Disastrous Predictions For State And Local Government Pensions

October 2010

This summer, a pair of university professors released a study regarding the size of state government pension obligations, and possible solutions to the enormous problems. In mid-October 2010, the professors released a similar study regarding local municipality obligations.

Josjua Rauh of the Kellogg School and Robert Novy-Marx of the University of Rochester prepared both studies. Using U.S. Treasury discount rates, they estimated that the states’ existing unfunded liabilities total $3 TRILLION, with the cities and counties adding another $574 BILLION. This is merely the current balance that would need to be funded now if future pension obligations were immediately terminated (i.e., no future obligations for additional service by public employees). And, no, those amounts are not typos.

The first report summarizes:

“There seems to be a high likelihood that future generations will have to bear the substantial burden of making up pension benefits for previous generations of state employees. While citizens of states that are particularly hard-hit by the pension crisis may be able to escape to other states, an acceleration of this demographic phenomenon would leave a dwindling economic base behind in the state facing the largest liabilities. This would increase the likelihood of a federal taxpayer bailout in which taxpayers in all states would bear the burden of the states in default. The problem of state and local pension liabilities is therefore a problem for all U.S. taxpayers, not just those in the states with the largest deficits.”

As an average, the state obligations equal approximately $27,000 for every household in the United States. The local government average obligation equals approximately $14, 200 for every household in the United States, bringing the total state and local existing unfunded pension obligation to over $41,000 for every household in the United States.

The problem is caused by politicians who face short-term labor challenges in their union negotiations. Realizing the disastrous political result that would occur with a public employee strike, the immediate problem is “solved” by promising rich pension benefits that will not be paid until years after the politicians involved are no longer in office. A private business would not dare this stunt because:

1. The pension obligations would make the business entity valueless, and
2. The business would need to initiate current funding requirements that are promulgated by the federal government

However, these two constraints do not apply to state and local governments, thus allowing the problem to fester for years.

Who Faces the Largest Problem?

The obligations are not uniformly distributed geographically. The local obligations are highly concentrated in urban areas, allowing for the possibility of residents moving to suburban areas to avoid the additional local taxes needed to fund these existing obligations. Similar taxpayer movement could occur at the state level, particularly for retirees who need not stay at a location because of employment. In the words of the most recent report:

“Part of the uncertainty stems from the fact that residents of one metropolitan area can move to another area in response to tax increases or spending cuts. At the municipal level, this is particularly stark, as residents can move to suburban areas in response to increased taxes and cut services in the urban areas. The fact that there is such a large burden of public employee pensions concentrated in metropolitan areas threatens the long-term viability of these cities. ... The economic incentives are particularly strong when the city borders on other cities or even other states that are in better financial health. For example, New Hampshire is just over 30 miles from downtown Boston, MA; Delaware is only around 20 miles from downtown Philadelphia, PA; Indiana is less than 20 miles from downtown Chicago, IL; and Kentucky is only five miles from downtown Cincinnati, OH.”

But, practically all states face some problem.

“Based on September 2009 asset values, if state pension fund asset returns have an average return of 8% going forward (the states’ typical assumption), states in aggregate will run out of funds in 2028.... If average returns are only 6%, state funds in aggregate will run out in 2024. This analysis assumes that state inflation forecasts, which average 3%, are met. If inflation is greater, holding the investment outcomes fixed, then even under the highest asset returns, the funds will run out sooner, as many states provide inflation-linked cost of living adjustments (COLAs) to beneficiaries ... If the average returns are 6%, then 31 [state pension funds] will have run out by 2025.”

In California (Fulcrum’s home), even if the state is able to earn a probably-unrealistic 8% compound rate of return, the state pension fund is projected to run out of money in 2030, which (as described in the above quote) is not too different than other states. However, the ratio of annual benefits to state revenues is generally higher in California than in the rest of the country. In California, annual pension benefits are projected to comprise fully 30% of all state revenues.

The following table summarizes statistics for some of the local governments where Fulcrum is located:

Under an extraordinary generous assumption that the plans will be able to earn an 8% compound rate of return, six major cities have current pension assets that can pay for promised benefits only through 2020: Philadelphia, Boston, Chicago, Cincinnati, Jacksonville and St. Paul. An additional 18 cities and counties, including New York City, Detroit, Cook County in Illinois, and Orange County in California would be insolvent by 2025. Los Angeles would be insolvent in 2027. With a less than an 8% compound annual investment return, insolvency occurs much sooner.

