Fate of the States: The New Geography of American Prosperity (10 page)

Maybe the most outrageous difference, however, is the fact that unlike the market-dependent results of private retirement plans, government pensions set return assumptions that are guaranteed by the taxpayer. Particularly outrageous are return assumptions that fly in the face of the actual performance of the market over the trailing ten or twenty years. The average annual-return assumption used by government pension funds today is 8 percent, despite the fact that the actual returns of many pensions funds over the past decade have been closer to zero.
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Understanding this makes it easier to see why unfunded pension liabilities have been growing at such a meteoric pace. For a $30 billion state pension fund, the gap between 8 percent and 0 percent represents $2.4 billion per year that has to be made up by taxpayers. No wonder that inside of just one decade, government pension funds went from being fully funded to being underfunded by nearly $1 trillion.

Compounding the problems of lower-than-expected returns, imbedded COLA increases, and low employee contributions are irresponsible politicians who too often treat the funding of pensions as a choice rather than an obligation. By not funding pensions in one year, a state could save money for another program, effectively robbing Peter to pay Paul. All this really accomplishes, of course, is adding to taxpayer debt down the road. Failing to make a payment or an actuarially recommended contribution is often justified as a temporary solution to a shortfall in tax revenues, one that will be made good in the following years. However, a state like New Jersey has been inadequately funding its pensions for over a decade and today is underreserved to the tune of $42 billion.
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Over the years, some states have been playing the equivalent of credit-card roulette with their pension funds. They pay the minimum owed—some shirk even that—hoping to outrun the debt being accumulated. If only they can get one great year of stock-market returns, perhaps their pensions can recoup some lost or withheld funds. If only there’s a pickup in their economies, then a tax-revenue surplus can be tapped to replenish their depleted pension funds. The worst kind of rationalization may be this one: If only we can get a market-thumping return on money borrowed through pension-obligation bonds—the equivalent of taking out a margin loan to buy stocks—then maybe we can make up for the shortfalls in what we owe. In Vegas they call this problem gambling. In state capitals it’s everyday accounting.

How could all of this happen in plain sight? Just consider the incentives behind sustaining a broken system to the bitter end. When it comes to pensions, politicians are like the guy at the party who orders pizza but then disappears when the doorbell rings and someone has to pay. Many of the pension guarantees were negotiated by elected officials who knew they would be long gone from office before anyone realized that the promises they had made were completely unaffordable for their constituents. Contractually negotiated pension benefits tend to grow during the good times, when the presumption is that the good times will last forever. They don’t, of course. But by the time that’s apparent, there’s usually a new mayor or new governor who has to deal with the consequences. It’s not unlike what happened in the financial industry: Few of the CEOs responsible for feeding the housing bubble are still in charge. “It is much easier for them to use a temporary solution and let the next set of government leaders tackle the problem,” said Edward Mangano, county executive for Nassau County, New York. “This ‘kick the can down the road’ policy has to stop.”
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There’s also a huge incentive for politicians to make aggressive, unrealistic assumptions about pension investment returns. After all, the more aggressive the accounting assumptions, the smaller the unfunded pension liability appears to be. Pension funds use gimmicks like averaging actual returns over several years so that the real status of the funds doesn’t look so bad. Additionally, by using high-return assumptions—remember, the average today is 8 percent—states hide or understate unfunded liabilities. Simply by assuming high, 8 percent compound rates of return on pension investments, the state can lower the amount of money it is required to contribute to the pension fund. The market does all of the hard work—at least on paper—and those cost-of-living adjustments suddenly become more affordable. States like Connecticut, Louisiana, and Massachusetts have investment-return assumptions of at least 8.25 percent, the highest in the nation. When a fund can assume its returns will be higher, its contributions, naturally, can be lower. In the case of Rhode Island, the state estimated that the contribution, or cost, for a state employee would be over 50 percent higher if the government were to move from an 8.25 percent investment-return assumption to a 6.2 percent investment-return assumption. The actual returns over the period in question turned out to be just 2.28 percent a year. And the lower the return, the higher the required contribution. It’s completely absurd, yet this is not a problem unique to Rhode Island. These games are played all across the country.
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State and local governments have underfunded—even nonfunded—their pension funds for years now, and they can’t seem to break the habit. As a result, taxpayers are now waking up to unfunded pension liabilities whose size rivals that of their municipal bond debt. When combined with the cost of health insurance promised to current and former state employees, the total obligation is almost 40 percent higher than the bonded debt. In other words, a muni investor or concerned taxpayer poring over state budget documents will end up grossly underestimating the amount of debt the state truly owes if all he’s looking at is bonds. In New Jersey actual debt is at least four times greater than bonds outstanding.
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But again, not all states are created equal. Collectively, as of 2011, the states are on the hook for nearly $800 billion of unfunded pensions, and when combined with other debts secured by tax receipts, total future obligations exceed $2.5 trillion. Drill down into the numbers and what you find is that some states have been especially reckless, whereas others have actually been strong fiduciary stewards for their taxpayers. So let’s review the good, the bad, and the ugly when it comes to pension policies and how those track records will shape the future of those states.

