United States: The Big Lie: Unfunded State Government Pension and Retiree Health Benefits

Last Updated: December 7 2010
Article by David Morse

When Wile E. Coyote walks off a cliff, he doesn't fall until he looks down and realizes there's nothing but air. That cartoon image neatly captures the approach taken by state governments to funding their employee pension and retiree health benefits. Generous accounting standards, a lack of funding requirements, and politicians' myopic focus on the next election have fueled a combined 50-state unfunded governmental employee retirement obligation conservatively estimated at over $1 trillion. Before the money to pay benefits runs out, state governments, unions, employees, and retirees should face up to the problem and learn from the experiences of the corporate world in confronting similar (albeit not as gargantuan) challenges. Further delay will only lead to legal and financial chaos, broken promises, and much suffering.

WHY THE PROBLEM?

First, government workers vote and second, promises to pay retiree benefits in the future are not booked as a state liability or treated in budgets as a current cost. Offering or increasing state-paid pension and retiree health benefits is a reliable way to get labor peace and the votes of represented and salaried government workers alike. As a result, even as economic pressures drove the private sector to trim coverage and switch to more predictable and lower-cost defined contribution programs, the retirement programs for government employees still look like a relic from the Eisenhower era.

Indeed, the typical public sector program has a relatively generous final pay pension formula, often including an automatic COLA for retirees, "normal" retirement at age 60 or even 55, and heavily subsidized lifetime health benefits. As an added kicker, some state programs base pension benefits on the employees' final year's pay, allowing hourly employees to bump up their pensions with overtime in the 12 months before retirement. Granted, these benefits are offset by the fact that state workers usually must contribute to their pension plans and may not be eligible for Social Security. Nevertheless, most private sector workers would swap benefits with a state employee in a nanosecond.

Happily, for the politicians and bureaucrats, there are no federally imposed funding rules on state retirement programs. Instead of ERISA, governmental plans are bound only by a watered-down version of the pre-ERISA Internal Revenue Code rules that imposes very few obligations on state governments other than cutting benefit checks. The Government Accounting Standards Board (GASB) does mandate that each state book its pension and (recently) health and other retiree obligations, but the measurement rules are loose and there has been little real consequence from reporting ever-larger unfunded retiree liabilities. Unlike state bonds and other borrowings, the benefit liability doesn't affect deficits and isn't counted as a debt. All this makes it easy for governors and legislators to sweeten benefits while still appearing fiscally prudent—until the day enough workers retire and out-of-pocket costs overwhelm state budgets.

CALCULATING THE SHORTFALL

There are various estimates of the extent of the shortfall. In an exhaustive study, the Pew Center on the States put the total unfunded liability at the end of fiscal 2008 at $1 trillion: $452 billion in unfunded pension liabilities and $555 billion for health and other benefit obligations. State pensions were calculated at roughly 84 percent funded and retiree health was essentially completely unfunded.

But the Pew Study observed that its estimate actually understates the size of the problem. Most states have a June fiscal year and use "asset smoothing" to even out market volatility, so that the reported aggregate plan asset levels do not fully reflect the ravages of the 2007–2008 market crash. Moreover, virtually every state assumes its pension investments will earn 8 percent annually in estimating how much money will be on hand to pay benefits; Pew's numbers are based on this rosy investment forecast.

To get a more realistic estimate, other academics have recalculated Pew's underfunding estimates using various market-based assumptions ( e.g. , yield curve on long-term corporate bonds, risk-free Treasury yields, or expected interest rates on the state's own bonds). For example, Novy-Marx and Rauh of the University of Chicago peg the underfunded liability at an astonishing $3 trillion. And, the Pew and other estimates exclude liabilities for municipal and local government entities that aren't part of their state's system, as well as future accruals for state employees.

HOW BIG IS A TRILLION?

Even in these days of mega-bank and corporate bailouts, it's hard for us mortals to get our heads around $1,000,000,000,000. You could think of it this way: if you invested $1 trillion at 6 percent interest, you'd earn almost $7 million . . . an hour. Using a different yardstick, the $1 trillion retiree benefit liability exceeds both total state borrowings ($798 billion) and annual tax revenue ($781 billion). States today are contributing an average of about $1 to their pension plans for every $10 in taxes they take in. To reach just full pension funding, those contributions would need to grow by 75 percent for ten years, while pension investments somehow earned 8 percent annually. Right now, unfunded state pension promises in the United States average an extraordinary $166,500 per participant.

STATE-BY-STATE

However, not all state pension messes are created equal. (Visit pewcenteronthestates.org for a handy, interactive, state-by-state funding map.) Despite the massive political dysfunction that regularly paralyzes my home state, I am pleasantly shocked to report that New York's pension system is pretty much fully funded (although its retiree health programs are virtually unfunded). In contrast, states such as New Jersey, Illinois, and Connecticut are on a trajectory that could see them blow through their entire pension portfolios before the end of this decade. But even those states that have squirreled away enough to cover their pension costs will have to find a lot of extra cash to pay for health benefits as baby boomers retire in droves over the next ten to 15 years. And, of course, if investment performance doesn't make the 8 percent bogey, even more cash will be required to satisfy existing obligations.

