Municipal Bankruptcies: It’s Not Just the Pensions

Municipal Bankruptcies: It’s Not Just the Pensions

Detroit has recently joined Stockton and San Bernardino in filing for bankruptcy.  It’s the largest city in the U.S. ever to go this route.  How Detroit resolves its inability to pay in full the promises it has made to creditors and retirees will affect municipal bond holders, the insurers that guarantee such bonds, state and municipal public-sector workers, and, of course, many American taxpayers.  But with out-of-control municipal pensions taking center stage in the media, you might think that solving the pension problem is all that’s required.  Don’t believe it.

The Motor City’s problems have actually been decades in the making.  They have arisen as the result of unrealistic commitments made by past city leaders to their employees.  It has always been easier for politicians to promise generous retirement benefits to public servants than to raise their wages.  That’s because politicians are held accountable for budgets only while they are in office.  By the time any future promises must be paid for, those politicians that made them are long gone.  Fiscal responsibility has never been a requirement for elected office.

But that’s not all.  Not only is there a lack of accountability for decisions involving future payments, the accounting standards themselves are seriously flawed.  Municipalities have been allowed to discount their future pension and health care liabilities at rates as high as 8% on the assumption that they will be able to earn that much on pension contributions.   The higher the discount rate, the less the municipalities are required to contribute upfront.  The problem is that getting returns of 8% require investing in risky assets such as stocks.  We all know what happened to stock portfolios in 2008, not to mention the consequent impact on municipal finances.  Insurance companies that sell annuities, by contrast, do not invest their annuity premiums in stocks.  They follow the much more conservative approach of utilizing high quality bonds for investment growth and matching the bond durations to the timing of the liabilities, a methodology known as immunization.  That’s one reason we haven’t seen insurance companies declaring bankruptcy at the same rate as cities.

The impact of unrealistic growth estimates can be huge.  According to The Economist, the Center for Retirement Research (CRR) at Boston College calculates that states’ pensions alone are 27% underfunded even with the assumption of 8% growth.  That adds up to a shortfall of $1 trillion.  Assuming a more realistic discount rate of 5%, the CRR reckons the shortfall could be as high as $2.7 trillion.  What’s more, states on average are paying only about 80% of their required annual contributions.  On that basis their pensions may be as much as 52% underfunded.

The underlying economics of pension funds have also deteriorated over the past several decades.  Fewer workers are supporting more pensioners.  The Economist reports that New York City now has more retired policemen than working ones, and spends more on police pensions than on police wages.

Health care for current and for retired workers is the other huge commitment that is putting pressure on state & municipal finances.  And health care costs have been growing at nearly twice the rate of inflation for decades.  Detroit’s unfunded health-care burden is actually larger than its pension deficit.  However, with health care, cities have more flexibility in controlling costs.  They can reduce benefits, for example, or require higher co-pays or deductibles.  In contrast, a pension promise of $3,000 per month can only be reduced by breaking it, and the legal guarantees associated with pensions have been difficult to overcome.

Pensions themselves typically include loopholes that allow senior managers and favored workers to glean overly generous payments.  One way is through so-called “spiking,” where public employees inflate their final-year salary by working overtime or cashing in unused holiday time to raise the base from which their pensions are calculated.  According to the Los Angeles Times, former Ventura County executive officer Marty Robinson, who retired in 2011, was able to boost her annual pension to $272,000 per year for the rest of her life based on a final salary of only $228,000.  While states and cities are moving to reign in these abuses, they still currently add to the problem.

Since a city or state’s obligations to its retirees is a burden that taxpayers ultimately have to support, underfunded pensions can also scare businesses and individuals away, making it even tougher for the municipality to be able to continue to pay its bills.  Detroit is one obvious example.  The state of Illinois, with 22% of its general fund currently being used to pay off pensions and service debt, may be getting close to that point as well.  The New York Times reports that its biggest city, Chicago, faces a $19.5 billion pension shortfall for retired teachers and for other retired city workers.

What’s the answer?  There’s no simple one, or it would have been addressed already.  One positive change would be to require public-sector workers to retire later, so that full benefits kick in at the same age as Social Security. An even bigger saving would occur if public-sector employees were to share the investment risk with their employers (see New Adjustable Pension Plan Looks Promising).  Some cities and states are starting to create two-tiered pension systems where newer workers have to contribute more to their pensions or, in some cases, must switch to a defined contribution plan in which the employee bears all the investment risk.

Making pension accounting more realistic would be another significant improvement. Unfortunately, more accurately recalculating each city’s and state’s pension shortfall will likely require larger pension contributions from money that would otherwise go to city or state services.  In the end it will probably take a financial crisis for states and cities to face up to the scale of their problems. When a crisis occurs, public-sector workers, not to mention politicians, are more likely to accept the need to sacrifice.

Lastly, some way of limiting elected officials’ ability to make unfunded future promises also needs to be part of the solution.  Or at least there needs to be some form of consequences.  Detroit is arguing that both pensioners and bondholders should suffer as a result of its bankruptcy.  Rahm Emmanuel in Chicago is taking aim at retirees: “People agreed to something. But things get updated all the time.”  What is being done about all those retired politicians that caused it?


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