Pensions: How states and local governments indulge in deficit-spending

I’ve finished While America Aged, whose last third is devoted to San Diego. GM was bankrupted by foolish executives, convinced that the auto market would continue to grow, that GM would continue as the leader of an oligopoly for North America, that health care costs would remain low, and that American life expectancy at age 48 would not grow. The New York transit system and then city were bankrupted intentionally by politicians, who were sure that handouts to public employee unions would win them reelection and that the collapse would come at a time when they’d moved on to higher offices. The City of San Diego is sort of the same story as New York, with public employees retiring earlier and earlier and the pension system not being sufficiently funded (though in reality it is almost impossible to fund a defined benefit pension for people who retire at age 50, especially if the benefits are adjusted for inflation; how can anyone know what interest rates or the economic situation will be like 50-80 years from the present?). Both New York and San Diego set up fenceposts every year. If between the fenceposts the stock market had done exceptionally well, the pension “surplus” would be paid out to retirees. If the market later fell back there was no way to recover the money. Given sufficient stock market volatility, both cities’ pension funds would have been reduced to zero within a few years (because after a big random upswing all of the money would have been paid out and then the remaining assets would have shrunk down to almost nothing).

New York City was bankrupted by Democrats who taxed their residents at some of the highest rates in the nation, spent all of that money, and then spent a lot more in the form of unfunded pension promises. The taxes were so high and services and crime in the city so bad that businesses and residents began migrating to Connecticut and New Jersey even before the financial house of cards collapsed in the mid-1970s. San Diego was bankrupted by Republicans who taxed their residents at comparatively low rates. The city kept growing but not at a rate fast enough to keep up with the growing unfunded pension liability. The problems were exacerbated by fraudulent disclosures in bond offerings, e.g,. “we are not underfunding pensions”, and conflicts of interest, e.g., the president of the fireman’s union was on the board of the pension fund and proposed then approved changes that would add $30,000 per year to his pension and have no effect on any other city employee, past or present.

One message of the book is that the corporate managers who agreed to massive pension commitments were uniquely short-sighted. They were mostly in industries with little competition, either due to oligopoly or government regulation. As soon as competition developed (autos, steel) or government deregulated (airlines), the companies would go bankrupt, a disaster for the shareholders but not for the country. Smart modern companies don’t offer pensions because they’ve have figured out what should have been a simple fact: the only enterprises that should be offering to send people a check every year for the rest of their lives are insurance companies (if they write annuities and end up paying twice as much as planned because of an innovation that extends human life they will save a corresponding amount by not having to pay out life insurance claims) and ones that have a printing press for money (i.e., the federal government).

Cities and states have a tougher time escaping pension commitments and traditional bankruptcy protection may not be available to them. If every household in San Diego owes $6,000 for unfunded pension liabilities, property owners and residents will have to cough it up in the form of higher taxes. If the pension fund does poorly in the stock market, the households will have to pay again.

We the people share a lot of responsibility for bankrupting our own towns and states. We vote for politicians who promise the moon but don’t immediately tax away all of our income and wealth. A politician who promises $2 in benefits and $1 in taxes will win an election over one who promises benefits equal to taxes. The federal government respects voters wishes by running a visible deficit, borrowing or printing money to cover shortfalls. The Federal government can’t truly be bankrupted by its obligations because it can simply print money to pay everyone back.

Local and state governments, however, are generally prohibited from running deficits. If they borrow, it is supposed to be for capital projects such as building roads or schools. They can do some Enron-style accounting to make it look like they are borrowing to build a new library and then skim money off to pay operating costs, but a city or state cannot simply say “We’re going to spend more than we’re taking in.” They can’t say it, but they can do it. The key is offering and then underfunding pensions for governnment workers.

If a worker is eligible to retire at age 41 (Boston bus driver) or 50 (many California state workers) and receives a lifetime pension comparable to final year’s salary, actuarially roughly half the cost of employing that worker is from the pension. If payroll is half of a state or local government’s budget, not funding the pension at all is financially equivalent to spend $1.50 for every $1 of taxes collected or running a deficit of 33% of total spending. By choosing a funding percentage every year, a government can elect to engage in deficit spending between 0% and 33% of its budget.

The early retirement ages agreed to by governments inevitably exacerbate the financial challenge. Because health insurance is tied to employment and our 41-year-old retired MBTA worker won’t have a job, the MBTA’s customers are now responsible for his health care up to age 65 when Medicare takes over most of the cost. For a worker who is currently aged 20, the MBTA is promising to pay whatever health care costs prevail in the years 2030 through 2054, both for the worker but also anyone whom he chooses to marry and for any number of children that he chooses to have. How can they possibly know what this will cost? Blue Cross won’t sell insurance for more than one year ahead. What does the MBTA know about health care costs in the year 2054 that Blue Cross doesn’t know?