LEGAL PROTECTIONS

Absent ERISA protections, eight states' constitutions protect retirement benefits, while 22 others have passed statutes restricting their ability to curtail benefits. Additionally, the Contract Clause of the U.S. Constitution prohibits states from impairing a contractual obligation to provide benefits unless reasonable and necessary to fulfill an important public purpose. Translation: It's unconstitutional to reduce vested retirement benefits unless a state is so broke it would otherwise be forced to fire every cop, firefighter, teacher, and sanitation worker. Even when benefits can be legally altered, changes still must be made through the very same cumbersome legislative process that got them into the mess in the first place.

TOMORROW'S PROBLEM

Faced with the more immediate problems of filling budgetary holes through furloughs; layoffs; school, hospital, and park closings; and tax hikes, most state governments are reluctant to worry about a retirement crisis five or ten years down the road. Unfortunately, delay will only make the problem worse and the eventual solution more costly. Even if benefits are protected by federal and state constitutions, when the money runs out (and it will: taxes can only be raised so high and services cut so deeply), benefits will have to be cut. It's estimated that in some states over half of state revenues will be needed just to cover out-of-pocket pension and retiree health payments. Faced with an unexpected and severe cut in benefits caused by their state's financial meltdown, retirees and near-retirees will find it difficult, if not impossible, to adjust. Employees and retirees in the weakest states have an added risk that a tax hike may not be an available solution to garner additional money for plan contributions; able-bodied taxpayers can move to less fiscally troubled and lower-tax jurisdictions, negating any revenue boost from higher taxes. Indeed, it's not a coincidence that the low-tax states generally have higher population and job growth rates than high-tax states.

Some states such as New Jersey have sought to postpone the day of reckoning by issuing pension obligation bonds (POBs) and contributing the proceeds to its pension plan. Since the POB bond proceeds are tucked away in the plan, they somewhat protect retirees by increasing funding ratios, but do nothing to improve the state's finances as a whole. Really, this is just buying stocks and bonds on margin. As with all leverage, pension investment returns must beat the state's bond interest expense, or the state's financial problem will worsen. If it wasn't obvious before the leverage-fueled Great Recession, it should be clear that POBs are toxic.

LEARNING FROM THE PRIVATE SECTOR

It wasn't pretty, but the private sector has worked through many of the issues of restructuring unaffordable legacy benefits. (Or, like GM, Chrysler, and a number of steel and airline companies, failed to adjust in time and went broke.) Some states have raised retirement ages and employee contributions, or closed their pension plans to new hires. Despite politicians' crowing about the money being saved, such changes alone won't do the trick. Most new employees are young and haven't built up years of service. Pension and retiree health promises get truly expensive close to retirement, when final pay formulas and the like ratchet up benefit levels. Indeed, putting new hires in a 401(k) or other defined contribution program can actually increase costs because those new benefits are more valuable than a pension that won't begin for another 30 years.

The solution lies where the costs are: outsized legacy programs for current workers. Reducing earned benefits would be unfair and is unlawful in most cases. But formulas for future pension accruals can be amended to extend the period over which final pay is averaged, or switch to career average or a cash balance approach. Raising the retirement age to 65 would reflect both increased longevity and economic reality (although cops, firefighters, and other public workers in physically demanding and dangerous jobs will need exemptions). Employee contributions may need to be increased and, wherever possible, COLAs should be eliminated. (With inflation near zero, this is a perfect opportunity.) Retiree health programs can increase the years of service required for eligibility and switch to defined contribution plans in which a fixed amount of money is set aside for each worker's benefit and when the money's spent, the benefit ceases. And, of course, pay-as-you-go has got to go. Every retiree program needs to be funded on an actuarially sound basis.

GETTING REAL

There has been a colossal failure of leadership by government heads and union bosses who have promised unsustainable retirement benefits. Like AA, step one is admitting there's a problem. In this case, step two is to stop cooking the books and reasonably determine the expected costs to satisfy existing benefit programs. With those numbers, all constituents—employees, retirees, unions, and taxpayers and government, can begin a dialogue over possible solutions. It will not be a pleasant discussion. Retirees will claim they've already earned their benefits; employees and unions will claim their benefits are fair compensation for lower salaries; cops and firefighters will state that risking their lives entitles them to a rock-solid retirement; and teachers will play the "we dedicate our careers to your kids" card. Taxpayers will point out that they're paying too much to fund their own retirement to be paying extra for someone else's golden years and vote (literally, or with their feet) accordingly.

IF NOT NOW, WHEN?

Doing nothing will doom state workers and retirees to a sudden and unexpected loss of benefits and the public to the chaos of a financial crisis and possible state insolvency. Ask Wile E. Coyote: Once over the cliff, it's too late to look down.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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