(
Steven Malanga)
The New Jersey legislature, looking to solve a budget crisis back in
1992, passed a bill that changed some of the accounting principles of
the state’s government employee pension system. The technical changes,
little understood at the time, made the system seem in better financial
shape than it actually was, allowing the legislature to reduce
contributions for pensions by $1.5 billion over the next two years.
Legislators seized those extra dollars and redirected them into other
spending.
Jersey officials could manipulate their pension system because local
governments have latitude in how they run their own retirement plans. So
what they did was not unique. Around the country, state and local
officials have increasingly discovered over the years that they can
exploit the complex and sometimes ill-defined accounting of government
pension systems, as well as loopholes in their own laws governing those
pensions.
Over time, elected officials came to promise workers politically
popular new benefits without setting aside the money to pay for them,
declared “holidays” from contributions into pension systems and changed
their own accounting systems midstream to make the systems seem better
funded — all just ways of passing obligations on to future taxpayers. In
the process, government pension systems became one of the chief
vehicles that state and local politicians used to massage their budgets.
Now we face the consequences. Our elected representatives played a
deceptive game of chicken with pension funds. And now the chickens have
come home to roost.
Years of gimmicks and politically motivated benefit increases for
government workers have left America’s states and municipalities with
pension funds that are short at least $1.5 trillion — and possibly as
much as $4 trillion if the investment returns of these funds don’t live
up to expectations in coming years. Just so the word “trillion” does not
pass by too quickly, let’s put it another way: That shortfall may be
$4,000,000,000,000.
Taxpayers are already paying the price. Since 2007, states and
localities have been forced to increase annual contributions into
pensions by $43 billion, or 65 percent, and in various places these
rising payments are crowding out other government services or driving
taxes higher or both. Retirement debt has even played a crucial role in
high-profile government bankruptcies — including in Detroit; Stockton,
California; and Central Falls, Rhode Island. Fixing the problem is
proving expensive, and it won’t happen quickly in places with the worst
debt.
At the root of the trouble are government pension systems, which
today differ vastly from the way they looked when many were created
about 100 years ago. Most states and localities initially designed
systems based on conservative accounting principles that were meant to
provide employees with a modest financial cushion for retirement —
pensions calculated to last a few years at best. The country’s largest
government employee pension, the California Public Employees’ Retirement
System, or Calpers, was formed in just such a way when it began
operating in 1932.
The system set the retirement age for employees at 65 years old, at a
time when the average worker 21 years of age could expect to live for
another 45 years, or until age 66. To reduce risks for the taxpayer,
California law limited the pension fund to invest in relatively safe
securities, such as U.S. Treasury bonds. Since these investments
generally produced modest returns, pensions themselves were modest. A
worker retiring after qualifying for a full pension could expect to
receive about 55 percent of his final salary in retirement.
But as government employees gained political influence, especially
through the emergence of public sector unions beginning in the late
1950s, they began lobbying for higher benefits. Politicians looking for a
way to satisfy those demands without busting their budgets fashioned
changes that made pension systems riskier to taxpayers, who cannot pass
the buck on to anyone else.
Hoping to generate higher returns, for instance, states and cities
began allowing retirement systems to invest in more speculative
financial products, such as stocks. Politicians also boosted benefits
without genuinely accounting for what that would cost over time.
Some people grew worried. A 1978 report to Congress on state and
local government retirement plans warned “there is an incomplete
assessment of true pension costs at all levels of government,” which
“impeaches the credibility” of many of the pension plans.” Adding that
“the potential for abuse is great,” the report called for federal
regulation of state and local pension plans. But officials in
Washington, fretting that legislation regulating state government
operations wouldn’t be constitutional, instead recommended changes to
accounting standards that the states were free to adopt — or ignore.
