Fate of the States: The New Geography of American Prosperity (9 page)

The overdependence on real estate had a profound impact on state revenues, sometimes in indirect ways. When the value of a family’s house declines—even if that family has no intention of selling and the breadwinners are gainfully employed—there is still an emotional and psychological toll. Call it the reverse wealth effect. They are less inclined to splurge on big-ticket items, they put off renovation projects, and they just generally spend less. All this leads to even further declines in tax revenue. States then have to increase taxes, cut spending, or both, which results in less discretionary income for those who are employed and the loss of all income for some with government-funded jobs. So the debt hangover is a double whammy for everyone—a gruel diet of reduced spending with a side order of higher taxes.

Pensions: The Debt Bomb Nobody’s Talking About

Back in the early 2000s—when Silicon Valley was still flush and the California real-estate market was soaring—Lou Paulson, then head of the Contra Costa County, California, firefighters’ union, negotiated a sweet new contract for his members. Veteran firefighters could now retire at age fifty with an annual pension equivalent to 90 percent of their final salary. “There was plenty of money around,” said Paulson. “To go back to that time, things were really good.”

That was about to change. After the housing bust, Contra Costa’s tax revenues plummeted. In order to avoid the closure of six fire stations, the firefighters’ union proposed a November 2012 ballot initiative that, if approved, would levy a new $75-a-year tax on every county homeowner. Kris Hunt, director of the Contra Costa Taxpayers Association, was outraged that the firefighters would ask more from taxpayers when it was the spiraling cost of firefighters’ own pensions forcing the county to shutter stations. Hunt’s group responded by publishing the names of every retired Contra Costa County employee with a pension of $100,000 a year or more. As it turned out, there were 665 members of this $100K club, including 24 whose pensions exceeded $200,000. Of the 665, 268 were firefighters—which meant there were more retired firefighters with a $100,000 pension than there were current firefighters on the job (261).

One of the $100K club members was a fifty-five-year-old retired fire captain named Jaad Ajlouny. Ajlouny said he was blindsided by the catcalls from angry voters—folks who not so long ago had gone out of their way to thank him for his service. “Just sitting around in a bar, you know, minding my own business,” Ajlouny recalled in a radio interview, “and a guy yells over: Hey, Jaad, come on over here and buy me a drink with that retirement I paid for.”

The Contra Costa ballot measure failed. Everybody might still love firefighters, but what they did not like was retired fifty-five-year-olds taking home $100K a year at a time when many taxpayers were out of work and could not afford to put any money aside for their own retirements. One such no voter—Matt Heavy, a construction worker who had gone through a tough period—told NPR in an interview that the firefighters were being unfair: “I felt hostage . . . either pay the extra money or we’re going to start shutting down stations. And the bottom line is the reason that they’re asking for the money is because the pensions are just skyrocketing.”
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A ballot measure that was intended to save six firehouses had morphed into a local referendum on pension reform. “After 10 years of being driven by pension costs,” said Dan Borenstein, a columnist for the
Contra Costa Times
who opposed the measure, “[the prevailing view was] we’re not going to let you put the cart before the horse. You’ve got to show us you’re serious about controlling costs before we’re willing to go along with the tax increase.” Stories like Contra Costa’s are sure to play out again and again and again simply because state and local governments don’t have the money to pay for the retirement packages they once promised public employees. In 2009 new Governmental Accounting Standards Board (GASB) rules finally exposed how much pension debt elected officials had incurred on our behalf. The numbers were two years old, but it was disclosure nonetheless. As of June 2008, states were on the hook for over $452 billion in unfunded pension debt on top of what they owed by way of traditional municipal debt (note, both guaranteed by the future taxes of their residents). Even scarier, those numbers were before the worst of the credit crisis—and each state seemed to have its own unique way of crunching the numbers. Indeed, the next year’s financial disclosures revealed that these unfunded pension obligations had grown 50 percent in just one year’s time, from $452 billion to $678 billion.
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Adding the amount of heath-care and other benefits states owed, and that number ballooned to $1.3 trillion in 2009. As of 2011, that number was $1.4 trillion, and that is not counting municipal-bond obligations.
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With not nearly enough money to go around, the impending war over public-employee pensions threatens to be one of the more vicious political debates this country has seen, pitting Americans against Americans, neighbor against neighbor. On one side there’s the public-sector employee, who worked an entire career—sometimes at a pay level below what she could have earned in the private sector—under the assumption that her job would provide a secure (and perhaps early) retirement with few financial worries. Until now, she hasn’t had to worry much about retirement. After all, a great retirement package, generous vacation days, and a better work-life balance are part of what attracted her to public-sector work in the first place. On the other side of the debate there’s the guy in the private sector who lost large chunks of his 401(k) savings in the stock market and perhaps even had to tap those savings for living expenses after losing a job. Now he’s being hit with higher taxes and continued cutbacks to basic public services. The fight is not just political but constitutional too: Courts are now deciding whether municipalities can use ballot measures and bankruptcy laws to void or change public-employee pensions.

