Judging from newspaper headlines and op-ed columns, you'd think that state and local governments are all on the verge of bankruptcy because of pension underfunding. Although I have spent the past two years chronicling the problems with public pension funds, it's time to set the record straight.
Many public pension systems have become bloated-but-underfed beasts that need to be tamed. That is not an impossible task in most states. With a few exceptions, state and local governments and their pension funds will slowly pull out of the current financial crisis. It may take a decade, but they will disprove the doomsday pronouncements of those whose primary objective is to roll back what they see as lavish benefits for public employees.
While state and local government leaders and associations are totally focused on defending their pension plans, they should be devoting twice as much time and energy to their real nightmare: retiree medical benefits, also known as OPEB (other post-employment benefits).
Just look at the numbers: Using conventional actuarial methods and the latest market value of pension portfolios, the current level of unfunded liabilities of public pension funds nationwide is somewhere in the range of $700 billion — give or take 20 percent. Stocks have rebounded 80 percent from their 2009 market vortex so real-time funding ratios improved last year. Even using the announced prospective methodologies of the Governmental Accounting Standards Board (GASB), which would discount the unfunded liabilities with a super-conservative tax-free interest rate, the total of unfunded liabilities today is around $1 trillion. Sure, that is a huge number, but it's a drop in the bucket compared to the $14 trillion of outstanding federal debt and the estimated $50 to $100 trillion of unfunded Social Security and Medicare liabilities now outstanding which Congress continues to side-step. And far more relevant to the state and local government debate and the deepening concerns in the municipal bond market for state and local government debt obligations is the $2 trillion of unfunded OPEB liabilities.
Pensions have drawn attention because of the abuses piled on by retiring cops and firefighters who rack up overtime in their final years and collect unused sick leave before they retire, in order to goose up their pensions — a practice called "spiking." The public postings of six-figure pensions for thousands of public-sector retirees have irked average citizens. And the unions invited public rebuke for their shenanigans in the last decade when they lobbied legislators nationwide for unfunded, unsustainable retroactive benefits increases that we now see were a stupid idea. So pension envy runs strong.
Meanwhile, the OPEB cancer continues to metastasize, unabated and untreated. The standard comment by politicians is that we spent thirty years getting into this ($2 trillion) problem, and we'll probably need many years to fix it. That's true, but very few have even started to seriously address their retiree medical benefits plans. A handful of public employers have cut back benefits for new hires, but few have dared to scale back their promises to incumbent employees. Even fewer have demanded that employees share part of the cost of their retiree medical benefits, which were given to public employees for free in many jurisdictions. Meanwhile, the employers just scrape by, paying the benefits for retirees without putting away even one nickel to pay down the accumulated liabilities.
For perspective, the pension deficits accrued to date will cost every man, woman and child in America about $2,000 over the next 15 years (about $10 per month per capita), based on current funding ratios. For OPEB, where half the nation's public workers receive a substantial retiree medical benefit and half do not, the $2 trillion national liability works out to six times that number for the unfortunate 75 million taxpayers who bear the burden of these bills. So a family of four living in a state where the police, firefighters, teachers, road crews and prison guards all get lifetime medical benefits should expect to pay $50,000 before the parents become grandparents.
So much for your college savings plan. Think about it: Our nation has decided by default to deprive millions of American families of saving for a college education for their kids in order to pay the inevitable bills for public employees' retiree medical benefits that many of them collect before attaining age 65 when most American taxpayers will retire. That's the paradox that nobody is talking about, the untold story that pension critics and elected officials have ignored.
Why doesn't OPEB get more attention? In part, the reason is that retiree medical benefits have never been funded, so there are no boards of trustees lobbying for their interests and sending out bills based on actuarial numbers. Public pension officials are smart enough to know they need to grab every penny of employer money they can get their hands on. OPEB remains unrepresented in the scramble for budget dollars. Public employees' pension rights under law are often stronger than their claims to retiree medical benefits. Also, the OPEB benefits are not uniform nationally: Each government determines its retiree medical benefits, and some have been very generous while others have been less so. There are very few formalized statewide OPEB plans for the media to inspect.
Thus, the newspapers can't generalize about the problem, so the media does not have as broad an audience because only half of the taxpayers nationwide are on the hook in a major way. The bond-rating agencies have focused on pensions but have put OPEB liabilities on the back burner when they assign ratings. So there has been no "heat" on elected officials to deal with this issue. Pension contributions have been a "habit" formed over the past 50 years, and many states have laws requiring public employers to make their actuarial contributions. Similar legislation does not exist for OPEB.
So guess where the corners were cut? When the Great Recession swept across the country, public employers-creatures of habit that they are — paid their pension bills (albeit underestimated) and kept paying the "pay-as-you-go" retiree medical benefits while ignoring the actuarial contributions for OPEB. After all, who wants to lay off more police in order to set aside money for their retiree medical bills when it's never been done before? That's too tall an order for most elected officials.
However, the piper must now be paid. Failure to quickly put OPEB plans onto sound, full actuarial footing as the economy gets back on its feet will assure a full-blown crisis before the end of this decade. How ironic that pension funds will collect 50 to 100 percent increases in employer contributions in order to achieve long-term solvency, while the OPEB plans starve.
Take the case of the Los Angeles Unified School District, whose $10 billion unfunded OPEB liabilities will compel its leaders to reduce teacher staffing and increase classroom size for an entire generation if they fail to get ahead of this problem soon. Even with immediate actuarial funding, 25 percent of the LAUSD budget would go for OPEB and medical benefits, and it will only get worse if neglected any longer. In New York State, the OPEB deficit for state and municipal employees exceeds $200 billion with no funding plan in place. That is triple the level of the state pension fund's actuarial deficit, which will require employer contributions to double by 2014.
The three-step solution. To get from pay-as-you-go financing of OPEB to a full actuarial contribution, most public employers must take three actions:
STEP ONE: Ramp up employer contributions incrementally over the next five years, paying annually an additional 20 percent of the gap between current contributions and full actuarially calculated contribution. By 2017, this would position public employers to survive the next recession whenever it ensues. Even so, that will leave no money for any new public expenditures other than deferred maintenance and replacement capital spending.
STEP TWO: Quickly begin to charge employees for as much as half of the normal actuarial costs of their retiree medical benefits. Some employers will even be compelled to charge vested workers for part of the unfunded liabilities if those employees want to receive such benefits before they become eligible for Medicare at age 65. As with the employer contributions, this will require annual increases in the employees' payroll withholding for retirement benefits, so they can tighten their belts one notch at a time each year.
STEP THREE: Adopt new policies for surplus funds. As the economy recovers, rising revenues will often exceed prudently conservative budget estimates. Until their budgets can finally provide for full actuarial contributions, elected officials should adopt policies to earmark 40 percent of any year-end budget surpluses to supplement their ramped-up, budgeted OPEB contributions. (The remainder can be reserved in a rainy-day fund to prepare for the next recession.) This is an ideal use of one-time surplus funds.
Hopefully, the genuinely well intended pension watchdogs will eventually realize that they are barking up the wrong tree. Hopefully public officials will take a broader and comprehensive view of their problem. Hope is not a strategy, however.
Let's make a deal — and pick Door #3. Public officials today face three doors in this real-life version of a popular TV game show. Behind Door #1 is the notorious pension dragon. Door #2 conceals the OPEB monster which is three times larger than the pension beast, and already shows a crack that will widen every year. Door #3 opens to a path to financial sustainability as outlined above: It is time for state and local leaders to bite the bullet and fund all their retirement plans actuarially while trimming benefits to sustainable levels and requiring employees to split the costs. The choice is clear.