What seemed like an emerging problem receded into the background once
the stock market boom began in the 1980s. Assets in pension systems
grew rapidly as stocks went on a 20-year run, with just occasional short
downturns interrupting the good times. To elected officials and public
sector workers, the stock surge seemed to provide free money. Some local
governments responded by sharply increasing the benefits they promised.
They lowered retirement ages to 50 for public safety workers and to 55
or 60 for other government employees, even as Americans were living
longer. They also increased pension paychecks. In California, for
instance, legislation in 1999 allowed public safety workers to earn up
to 90 percent of their final salary as a pension upon full retirement.
States and cities added expensive perks, such as cost-of-living
increases. In Illinois, thanks to changes over the years that came to
guarantee retirees an annual boost in the value of their pension, a
worker retiring with a full pension at age 62 could double his pension
over the next 14 years. Governments began granting retirees another
costly perquisite — health insurance for life — even though the majority
of those governments set no money aside to pay for these promises.
The stock boom perversely encouraged politicians to take on ever more
risk. Many states and cities, for instance, stopped making meaningful
contributions from their budgets into pension funds and instead began
borrowing money and depositing it into their retirement systems, betting
that their investment managers could generate better returns in the
stock market than the cost of interest on the bonds. The move was the
equivalent of a worker taking out a home equity loan and placing the
money in his IRA to invest for retirement, something no responsible
investment adviser would counsel.
From the late 1980s through 2009, according to a study by the Boston
College Center for Retirement Research, 236 state and local governments
issued nearly 3,000 pension bonds totaling $53 billion. In 1998, for
instance, New Jersey floated $2.7 billion in debt for its underfunded
pension system, agreeing to pay investors back $10 billion over 30 years
for the borrowing. Illinois went much further, issuing a whopping $10
billion in bonds in 2003 alone. Financially troubled Detroit, short of
cash, floated $1.44 billion in pension bonds in 2005.
One perverse consequence of these offerings is that the borrowed
money made pension systems seem better funded than they actually were,
which provoked further benefit increases. From 1999 to 2003, New
Jersey’s legislature increased worker benefits 13 times at an additional
cost of $5 billion to the pension system. In Detroit, the pension
system handed out bonus checks to retirees after the 2005 borrowing,
even as the city’s finances deteriorated and Detroit spiraled toward
bankruptcy.
All of this new risk started to unravel pension systems when the
stock market stalled, first in 2000 with the end of the technology stock
bubble, and then again in late 2001, with the sharp decline in markets
after the Sept. 11 attacks, and then again in 2008, when the housing
bubble burst. Assets in pension systems plunged, and those with the
riskiest investment strategies suffered the most. California’s giant
Calpers fund had forged heavily into speculative real estate investment
starting in the late 1990s. When the mortgage bubble burst in 2008, the
fund’s real estate portfolio lost nearly half its value.
Some government retirement systems, facing severe shortfalls, began
demanding greater contributions from governments. San Jose, California,
for instance, saw its required pension contributions soar from $72
million annually in 2002 to $250 million by 2012. Short of cash and
anxious to keep costs from growing even more, the city began laying off
workers, eventually shrinking its workforce by 2,000.
Across the country in New York City, pension costs rose from $1.5
billion annually in 2002 to $8.5 billion by 2012. Those increases ate up
big chunks of money the city had stashed away during the stock market
boom. School districts, where compensation is a significant part of
total costs, also faced rapidly growing payments. The Philadelphia
school district spent about $35 million of its budget on pensions in
2005; last year pensions cost the Philly schools $155 million. In
response, the state legislature allowed Philadelphia to raise taxes by
tens of millions of dollars.
In some places, politicians unwilling to make tough decisions
initially refused to raise payments into pension systems or cut
benefits, hoping that some unanticipated stock market boom would solve
their funding problems. But such delays only made things worse. In 2010,
a state government report warned that California’s teacher pension fund
was on a “path to insolvency.” Not until last year, however, did the
state finally resolve to send more money into the system — at a great
cost to school districts around the state. Between now and 2020, their
payments for pensions will triple, from less than $1 billion in the
aggregate annually to more than $3.7 billion.