At the heart of the problem is a difficult truth: There’s not enough money to pay for everything, and by law, pension payments trump most other types of spending. Tax revenues are down, bills keep rising, and spending keeps growing. But based on the official pecking order, pension obligations and municipal-bond debt service must be honored before any money can be funneled to everyday expenses for education, police protection, road repair, and other essential services. Because so many baby-boomer teachers are now retiring, taxpayers are being called on to pay more but are actually getting less in return. Pension and health-care costs are increasingly crowding out other line items in state and municipal budgets. The number of retirees drawing a pension is growing, but the number of workers contributing to the pension plan is declining (which is the same scenario that led to GM’s demise). Back when overall tax receipts were rising, this disconnect went largely unnoticed. But with revenues as strained as they have been for the past five-plus years, crowding out has become a real hot button in communities across the country. “I went toe to toe with the public unions looking out for the kids of Rhode Island because if we didn’t fix those pensions, there would be no good public schools,” says Gina Raimondo, treasurer of Rhode Island.
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Taxpayers are asking some very pointed questions. “Why is my neighbor’s pension payment more important than my daughter’s right to a good education in a class with a low student-teacher ratio?” “Why are we laying off police officers and letting crime rates spike to pay pensions for retired cops who now live out of state and don’t even pay local taxes?” Public employees have a reasonable response: If taxpayers don’t like the terms of their union contracts, then they shouldn’t have elected the mayors, school boards, and city council members who approved them. Of course, mortgage lenders had a similar type of response—if you don’t like the terms of your adjustable-rate mortgage, why did you sign the papers?—but their argument was overwhelmed by financial realities. In the aftermath of the housing bubble, the priority of payments got flipped. Consumers who had once paid their mortgage bills before anything else—they couldn’t risk losing the equity in their homes, after all—suddenly started giving precedence to car and credit-card payments over their mortgages since they no longer had any home equity to protect. The priority of payments for taxpayers is about to undergo a similarly dramatic shift.

Years from now, 2008 will prove to be a turning point in American history. In just one year the Dow lost 33.8 percent and the S&P lost a staggering 37 percent. For many Americans this meant huge portions of their retirement nest eggs; their IRA and 401(k) savings suddenly evaporated after years of scrupulous saving. Factor in job losses and destroyed home values, and the retirement hopes of many Americans faced some serious downgrading. No more beach houses. No more summer homes on the lake. The dream now is just having enough money to live comfortably.

But not all retirement dreams have been downgraded—certainly not those of state and local government employees and retirees. Not only didn’t they have to contribute much money, if any, to their retirement plans, but the payments they receive postretirement are guaranteed by tax dollars. The ups and downs of the stock market had little bearing on their retirement plans. As their neighbors wept over their year-end 401(k) statements, public employees barely even looked at theirs. Their retirement was money in the bank.