In 2000 seventeen states did not meet the “recommended” funding contribution of 80 percent; by 2010 that number had grown to twenty-nine states. If you entered the millennium underfunded, odds are that you are in bad shape today. However, for states that got hit hard by both high exposure to the housing downturn and the 2008 market crash, refilling pension coffers will be a huge challenge. Further tax hikes and budget cuts are political nonstarters in states like Arizona (73 percent funded, with a $10.3 billion unfunded liability), California (79 percent and $104 billion), and Connecticut (53 percent and $21 billion). Nevada began the millennium with a funded ratio of about 85 percent; today that ratio is just over 70 percent, with a $10 billion unfunded pension liability. Which states have managed pensions most responsibly, even in the face of declining tax revenues and weak investment returns? Leaders include Delaware (92 percent, $1 billion), Nebraska (83 percent, $2 billion), Oregon (86 percent, $8 billion), and Washington (92 percent, $5 billion). But the standard setter is clearly New York, which has the only fully funded pension plan in the nation.
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In a state known for political dysfunction, New York has been surprisingly proactive when it comes to pensions. Reforms New York has enacted include raising the retirement age from fifty-five to sixty-two for state workers and from fifty-five to fifty-seven for teachers; requiring higher pension contributions for some public workers; and capping the impact of overtime on pension payouts.
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As if not contributing to their pensions weren’t bad enough, some states have essentially doubled down on their unfunded liabilities—taking out margin loans, via issuance of pension-obligation bonds, in the hopes of turbocharging their investment returns. Pension-obligation bonds work like this: If a state doesn’t have the money to contribute to its pension funds but doesn’t want to cut money from other spending projects to get it, it has the option of issuing pension-obligation bonds. The idea is that the proceeds of these bond sales can plug big holes in the state’s pensions, so long as the investment returns earned on the bond proceeds exceed the coupon payments to bondholders. The biggest and best example of this “logic” was in 2003, when Illinois issued $10 billion in pension obligation bonds.
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The governor at the time, Rod Blagojevich, sold the bonds as “no-risk, no-new-debt”
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and likened the transaction to a mortgage refinancing. In reality, it was high risk, and it was new debt. It was just a transfer of debt in the form of unfunded pension obligations to the bonded debt of the state. The arbitrage didn’t work: At a staggeringly low 45 percent, Illinois’s funded ratio is 9 percent lower today than it was before the issuance of the $10 billion in pension bonds, and the state’s bonded debt has tripled from $8.4 billion at the end of 2002 to over $28 billion in 2011—$17 billion of which stems from pension bonds.
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Today Illinois has a staggering $160 billion in unfunded pensions and bonded debt. It also owes an additional $44 billion in unfunded health-care and related benefits.
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This works out to almost $13,000 per capita, the fifth highest in the country but the fourth highest as a percentage of gross domestic product. Add up all the various obligations—pension-bond debt, unfunded pension liabilities, and unfunded retiree health-care costs—and Illinois finds itself in the deepest pension hole in the country.