Similarly, after the stock market tanked in 2008 and the country
dipped into a deep recession, the Pennsylvania legislature allowed
school districts to reduce their contributions into the pension system
for teachers. But legislators also resisted cutting the cost of the
pension system by reducing benefits. Now the teachers’ pension system is
so badly funded that the state, under pressure from fiscal watchdogs,
has demanded sharply higher contributions from schools equivalent to 16
percent of the teachers’ salaries. That’s the highest contribution rate
in the history of the fund dating back to 1955. Years of similarly steep
pension contributions lie ahead.
Around the country, taxpayers watching these scenarios unfold began
demanding reforms and then electing politicians promising change. But in
many places, reformers woke up to a startling reality: Over the years,
legislators and state courts had granted unusually strong protections to
government worker pensions, far greater than the kinds of protections
that private workers enjoy. That has made cutting the cost of pensions
difficult, if not impossible, in some places with the deepest debts.
In 1974, Congress passed the Employee Retirement Income Security Act
to provide standards and protections for private sector pensions. That
law, and the way federal courts have interpreted it, protects the
pension wealth that a worker has already earned. But an employer has the
right to change the rate at which a worker earns pension benefits in
the future. And so, an employer who is setting aside the equivalent of
10 percent of a worker’s salary toward pensions could decide that next
year it will contribute only 5 percent. The worker has the right to
accept that, or find other employment.
But the ERISA law doesn’t apply to state and local pensions. As a
result, state legislators and courts have shaped pension law for
government employees, and in half of the states, reformers have found it
virtually impossible to make any changes to pensions for any current
workers, even for work they have yet to do. In Arizona, for instance, a
judge in 2012 overturned pension reforms that required state workers to
contribute more toward their pensions, ruling that those changes could
apply only to new workers.
In California, a court undid significant portions of reforms passed
by San Jose voters in a 2012 ballot initiative that sought to have
workers contribute more toward their retirements. The judge based her
decision on previous state court rulings that had said state legislation
creating government pensions is a contract with the worker that goes
into effect on the first day of the worker’s employment — and can’t be
altered for as long as he works for the government.
The problem that governments face in states like this, where
virtually any changes to pensions for current workers are banned, is
that the cost of paying for benefits that workers are earning is rising
even as municipalities struggle to pay off the debt that’s already
amassed. Consider the case of Sacramento. Its price tag for funding new
pension benefits increased by $9 million, or 37 percent, from 2006 to
2013. At the same time, Sacramento’s bill for paying off the debt
accumulated in its pension funds soared from $12 million in 2006 to
$23.4 million in 2013. The net increase from both of those factors
amounted to nearly $21 million, or 55 percent, in higher costs in just
six years.
These laws and rulings that make it difficult to reform pensions have
contributed to fiscal meltdowns in places such as Detroit and Stockton.
After Detroit came close to running out of money, Michigan Gov. Rick
Snyder hired an outside financial manager to study the city’s
predicament. That emergency manager, Kevyn Orr, said the city’s debts,
including $3.5 billion in unfunded pension obligations and another $5.7
billion in promises to pay healthcare for retirees, were simply too
great for the city to pay off, especially with Michigan’s strong
protections against any changes to pensions. Orr instead placed Detroit
into federal bankruptcy court in 2013, where it’s possible to reduce
such debt. Employees lost some of their pension and retiree healthcare
benefits as a result.
Similarly, officials in Stockton spent years enhancing benefits to
workers without understanding the debts they were accruing. The city
agreed back in the 1990s, for instance, to pay not only its own share of
contributions into the pension system, but those of staff, too. It also
guaranteed healthcare for life for retirees.