For decades this divide wasn’t something broadly discussed because the trade-off seemed reasonable. Even as the private market largely abandoned pension funds in exchange for employee-driven and paid-for retirement plans, the fact that the public sector was still sticking to the same old system got little attention. Rather, most understood that there was a fair trade-off between working for the private sector, where benefits might be less generous but salaries were higher, and working in the public sector, where lower pay was offset by a more secure retirement. Moreover, being a police officer or a garbage collector can be dangerous, unpleasant work, so it makes sense to offer some incentives to get people into those jobs. After all, the work-related fatality rate for police officers (nineteen deaths per hundred thousand people) is four times higher than that of the average American worker.
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The problem is, the size and cost of those incentives seemed to grow exponentially. In 2012 the Bureau of Labor Statistics compared compensation (both salary and benefits) for state and local government employees with that of the private sector, and the differential was a staggering 34 percent—in favor of the government employees! Today, “pensions” are almost uniformly associated with the public sector and never discussed in the private sector—unless the topic is reducing or eliminating them.

Generally, in the private sector an employee is on his own when it comes to retirement savings. Ironically, however, that same employee is on the hook for the public sector’s retirement savings. In other words, a dry cleaner working for himself is responsible not only for his own unguaranteed retirement but also for the retirement of his next-door neighbor, the county judicial clerk. The outrageousness of this guarantee became clear when, in 2009, under directives from the Government Accounting Standards Board, states first disclosed both the size of the pension obligations and how much elected officials had looted from pension funds—usually by borrowing money from pension funds and promising with IOUs to repay it in the future.
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Aside from suffering dramatic declines from the equity markets over the past decade, pensions have also been the secret slush fund of elected officials. Monies from pension funds are not withdrawn all at once; it’s an ongoing payout as employees retire. Therefore, as long as the retiree is getting his or her check on time, nobody worries about where the money is coming from. By design, officials can offer grand promises of future benefits with little sacrifice today. For example, rather than give a public-employee union a pay raise, which could affect a city’s ability to balance next year’s budget, mayors can offer future cost-of-living adjustments on employees’ retirement plan. These COLAs are effectively built-in annual raises on pension benefits. Over the past decade, while real wage inflation has been just 2 percent annually and closer to 1 percent more recently, many retirees have gotten annual increases of 3 percent or more from their pension payouts. So in reality, pensioners have done a whole lot better than workers. But at some point, when those future promises become current-day realities, there won’t be enough money. That time may be upon us sooner than you think. Josh Rauh, of Northwestern’s Kellogg School of Management, believes that by 2025, over half of states’ pension funds will run out of money.
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There are other examples of abuse in the pension system that I will describe later, but first here’s a quick primer on how pension accounting works. Today states owe nearly $3 trillion between bonded debt, unfunded pensions, unfunded health insurance, and other benefits. Over half of this relates to benefits for past and current state and local government employees. But even among neighboring states conditions vary greatly. For example, in Illinois the total tax-supported debt per capita is $20,000, but next door in Indiana, that number is a mere $2,000—one-tenth of the pension debt Illinois taxpayers are on the hook for.
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Under most private-sector retirement plans in the United States, postretirement payouts depend upon how much an employee has put into the plan—usually a 401(k)—how long the employee has been contributing to the fund, and how well the underlying investments have performed. Weakness in any of those three variables reduces the ultimate payout. Of course, how much an employee contributes to a fund and for how many years are factors under the employee’s control, depending upon how much money he can afford to put aside. And as we have learned over the past “lost decade” of zero market returns, investment results are highly volatile. The market crash of 2008 wiped out a decade’s worth of gains for some employees. There are no guarantees under these plans; the employee bears all the risk. How well the fund performs and how much the employee puts in are often the only determinants of how much money will be left at retirement.

Government pension plans work very differently from private-sector 401(k)s and IRAs. Under government pension plans, the employee contributes little, typically less than 10 percent of the total contribution. The taxpayer is responsible for the rest, and those contributions start on the very first day of employment, whether there is money available or not.
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There are imbedded annual COLAs meant to be buffers against inflation, yet those adjustments are not tied to any particular inflation metric. In a low-inflation environment, they’re akin to pay hikes. The average COLA is around 3 percent per annum. Note that average wage growth has been 2 percent for most of the past decade—and 1 percent more recently.
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