A lot of newspaper ink and television time is spent fretting about Social Security and Medicare/Medicaid. These programs, however, cannot implode. The government at any time can raise the age of eligibility for Social Security and immediately any funding problems disappear. It might be 75 in 2020, 80 in 2030, and 85 in 2040. Similarly the government can decide not to cover expensive procedures or drugs under Medicare/Medicaid. Alternatively, the federal government can print money and hand it out to those entitled to Social Security and Medicare/Medicaid.

The more serious problem is with state and local governments. Their obligations for pensions cannot be ducked and will fall on the shoulders of residents unlucky enough to remain within the taxing jurisdiction that owes the money.

What hope does the author give us for a solution? Precious little. You know that a problem is tough any time that hundreds of pages of descriptions of the problem flow easily and the suggestions seem tacked on as an afterthought. He says that public employeers unions are now so large, entrenched, and politically powerful (literally able to vote their bosses out of a job) that it is hopeless to consider reducing pensions for government workers. The only hope is to put massive amounts of money aside at the time pension commitments are made, relying on actuarial calculations. He fails to note that actuaries are forced to make a lot of assumptions, all of which proved to be untrue in the Crash of 2008. The stock market might collapse. Interest rates might fall to zero. The U.S. economy might go into a prolonged period of decline and deflation. All of these contingencies could be insured or hedged against, but the counterparty risk would be significant. What good would it do for a state to get an insurance company to agree to pay $100 billion in pensions thirty years in the future? The insurance company might not be solvent in 30 years and the federal government might not decided to bail them out. The state or local government is promising to protect the lifestyle of a present-day 19-year-old worker in the year 2100 when he turns 110. “State government” here includes basket cases such as Michigan and “local government” includes Flint, Michigan (very likely to have be reclaimed by forest before 2100).

More postings on the same book: “History of Public Employee Unions”; one on the General Motors section.

11 Comments

  1. Colin Summers

    September 18, 2009 @ 1:41 am

    1

    I know what the solution will be.

    A huge pension fund will collapse and the public employee unions in several states will force the federal government to come in and “take over” the pension funds and make good on all the promises. see also: General Motors.

    GM should have failed and those collecting the pensions would have gotten zero. Instead they rattled their labor union sword and underpaid regional jet pilots are now paying the pensions of autoworkers who are sitting at home on the couch.

    Is this why everyone moved to Bermuda when they got older? Shelter the money, get the hell offshore and away from this mess?

    What is the smart move in this growing mess?

  2. Joe Internet

    September 18, 2009 @ 4:27 pm

    2

    Heck, just found this good one:

    Definition of “pension”: “An allowance made to any one without an equivalent. In England it is generally understood to mean pay given to a state hireling for treason to his country.”

    Johnson: A Dictionary Of The English Language. (A selection of definitions can be found here.)

  3. Michael

    September 19, 2009 @ 12:25 pm

    3

    Pensions seem to be such a foreign concept for someone like me, a software developer. Companies in this industry rarely ever let employees stay with them long enough to reach retirement. There is always a reorganization or layoffs happening, regardless of how the economy is doing. That is, if they even bother with full time hires. In today’s market contractors with no benefits at all seem to be more and more often the normal way of hiring.

  4. Pavel

    September 20, 2009 @ 12:38 am

    4

    Some of these public pension programs may also go bankrupt up here in Canada. Our politicians are basically set for life after two terms in office (usually around 8 years). Our teachers also have pension plans that are most likely unsustainable.

    Although the Canadian Pension Plan (CPP), which gives minimal support to live after the age of 65, seems to be holding for now because the government increased the required contributions (which are mandatory for every Canadian over 18 years). Right now you can get a maximum of $884Cdn per month (after the age of 65) and an extra $462Cdn per month if you are older than 65 and lived in Canada for at least 40 years. Not much, but it should allow you to live if you own a place to live and have no debt, even if you did not save any money.

    The rich pension plans that the public sector employees get, both in the US and Canada are totally unsustainable and will go bankrupt, or they will bankrupt private industry. One solution would be to provide some sort of minimum pension after the age of 65 (like in Canada) If you want to retire early or you want to travel the world you will have to save and plan your own retirement without some public pension ponzi scheme to help you.

    As for the politics involved the unions have to be told directly that the public has no more money. At this point they can raise the contribution rates to cover the pensions or cut the amounts of pensions and the age at which they can receive them. It does not matter what the contract says if there is no money, its like trying to get money from a bankrupted company with no assets, no matter what the court says the company has no money. We have to abandon the concept that the state can always print more money, unless we really want society to end.

