over 9,000 such pensioners are getting more than $100,000 a year. The second is “spiking”. In a final-salary scheme, earnings in the last year before retirement can be crucial in determining the pension; these can be boosted by, for example, offering the employee a promotion or a large amount of overtime. Some states have now moved to making pensions dependent on average income over several years.

To be fair, fat-cat pensions in the public sector are far from typical. According to Alicia Munnell of the Centre for Retirement Research in Boston, the mean public-sector pension is just $20,000 a year, well below the average wage. But public-sector workers still seem to be getting a better deal than their private-sector equivalents, who usually have to work for 40 years to get full benefits. In the public sector the qualifying period is often shorter; in California, for example, highway patrol officers retire at 50, after an average of 28 years of service.

This is partly an accounting issue, of which more in the next section. But it also raises questions of transparency. Neil Record, a fund manager, argues that the pay deal offered to a DC plan member is clear; it consists of basic salary and the employer’s contribution to the plan. A DB member, by contrast, gets his salary plus the employer’s promise to make up any pension-fund shortfall. This guarantee is very valuable, particularly when markets plunge, as they did in 2008. So comparing the public and the private sector becomes extremely difficult and taxpayers cannot tell whether they are getting a good deal.

Creditors, as well as taxpayers, are waking up to the scale of the problem. In January this year Moody’s, a rating agency, published research showing combined totals for individual American states’ public and pension debt. It used the pension funding ratios calculated by the states themselves, which almost certainly understate the size of the hole. Measured by the ratio of this combined debt to state GDP, Hawaii has the biggest hole, with a ratio of 16.2%. Thirteen other states have ratios of more than 10%. Those figures may sound modest, compared with the 100%-plus ratios seen in Greece and Japan. But the states do not have first claim on their GDP; the federal government deducts its share through income and corporate taxes, so citizens of those states need to service both their own burden and the federal debt.

via economist.com