Economic Development

Plight of the Benefits

Retiree costs are moving from the easy promise of a nest egg to the harshness of a political hot potato.
by | April 2006

Governor Bill Owens hopes to get his state's fiscal house in order before leaving office in a few months, but he faces one particularly vexing problem. Colorado's pension funds are more than $11 billion short. There's still plenty of money in the system right now to keep paying annual stipends to retired teachers and bureaucrats, but not enough to satisfy Owens' concerns about adequate funding in the future. If legislators can't come up with a solution he can support by next month, Owens vows to call them back into special session.

Owens isn't the only state or local leader putting himself on the line over pension issues. So have such governors as California's Arnold Schwarzenegger and Illinois' Rod Blagojevich. For good reason: Collectively, states are close to $300 billion short of meeting future pension obligations. And now, with a new government accounting rule forcing states and localities to budget for future promises of retiree health care coverage, retirement benefits are quickly turning into a potential political crisis and a major budget-buster.

The ramifications trickle out everywhere. Pressures to cut spending on non-retiree programs are intense along with counter pressure to cut the benefits themselves. These twin strains may mark the beginning of a profound shift in public-sector employment. Governments have never paid as well as private companies but have usually offered their workers greater security and superior benefits. Now, states and localities might not be able to raise taxes to maintain the same level of promises in the future. "The fundamental principle," says Dan Pellisier, a top aide to California state Representative Keith Richman, who is sponsoring a bill to lower public pension benefits, "is that public employees should not be retiring early and relying on private-sector employees to work longer to pay for their retirements."

THE UNFEATHERED NEST

In Colorado, the pension fix will be a choice between Owens' preference to shore up the shortfall by diverting 1 percent of employee pay, taken out of future pay raises for the next three years, and the more traditional tax-based approach of plan officials. Because the Democrats, who control the legislature, don't particularly like Owens' solution, they'd probably be inclined to wait him out. But there's one other factor that's keeping them at the negotiating table.

An initiative is all set to go on this November's ballot, sponsored primarily by the anti-tax Americans for Prosperity Foundation. In place of today's "defined benefit" plans, in which Colorado teachers and state employees are paid a fixed amount each month from retirement until death, Colorado would move to a 401(k)-style "defined contribution" system. Every month, the state and its employees would each pay a certain percentage of the workers' salaries into the retirement plan to be invested in funds of the employee's choosing. When they retire, employees would take their accumulated assets with them. At that point, the state's financial obligation to them would be at an end.

This would line Colorado up with what's been happening in the private sector: Companies have been turning their defined-benefit plans into defined-contribution systems for years. The decline of big pension plans run by struggling companies such as United Airlines and General Motors has gotten lots of attention of late, but even healthy employers such as IBM, Verizon and Hewlett-Packard are now getting out of the old-fashioned "until death do us part" plans. Today, only 17 percent of employers still provide defined-benefit pensions, reasoning that they represent too much risk when people are living so much longer than they did just decades ago. Defined-contribution plans may or may not require more employer contributions up front, but they put an end to open-ended obligations once the employee retires.

In the public sector, defined-benefit plans still dominate. Some states and localities have experimented with defined contribution-- offering employees a choice or shepherding new employees into the new plan. Alaska became the first state last year to set up a defined- contribution plan to cover all employees. Nonetheless, 90 percent of state and local government employees are covered by defined-benefit plans. That is a discrepancy that some lawmakers believe is unsustainable.

Many state and local leaders are looking to defined contribution and other approaches for answers. And they see public opinion swinging their way. "Pension plans are, to put it bluntly, a ticking time bomb set to explode," says Dave Owen, who is carrying Bill Owens' pension package in the Colorado Senate. "Ninety-five percent of the people in this state aren't in PERA"--the Colorado Public Employees' Retirement Association. "They're in some other plan that's going down the tubes."

But the plans may not be as imminently threatened as Owen believes. It's the public employees whose benefits are on the line that can make a strong case that sways public opinion. Last year, Governor Schwarzenegger came to grief when he backed a plan to move California state employees into a redesign of their pension systems, a design that, unfortunately for Schwarzenegger's political health, appeared to cut off funds from widows and orphans left behind by police and fire fighters.

BIG NUMBERS

The fiscal instability of public retirement systems is widespread. Just a few weeks ago, Oklahoma became the latest state to announce a huge shortfall--more than $10 billion in unfunded pension liabilities. With an overall state budget of $6.6 billion, that $10 billion looms especially large. Meanwhile, many municipalities' plans can rival those of the states in per-employee shortfalls.

It's worth bearing in mind that we've been here before. Public pensions were running similar deficits, on a percentage basis, back in the 1980s. At that point, they became more aggressive in their investing--they turned to the stock market to earn healthier returns-- and were able to lower the amount of money a state or locality had to put into the plan to keep liabilities in check. Today, about two- thirds of incoming pension monies come from investment returns, with governments putting up 25 percent and employees 12 percent.

Of course, aggressive investment policies have their downside. During the bear market of the early 2000s, investment returns declined precipitously--creating immense pressure on state and local governments to shore up their pension funds. Several states, suffering their own budget shortfalls, turned to the bond market to fund pension needs. More recently, states have been enjoying double-digit returns. However, since they average returns over periods of time, they are still feeling the effects of the earlier bear-market losses.

Investment returns in the exuberant 1990s had an unfortunate effect. Governments grew lazy about making their regular contributions. And that's a big reason that they're in so much trouble now. "Defined- benefit plans have been victims of their own success," says Steve Kreisberg, AFSCME's collective bargaining director. "They've been so successful that some politicians decided that the benefits are free and stopped contributing to the plans."