“Nobody gave a thought to how it was eventually going to be paid
for,” said Bob Deis, a financial manager the city hired in 2010 to start
clearing up its financial mess. Facing $400 million in pension debt and
$450 million in promises for future healthcare, the city declared
bankruptcy in 2012. Employees lost some of their perks, like healthcare
in retirement, but citizens suffered, too. Trying to save money, the
city cut essential services, including the police department, and crime
soared. “Welcome to the second most dangerous city in California,” said a
billboard placed in Stockton around the time of the bankruptcy.
Places that cannot reform pensions, or where legislators were slow to
act, are inevitably seeing tax increases to finance these steep
obligations. In Pennsylvania, 164 school districts applied in 2014 to
increase property taxes above the state’s 2.1 percent tax cap. Every one
of them listed pension costs as a reason for the higher increases. In
West Virginia, the state has given cities the right to impose their own
sales tax to pay for increased pension costs.
Several cities, including Charleston, have already gone ahead with
the new tax. Chicago Mayor Rahm Emanuel tried to impose a $250 million
property tax increase last year to start wiping out pension debt in the
Windy City, where pensions are only 35 percent funded. When the City
Council balked, Chicago instead passed $62 million in other taxes,
including a levy on cell phone use, as a stopgap measure. But the city
faces a pension bill that is scheduled to rise by half a billion dollars
annually in 2016.
Not every place is facing such fiscal stress. Although the total debt
of state and city pensions is worryingly large, the burden is not
evenly distributed. Some states and municipalities remained true to
responsible accounting principles and didn’t increase benefits without
funding them. Others moved swiftly to fix problems as soon as they
emerged.
Utah, for instance, had a pension system that was nearly 100 percent
funded in 2007. When its debt rose after the stock market meltdown of
2008, the state quickly enacted reforms for new workers. It created a
defined contribution plan, in which workers accumulate money in
individual accounts, for new employees, and placed a limit on how much
the state would contribute to pensions.
Other states, such as Colorado and Rhode Island, have reduced or
eliminated annual cost-of-living adjustments. Although these increases,
sometimes averaging 3-5 percent annually, can seem small, over time
COLAs add significantly to the cost of a pension system, especially
since workers can live for 20 years or more after retiring. One 2010
study by two finance professors, Robert Novy-Marx of the University of
Rochester and Joshua Rauh of Stanford University, estimated that COLA
promises alone account for nearly half of all the state and local
pension debt.
But digging out of pension debt for other states will be far harder
because they’re so deep in the mire. A 2013 Moody’s report ranked the
states with the biggest pension debt relative to their state revenues as
Illinois, Connecticut, Kentucky and New Jersey. New Jersey passed
pension reform in 2011 that suspended COLAs, required higher
contributions by workers toward their pensions and raised retirement
ages. But the state, which a decade ago was contributing virtually
nothing out of its budget into pensions, still faces rising taxpayer
contributions to fix the system.
By 2018, Jersey will have to pay about $4 billion a year into
pensions, even after the reforms of 2011, so Gov. Chris Christie has
proposed new reforms, including closing the current pension system,
where workers earn a percentage of their final salary as a pension, and
shifting workers into a defined contribution plan similar to what most
private workers now enjoy, where they accumulate a pot of money in an
individual retirement account. Last week, the Supreme Court said
Christie could forego a $1.6 billion pension fund payment.
The varying levels of retirement woes among states and cities will
produce a landscape of winners and losers. In places with the deepest
debt, taxpayers face rising taxes and declining services, which is
hardly the sort of place that a family or a business wants to call home.
As Emanuel said back in 2012, without reform of its pension system, the
city faced a future where “you won’t recruit a business, you won’t
recruit a family to live here.”
The problem for America is that Chicago is not alone — far from it.
Steven Malanga is City Journal’s senior editor, a Manhattan
Institute senior fellow, and author of Shakedown: The Continuing
Conspiracy Against the American Taxpayer.
When you look back on this moment in history, remember
that spectacular extremes in reliable valuation measures already told
you how the story would end.
