Monday, November 06, 2006

Looming Trouble with State and Local Employee Pensions

Mary Williams Walsh brings us all up to date on the problem in today's New York Times:

Across the country, government workers’ pensions are protected by guarantees even stouter than those on pensions in the private sector. The legal promises, often backed up by union contracts, cover more than 15 million people.

Years of supporting court interpretations have enshrined the view that once a public employee has earned a pension, no one can take it away. Even during New York City’s fiscal crisis 30 years ago, no existing pension promises were reduced.

But now a number of state and local governments are quietly challenging those guarantees. Financially troubled San Diego is the highest-profile example, but a handful of states, cities and smaller government bodies have also found ways to scale back existing promises and even shrink some current payments.

While still only scattered cases, these examples may be an early warning sign of what could be coming elsewhere. As local officials take stock of unexpectedly large obligations to retired public workers, some are starting to question whether service cuts, sales of government property and politically acceptable tax increases can ever go far enough to bring things into balance.

And it's not just retirement income benefits:
Governments are also studying the guarantees on retiree health benefits because of a new accounting rule that is now requiring them to calculate, for the first time, the total value of the health benefits they have promised to retirees.

The numbers now being disclosed are daunting. Mercer Human Resource Consulting estimates that when all the calculations are done, the nation’s states and cities will find they have promised a total of about $1.4 trillion, said Derek Guyton, a senior consultant.

Little, if any, money has been set aside to fulfill these obligations.

We'll be hearing more about this issue in the coming years, as the bills come due in more places and other localities join San Diego in its financial woes. (For example, see Walsh's earlier article from August.)

If there were anything with which to take issue in the article, it would be the title, "Once Safe, Public Pensions Are Now Facing Cuts." Safety comes from direct ownership or a binding guarantee. Public sector employees are in a situation where they thought they had more of a guarantee than they do. If you were open to attack but weren't attacked, were you really "safe?"

As a matter of policy, when focused on replacing income in retirement beyond Social Security, I'd much prefer the transparency and ownership of a defined contribution or 401(k) plan to the vague promises of a defined benefit plan, acknowledging that running such a plan effectively requires thoughtfulness applied to plan design and participant education.


doc said...

This is hardly a new problem, nor is it a problem that we couldn't see coming. When I left a public university in Illinois in 1987, to take a job at a public university in Indiana, the first thing I did was remove all the accumulated retirement contributions to which I had access in the Illinois Teacher Retirement Fund. Even in 1987 the funding gap was large and serious. Fortunately, in my opinion. Indiana's public university retirement plan for faculty is TIAA-CREF, a defined-contribution plan, in which any shortfall in contributions would be immediately noticed--and immediately responded to. Which would suggest that I'm in general agreement with your position. I do thnk, however, that a national, public, defined benefit program--such as Social Security--is needed to provide a floor for retirement incomes. It is, for me, a question of having a diverse portfolio of retirement income.

Chip said...

Professor Samwick -- thank you very much for your post. I read it relative to the ongoing burst of the national housing bubble. It reinforces my view that the burst/bust/crash will be longer and deeper than all but a few had forecast. When insecurity seeps into the minds of so many people who thought they had a solid gold pension locked up, I believe it will put more and more of them off buying another home or incurring any additional mortgage debt. Still to be addressed is the number of local-government layoffs and terminations that will be required to deal with falling property tax revenues, a windfall squandered by the great majority of taxing entities.

Finally, and tangentially related to your post, I think there is potential for significant losses by these state and local employee pension funds as a direct result of their investment in mortgage-backed securities and related hedge funds.

PGL said...

Doesn't Alicia Munnell follow these types of plans? Has she commented on this issue?

monkyboy said...

Assuming American workers became as thrifty as their Chinese and Japanese counterparts...

And assuming their increased investments would represent claims on someone's future income...

Would there be enough income in the future to pay everyone's pension and the wages of everyone working then?

Lord said...

I'd much prefer the transparency and ownership of a defined contribution or 401(k) plan to the vague promises of a defined benefit plan

But I doubt the recipients will think so when retired. While many states and localities will have shortfalls, some no doubt will be solvent, and the solvent ones will appear superior to many contribution plans.

A plan that combines some features of both may be best, but the agency problem is severe no matter who is in charge. Clear accounting and disclosure is a necessity in any event.

chris edwards said...

We came up with the same $1.4 trillion estimate for unfunded state health costs. See here

Chris Edwards
Director of tax policy
Cato Institute

Anonymous said...

This is an important and useful article, because it highlights the fallacy of considering publicly-run defined benefit programs as "risk-free" for participants.

The risk to participants in such plans is that the government will not adequately fund the program and that participants will need to accept cutbacks.

This is a foreshadowing of what is to come on Social Security. As efforts to shift the program to a partially advance-funded basis have been, for now, obstructed, the program remains out of balance, an imbalance that is partially obscured by the misleading nature of Trust Fund accounting.

Much of the argument against reforming Social Security has turned on the question of "risk," but the reality is that participants face enormous risks under the current program, and those risks will be exacerbated as long as the current system remains unreformed. The problems in the Soc Sec system and these state and local pension plans mirror one another; they are examples of how public servants find it easier to duck the hard choices until the problems become so large that they cannot be resolved without an immediate adverse impact upon beneficiaries.

HitTheBid! said...

"I'd much prefer the transparency and ownership of a defined contribution or 401(k) plan to the vague promises of a defined benefit plan..."

1) you're a highly educated economist, so of course you would
2) a defined benefit plan is vague? its pays out a defined is that vague? there may be vagueries with respect to whether or not your govt or private entity will welch on it, but it is defined.
3) have you thought about the vagueries of a 401k plan? do you know what your tax rate is going to be when you retire and take that lump sum? I didn't think so.
3) its much more complicated than you think.
4) I am a firm believer in the value of "social insurance", especially in this day and age...basing retirement and health care policy on employment is whats outdated...especially in this era of glibalization and collapsing labor margins.

Andrew Samwick said...

Interesting points. Here are some quick replies:

2) Ask the workers in the auto, steel, and airline industries whether they think their pension promise could now be deemed "vague."

3) I don't know exactly what my tax rate will be when I retire, but that would also affect the payouts from a defined benefit plan. The uncertainty in the nearer term tax rates on the inside buildup is more of a difference, but probably not a big one.

4) You are absolutely right--we are suffering from this notion that we can still do social insurance effectively through employment.