The local government amounts are based on a sample consisting of 77 defined pension plans sponsored by 50 major U.S. cities and counties. The sample comprises all non-state municipal entities with more than $1 billion in pension assets, covering 2 million local public employees and retirees. This makes up around two-thirds of total local government employees. The remaining one-third of local government employees were assumed to be comparable to the specifically-estimated plans. A possibility exists that the smaller government entities that comprise the estimated one-third could have been more responsible than their larger counterparts. This might have occurred because (i) decision makers at the smaller entities could realize that the problem is “closer to home”, and might therefore feel a greater responsibility to their constituencies before giving in to government employee workers, and/or (ii) employees at the smaller municipalities might be easier to replace as a group if union strikes are threatened.

How Can the Problem be Solved?

Solving this problem with additional taxes on the “rich” will not work here because the amounts are way too large. Addressing just the states (i.e., ignoring the similar the local issue), the authors explain:

“If states want to remedy this situation over the next ten years with supplemental contributions, total contributions would have to rise by $75 billion annually, again assuming 8% investment returns. For comparison, total 2008 state tax revenues were $781 billion, and annual contributions in 2008 were approximately $100 billion. Thus, annual contributions would have to rise 75% during the coming decade.”

Even moderate policy changes that affect current workers and retirees are highly controversial. But, even if only moderate changes were to occur, the problem would remain. For example, a 1 percent reduction in COLAs would reduce total liabilities by 9 to 11 percent, and increasing the retirement age by one year would reduce total liabilities by 2 to 4 percent. Consequently, more dramatic benefit changes are needed, although even these do not solve the problem. For example, the dramatic changes of (i) eliminating COLAs altogether, or (ii) implementing Social Security retirement age parameters would cut the cost by approximately half. According to the authors:

“The bottom line is that even much more drastic versions of the policy actions currently being discussed don’t come close to solving the problem, since so much of the pension debt is owed to workers who have already retired. ... More than half of the liability is owed to people who have already retired, and the idea of large outright cuts to current retirees is not under serious consideration.”

Studies show that numerous government employees have current take-home pay (meaning, before retirement benefits) that are larger than what comparable workers in private industry are making. Consequently, the retirement benefits are not a tradeoff for poor current compensation. The retirement benefits for the state and local government workers are also larger than what typical private-industry workers receive. Private industry has generally eliminated defined benefit plans, leaving defined contribution plans (like a 401k) as the primary retirement vehicle. For the most part, this major change in retirement plans has not affected government workers. In short, government retirement benefits are generally more generous than what is received by those not working for the government.

To prevent the accumulated past problem from growing, the authors of these studies suggest that the state & local governments close the defined benefit plans, and instead offer a defined contribution plan similar to the federal Thrift Savings Program. Current workers should then be required to participate in the Social Security program. Currently, only around a quarter of all state & local workers are in the Social Security program. The cost to the Social Security program is negligible, (and may actually be a benefit to Social Security) since the state & local governments and their employees would be paying into the program. These steps are not different than what private businesses and their employees are already doing. Not taking these steps runs the risk that current state and local government workers are receiving empty promises that have no realistic means of actually been met.

Personal Investment Impact

Ominously, the professors end their October 2010 report as follows:

“What is clear is that state and local governments in the US have massive public pension liabilities on their hands, and that we are not far from the point where these will impact the ability of state and local governments to operate. Given the legal protections that many states accord to [pension] liabilities, which in a number of cases derive from state constitutions, attempts to limit these liabilities with benefit cuts for existing workers will only go so far. The question going forward is one of how this burden will be distributed between urban and non-urban areas, between state and local governments, among the more and less fiscally responsible states, and between local and federal governments. If this question remains unresolved, state and local fiscal crises may translate into losses for municipal bondholders.”

The last sentence above is of interest to our affluent clients who are being tempted to pour money into municipal bonds because of expected tax increases in 2011 and beyond. Municipal bond capital inflows are quite healthy now. Faced with losses caused because government employee claims often have priority to unsecured bondholders, perhaps this is one trend that you should avoid.

Fulcrum Inquiry performs business valuations, forensic accounting, and litigation damage analyses.