Illinois is one of a handful of states that owe more to their pension funds than they do on their tax-supported municipal bond debt. Ohio and New Jersey owe more than twice their tax-supported municipal debt in unfunded pension obligations. Neither has adequately contributed into its pensions for over a decade, so the hole has gotten deeper with each passing year. All three states are in desperate need of pension reform. In fact, the recent teachers’ strike in Chicago seemed to reflect a go-for-broke, get-it-while-you-can negotiating approach by the Chicago Teachers Union. The union had to know that a day of reckoning was coming for its retirement plan—only 60 percent funded and saddled with $10 billion in unfunded pension and health-care liabilities. Rather than pick a fight over pensions, Chicago’s 30,000 teachers went on strike early in the 2012–13 school year to demand huge pay hikes and to protest teacher evaluations and provisions dealing with jobs for laid-off teachers. The strike closed over 400 of the city’s 578 schools, put about 350,000 students in limbo with no supervision and no place to go, and left parents desperate to find some type of accommodation. With the average public-school teacher salary in Chicago at $74,839—versus $56,069 nationally—striking for a 16 percent salary increase over four years seemed outrageous to many Chicago parents, particularly when general wage growth had been barely 1 percent per year.
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But perhaps Chicago teachers felt they needed to get what they could now, knowing that they’d have to give back on pensions later.
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The biggest problem for state and local governments is how pension costs are crowding out other budget items. Consider the California cities of San Diego and San Jose. In San Diego expenses for the city’s retirement fund increased from $43 million in 1999 to $231 million in 2012 and now comprise the equivalent of 20 percent of the general-fund budget. However, even as the city budget grows, San Diego is actually lowering its current payroll, with the total city workforce down 14 percent since 2005.
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In San Jose the city’s pension expense increased from $73 million in 2001 to $245 million in 2012.
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The latest payment is equal to 27 percent of the city’s general-fund budget, which is the same percentage by which San Jose has downsized its workforce over the past decade. As both of these cities work through a tough economy and an even worse housing market, the retirement-benefits problem looms larger, even for traditionally prounion Democrat lawmakers. San Jose mayor Chuck Reed, a Democrat, called reforming pensions “my number one priority because it’s the biggest problem we face. It’s a problem that threatens our ability to remain a city and provide services to our people.”
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San Diego’s Republican mayor Jerry Sanders took a similar tack: “If we continued to have hugely escalating pension costs every year,” he told
Governing
magazine, “we simply could not sustain any level of service in the city of San Diego.” The people agreed, and with two historic ballot measures, voters approved trimming retirement benefits for government workers in both cities so that more dollars could be allocated to productive means rather than for pensions and retiree health-care costs.
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Again, what this all this boils down to is the simple fact that there is not enough money to go around. All sides need to give. If compromises cannot be reached, the only alternative may be bankruptcy, and as alternatives go, bankruptcy has pitfalls for everyone involved. In government bankruptcy proceedings, coupon payments to muni investors and pension payments to former state employees have “senior” status. That is, they take priority over funding of basic social services like education, police protection, and road and bridge maintenance. In other words, municipal bondholders and pensioners have equal and first claim on tax receipts, and all other spending is subordinate to those payments. Something often forgotten is that the deal on the table is often better than the one determined by the courts. Consider Central Falls, Rhode Island. When the unions couldn’t agree on appropriate concessions, the town was forced to declare bankruptcy. The ultimate pensions granted to the unions were far worse than the ones the city of Central Falls had been offering during negotiations, so much so, in fact, that other cities and towns in Rhode Island were scared enough to fall in line on one of the most sweeping pension reforms yet in this country. Rhode Island’s state treasurer, Gina Raimondo, is now the go-to adviser on pension reform to politicians across the country.