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Public Employee Union Benefits Are a Fiscal Disaster


medium (1)State governments are in a huge hole, and they’re still digging. Thanks to the Great Recession, their tax receipts have suffered the greatest decline since the Great Depression: now 12 percent below pre-recession levels (adjusted for inflation). For their 2012 budgets, states face gaps hovering around $140 billion, and that’s on top of previous budget shortfalls of over $400 billion since the recession began.

Federal assistance had mitigated previous-year deficits, but there is now only about $40 billion left in the program. High unemployment will keep state income tax receipts below normal levels. President Obama’s healthcare bill has compounded the fiscal effects of Medicaid expansion on states. Medicaid costs from 1998 to 2008 had already risen four times as fast as the consumer price index, but the new impositions are eating up state budgets as additional support for Medicaid from the federal government will expire in June 2011. Add to this red ink the drop in revenue from the big investment losses experienced by state pension funds.

Some 30 states face a structural budget gap, where ongoing expenses are not covered by revenues. California, for instance, projects a structural budget gap of over $20 billion in fiscal 2012, $22.4 billion in 2013, and $20.4 billion in 2014. New York’s projected gap is $9 billion in 2012, $14.6 billion in 2013, and $17.2 billion in 2014.

States have shied away from making unpopular cuts in core services and state workforces beyond what they have already done. They sowed the dragon seeds in the fat years by buying off service unions with generous pensions, employee contracts, healthcare, pay, and benefits. According to a study by Daniel DiSalvo, a political scientist at City College in New York, state and local workers now earn an average of $14 more per hour in wages and benefits than their private sector counterparts. In general, the average state government worker reaps retirement benefits several times richer than a counterpart in the private sector, a critical reason why public pension costs have become unsustainable. For example, state and local governments contributed $3.04 per hour toward each employee’s retirement in 2007, according to U.S. Labor Department figures, while private employers paid 92 cents an hour.

Public and private sector workers live in separate economies. The public sector unions are flourishing. The private sector has had to let go many of its workers as economic conditions have worsened. They suffer through frequent turnovers, relentless downsizing, stagnant wages, and rising health insurance premiums. They often fund their own retirements through 401(k)’s and similar plans, which rise and fall with the tides of the economy. By contrast, the public sector is a haven of security and stability, where people have jobs for life and performance measurements are rare. Most public sector workers enjoy job security and boast defined benefit retirement programs. The number of government jobs rose even as overall unemployment in this recession jumped past 10 percent.

States may not declare bankruptcy and cannot be sued by creditors. Nor can they be forced to behave by a higher level of government­—and the federal government is broke anyway. Yes, all states, except for Vermont, require annual operating budgets to be balanced. But the definitions of what constitutes revenue is vague enough that it is still possible for states to rack up debts by hiding the gaps through one-shots like asset sales and borrowing.

The most egregious issue is pensions. Many state workers can retire in their mid-50s on close to full pay and, therefore, can receive pensions for more years than they have worked, even though they are young enough to take another job. In this sense, public sector pensions have created a new class of millionaires. Take a pension’s present value; that is how much cash you would need to buy an annuity making payments equal to the pension. In many cases, you would find the cash needed would be well into seven figures. And these calculations don’t even include the value of retiree healthcare benefits, which for many retirees vastly exceed those in the private sector. In a number of states, these benefits include health insurance approximating $14,000 per year for family coverage, which is exempt from taxation.

It has taken a major fiscal crisis to bring these inequities to light. The private sector, which pays for these incremental costs, has now had the chance to focus on them and is in a rage. It now realizes that politicians have been leaving the bills to their successors. If governments do not set aside sufficient funds to honor all the promises, they will be deferring the burden to future taxpayers.

This is a fiscal disaster in the making. Most of the estimates of unfunded pensions are unrealistic, for they use unique valuation methods. Were officials to use accounting practices employed in the private sector, these unfunded liabilities would greatly exceed the estimated amounts and probably approach $3.5 trillion.

According to “The Pension Bomb,” an article by Joshua Rauh of Northwestern University in the January Milken Institute Review, the assets of the systems in seven states and six big cities are likely to be insufficient to pay for promised benefits past the year 2020. If you extend the solvency horizon to 2025 (or perhaps sooner), another 20 states and 24 localities will not have the money. They’ll need substantial contributions to pay for public worker services performed long ago. And if the unfunded parts of these pension bills then have to be covered by current revenues, benefit checks will consume a crushing 20 to 50 percent of general tax receipts. State and local governments could not provide essential services and service their other debts unless they imposed significant tax increases.

About 85 percent of state and local government employees still have access to defined benefit plans. The consequence, as Rauh points out, is that taxpayers, who no longer are likely to receive defined benefit pensions from their own employers, are still promising such pensions to their own “employees”— teachers, police officers, firefighters, administrators, and the like.

When the assets that state governments have set aside prove insufficient, future taxpayers will have to bear the costs. What are those costs? We won’t know until states are required to disclose the magnitude of their unfunded liabilities using discount rates, or yields, similar to private pensions. In the end, it is the taxpayers who are underwriting that guarantee.

The problem is compounded by the difficulties states will face when they try to realize savings by cutting the benefits of current pensioners. You can hear the hullabaloo now. Not only will there be a huge outcry, but the states will also face major legal obstacles. It may even prove impossible to make the cuts demanded by solvency.

What can be done? For one, future outlays for defined benefit plans could be shifted to defined contribution plans. That would at least create no new unfunded liabilities.

This was the message of the mayor of Atlanta to his city employees last year. That is, if they don’t accept the change in the plan, they will eventually have no plan, as a defined benefit system is no more viable or credible than the ability of states and localities to pay their bills in decades hence.

The result may be that a series of state and local government pension trustees will fail their obligations. The federal government would be wise to explore how it could provide a series of incentives to ensure that the states and localities get their off-balance-sheet liabilities under control.

One suggestion that Rauh developed with Robert Novy-Marx of the University of Rochester would be to provide pension funding for the next 15 years by allowing states to issue tax-free bonds, partly subsidized by the federal government. But that’s if and only if the states agree to impose cost-cutting measures, close their defined benefit plans to new workers, fund existing defined benefit plans on an actuarially sound basis, enroll employees in Social Security, and provide them a decent defined contribution plan. Otherwise, we are looking at a huge crisis in municipal finance over the next decade that literally might create a bond market panic. To ignore the problem until the credit markets take notice is a formula for financial disaster. And we have had enough of those. It brings to mind the tale of the man who jumps off a 30-story building and, as he passes the 10th floor, he says, “Don’t worry, nothing’s happened yet.”

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