BENEFIT MANIA

Pensions are both complicated and lacking in sex appeal. Few people without a direct interest pay much attention to them. It's easy to punt the problems into the future, if only by fudging out-year numbers. "Who's going to protest?" wonders Peter Ricchiuti, Louisiana's former chief investment officer. "It's not like you have people on the steps of the capitol saying, 'Don't raise the actuarial assumptions!'"

Despite the problems, states and cities kept adding to the benefits offered to their employees. But the years of neglected contributions and generous benefit add-ons have finally come home to roost. San Diego has become notorious for just this problem. City officials conspired with pension board members to hike up benefits even as the city failed to put more money into its stagnant fund.

In Colorado, at least some of Bill Owens' pension problem was self- inflicted, the result of his pressuring PERA to sell discounted "service credits" to public employees, allowing them to buy more time on the job. A 15-year employee, for example, could buy enough service credits to retire and collect the amount of pension due someone with 20 years on the job. Owens hoped that state employees would retire early, helping his efforts to streamline government. Many rushed to take advantage of the offer; in 2002 and 2003, PERA members bought 128,133 years worth of credit toward their pension service time. The result is that more employees are retiring earlier at greater expense to the state.

Other governments have had a hard time in recent years resisting the temptation to give their workers souped-up benefits--benefits that they are now having a hard time paying for. It was easy for governments that couldn't afford raises for workers to promise better pensions, which didn't cost much at first.

Because pensions are, by their nature, a long-term problem, it's difficult to get public officials--classic short-term thinkers--to pay them serious attention even when the bills are coming due. That's well illustrated by the situation in Illinois. When he took office in 2003, Governor Blagojevich inherited the nation's largest pension deficit--a massive $43 billion. The state hadn't paid its full share of pension contributions for 30 years. Illinois had come up with a plan to deal with it in 1995, but in the usual fashion, the pain of repayment was put off.

Blagojevich has taken a more serious swing at the problem, issuing $10 billion worth of pension bonds to help close the gap. His administration has also reduced state employment ranks by 13,000, which among other things reduced long-term pension liabilities by $5 billion. Blagojevich made some changes in pension rules as well. The end result is that pension fund assets should cover 60 percent of liabilities--a far from robust ratio but better than the 2003 ratio of 48 percent. That may be progress but, as budget director John Filan concedes, pensions remain "a long-term problem that will take continued discipline."

Blagojevich and his team weren't able to summon up quite as much discipline as was required during last year's budget process, in which they finally closed a deal with legislators by agreeing to spend $2.2 billion scheduled for pension repayment for other purposes. Other programs, Filan says, such as education and health care, felt more "urgent and immediate."

That is also the case in Omaha. Each year that city waits to fill its $235 million police and fire pension deficit, the cost of the fix increases by more than $400,000. The city is negotiating with those unions for workers and the city to each make a contribution into the system. But during the last budget season, pension fixes ran into the usual wall. "Of all the things we were trying to accomplish," says Paul Landow, chief aide to Mayor Mike Fahey, "dealing with an underfunded pension was not a high priority. It's not something you have to deal with the day after tomorrow. Omaha's not going out of business."

THE OTHER SHOE

Policy makers will soon have to grapple with another set of figures that could be even more daunting than pension shortfalls. Because of a new rule put forward by the Governmental Accounting Standards Board, all states, cities and counties will have to declare the amount they expect to pay out for retiree health benefits over the next 30 years.

Most states have no idea what their 30-year projected cost is going to look like, but the early returns are sobering: California, $36 billion; Alabama, $11 billion; Maryland, $20 billion.

Currently, governments typically pay retiree health costs on an ongoing, annual basis. GASB won't require them to change this or declare how they intend to pay these bills in the future. But bond- rating agencies are on the case. "Obviously, Wall Street doesn't care whether you reduce benefits or whether you provide the necessary funding," says Robert Mears, finance director in Fairfax County, Virginia. "But Wall Street has made it pretty clear that they are looking for the well-managed jurisdictions to deal with this one way or the other."

Unlike pensions, which are pretty well guaranteed once a worker is vested, retiree health benefits can be altered--or eliminated. Some places are doing just that, whether it's changing the age at which full benefits kick in or requiring higher copayments. "Employers don't like to use their compensation money for people who don't work there anymore," says John McFadden, a benefits and compensation expert at the American College.

Some governments are considering issuing bonds to cover their expected retiree health costs. The city of Gainesville has already done so, while Rhode Island Governor Don Carcieri wants to establish a trust using tobacco bond money. Such moves guarantee financing but would also cap benefits.

Mayor Michael Bloomberg, presumably one of the best financial minds in government, is looking to put $2 billion in city money into a trust as earnest money in New York City. Mears is leaning toward a trust for Fairfax County. The earnings on the money, he says, will ultimately mean the trust will cost the county millions of dollars less than a pay-as-you-go approach.

Such trusts require putting the money aside. That's the tricky part. Maryland state Senator Patrick Hogan led a task force on the GASB issue that has recommended putting aside $100 million in the coming fiscal year and $300 million in 2008, while creating a commission to decide how to address the state's projected $20 billion retiree health bill over the long haul. "The good news of the new GASB rule is that it has forced us to quantify our problem, face and pay for it," he says. "We don't have any choice." Hogan also thinks that proper planning will save Maryland money over time, as opposed to staying on a pay-as-you-go footing. But he admits that some colleagues, who have not yet fully focused on the issue, may be tempted to spend the proposed $100 million down payment on other things.

"To fund it for the long term means hitting today's taxpayers for future costs," says David Wyss, chief economist for Standard and Poor's. "The longer you can put it off, the less likely it is to affect your reelection. My feeling is that nothing will change until it's a crisis on both GASB and the pension plans."

But that's a crisis that is moving closer.

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