  5. CHenry

    September 20, 2009 @ 9:45 am

    5

    There is a solution, and it comes from regulation through a commission, apart from the Congress. State and local governments must be prohibited from making unfunded pension liabilities. Every “guaranteed” pension fund has to be fully funded with no delays. No cut-rate default “insurance” from the federal government unless the states comply. (And the local governments worst-case scenario is a government bailout.) The bailout plan should be social security under the same terms as received by everyone else. Let the local governments buy a supplemental private pension default policy that covers any gap between promised benefits and the benefits they have adequately funded. I imagine the private insurance market will do a better job at keeping them honest than will the voters.

    The State of California will likely become both the largest residential landlord and residential property lien holder before too long (if they aren’t already.)

  6. philg

    September 20, 2009 @ 9:37 pm

    6

    CHenry: Your ideal of “fully funding” pensions is a good one except that I don’t think anyone can agree on what would constitute full funding. An MBTA employee can retire at age 41. He easily might live to 111. Suppose he is eligible to retire in 2030. How much exactly do we put aside now to ensure that we can be paying him a comfortable inflation-adjusted full salary in the year 2100? There are very few financial instruments that go out 90 years.

  7. Hubbert

    September 21, 2009 @ 1:28 am

    7

    While the current experience is unique (Baby Boom demographic issues plus an unprecedented ratio of public to private employment and unprecedented gap between public and private compensation, what’s the broader historical context?

    Otto von Bismarck instituted a pension/retirement system in 1889, and other countries may have followed not much later. Given 120 years of history times several countries, what similar situations have occurred and how were they handled?

  8. Jeff

    September 21, 2009 @ 8:26 am

    8

    I would’ve thought that switching from defined-benefit to defined-contribution would work, but then this happened:

    http://money.cnn.com/2008/05/19/pf/retirement/West_virginia_pensions.moneymag/index.htm

    I don’t remember if you’ve covered this but in West Virginia, teachers were switched to a defined-contribution retirement system in the early 90′s. The returns were bad because the teachers didn’t pick the right investments and because the administrators picked crappy investment vehicles (annuities?!). Anyway, they got a chance to rejoin a defined-benefits system but not based on the value of their 401k. With a flick of a pen, West Virginia screwed it’s taxpayers even more.

  9. philg

    September 21, 2009 @ 2:09 pm

    9

    Hubbert: I don’t think that you can draw too many lessons from the great von Bismarck. In their original form, pensions were much lower than working salaries, the working-age population was growing continuously, and people did not start receiving a pension 40+ years prior to their expected year of death. A pension that is close to 100% of a worker’s salary, a gradual shrinkage in the ratio of the number of workers to the number of retirees, and pension payments that stretch for decades longer than the period of years worked all make our current situation much more difficult to fund.

  10. jmorgan

    September 29, 2009 @ 6:38 pm

    10

    New York City was bankrupted by Democrats AND Republicans: Nelson Rockefeller and Malcolm Wilson were Governors in the 1960s-early 1970s, and John V. Lindsay was elected as a Republican. And let’s point out that Democrats also RESCUED the city: Abraham Beame, High Carey and Felix Rohatyn. More salient, the current egregious public pensions in New York City were agreed to by the two Republican Mayors of the last 16 years: Giuliani and Bloomberg.

    As a former Michigander– not a resident of Massachusetts with keen insight into Michigan cities– I doubt if Flint will be forest in 91 years. There’s valuable infrastructure there, land is cheap, and it’s in a location near an increasingly scarce resource: large quantities of fresh water.

  11. Gary

    May 23, 2010 @ 10:15 am

    11

    It used to be that federal workers were enrolled in a pension plan. A Fed hired under the “old” system can retire at 55 with 30 years of service, 62 with 25 or 65 with 20 years.

    Reagan changed it in 1987(?) so that new hires had to contribute to Social Security and their own 401k (called TSP), with matching.

    I work with people in their late 40s today who should be able to work until they are least 65, but they stop working when they are 55–because they can, even though they work desk jobs. At least with the new system, you’ll see Feds working until 65 at a minimum.


    “A democracy cannot exist as a permanent form of government. It can only exist until the voters discover that they can vote themselves largesse from the public treasury. From that moment on, the majority always votes for the candidates promising the most benefits from the public treasury with the result that a democracy always collapses over loose fiscal policy, always followed by a dictatorship. The average age of the world’s greatest civilizations has been 200 years.”
    — Alexis de Tocqueville

    I hope ours lasts longer.

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