As the U.S. economy wobbles forward, recovering from the worst recession in a lifetime, state and local officials will soon be bombarded by hosts of constituents and labor unions to restore services, programs and pay increases. Despite the pressure, public leaders must resist special-interest Sirens singing for a return to the "good old days." Otherwise, another Odyessian shipwreck lies ahead.
This economic recovery will not follow past patterns. The housing market remains a mess in many states, with foreclosures overhanging most regions of the country. That alone will impede the rate of new job growth because housing is typically a leading economic propellant after recessions. Even with the stock market recovering 70 percent of its bear market losses from 2008, most investors have plenty of unrealized capital losses to offset profits on their income taxes, which wipes out that source of state revenue for at least another two years. Thus, revenue growth will be sluggish, albeit positive.
Pay the past-due rent, first. Meanwhile, the bills for promises-past continue to mount. Almost all state and local governments chose to defer maintenance and capital equipment replacement in their efforts to save cash flow during the Great Recession. They must now play catch-up to replace aging police car fleets and road equipment, while fixing the leaky roofs in public buildings.
Even more problematic are the swelling IOUs of the nation's public pension funds and unfunded retiree medical benefits plans, which together now exceed $2.5 trillion. With stock markets well below previous peak levels and liabilities growing every year, the additional annual cost to amortize unfunded state and local government retirement benefits above current budget levels is roughly $150 billion nationwide or $500 per capita, divided between the various public employers at state and local government levels.
Nationally, this problem represents 15 to 20 percent of most state and local government payrolls on average -- and that's just to put these retirement plans on a proper actuarial footing to fund benefits before these workers retire. Unfortunately, this is in addition to the announced pension cost increases already communicated to public employers! That is the colossal magnitude of the annual underfunding by public employers.
Imagine being told that your home mortgage payment (which represents about 30 percent of your household budget) will increase by 50 percent for the next 15 years, beginning immediately, and it will get even worse if you don't pay up. That is the personnel budget squeeze facing many states and localities as they finally confront their true costs of retirement benefits.
Most states and localities will come to realize they must refrain from new spending in order to pay off these past-due bills. Elected officials must learn the "Power of No": the resolve to tell constituents and employees that they cannot vote in good conscience for new programs, more employees or pay raises for current workers. That is, they can't do so until and unless their management team first proves that their jurisdiction is making all its actuarial payments to the various retirement plans, and that equipment and facilities are being replaced and repaired properly. It's no different from telling your recently graduated son that he can't let the rent fall past due in order make a down-payment to lease a shiny new car, despite what he would like to do.
Discipline is the new normal. This requires immense discipline, and most politicians in America have failed to follow this strategy in years past. But these are different times: the public's mood has shifted to a belt-tightening and budget-balancing frame of mind, as voters have seen the consequences of free-spending governments like Greece. Almost everybody understands that we must begin to pay the piper, so the Power of No can be a formidable force in local decision-making. If you ask city managers or county executives what would be the first request that they would make of their elected officials, it would be the conviction to hold their ground in the face of special interests seeking to raid the public treasury for their benefit while the bills keep piling up. Even a minority on a city council, county commission, school board or state legislature can now block most unsustainable spending measures with their new Power of No.
New York City Mayor Michael Bloomberg recently announced his strategy to rein in pension costs and share the bills with employees. Other leaders across the country are now adopting the same line, and their remedies are increasingly stark.
Labor unions are not accustomed to hearing public officials tell them that there will be no pay raises for years to come unless they get their pension and retiree medical benefits contributions budgeted properly. That will compel union leaders to come to the bargaining table with concessions in benefits and to accept higher levels of employee contributions toward their own benefits. The latter will be especially important in states where laws prevent reductions in retirement benefits for incumbent employees. For employers whose unfunded retirement liabilities will require them to contribute another 15 to 20 percent of payroll to achieve actuarial funding, their employees will sadly face another three or four years of pay freezes unless they agree to pay a good part of that incremental cost.
Earmark budget surpluses. A final strategy for public managers and elected officials is the earmarking of budget surpluses for fiscal restoration. Public budgeteers typically forecast revenues conservatively, so that policymakers are not forced to cut back every time revenues come in below estimate; that is just prudent public budgeting. So as the economy gathers upward momentum, the odds favor revenues overshooting the conservative budget estimates, which will produce year-end budget surpluses in 2011-14 -- if this cycle follows a normal pattern into economy expansion. Wise use of these budgetary surpluses is a key strategic policy that elected officials can adopt to ensure prudent financing ahead of the next recession, whenever it may occur in the future.
For decades, public managers have recommended budgets to public officials that spent year-end budget surpluses (which are one-time money) to fund new programs, salary increases and expansion of the workforce. Elected officials caught on to the game and took a short-term view of their policy options during their limited terms of office: They spent one-time money for perpetual obligations, letting the next guy figure out where to find the money necessary to continue these unsustainable commitments.
Focus on the balance sheet, not new spending. The Power of No includes a commitment to devote year-end budget surpluses to permanent balance-sheet improvements. For example, a state or local government that has failed to fund its retiree medical plan (known as OPEB for "other post-employment benefits") on an actuarial basis is digging a deeper hole every year. So it makes sense to devote one-third of all forthcoming budget surpluses to begin funding the OPEB plan until the annual budget is able to contribute annually the required actuarial contribution.
A reward for conscientious workers. As part of a responsible labor-relations policy, public leaders could earmark a small portion of budget surpluses for one-time contributions to a deferred compensation plan for diligent employees who accept benefits cuts, salary freezes and higher employee contributions to the retirement plans. For example, 10 percent of the year-end budget surplus could be distributed as an ad hoc employer-matching contribution to a 457 or 403b plan so that responsible employees don't feel that it's all give-backs and nothing on the upside. This avoids permanent increases in the pay base, and matches one-time money with one-time compensation. It delivers the message that deferred compensation with employee contributions is a key component of the overall retirement plan. Think of it as "nonprofit sharing" in the public sector.
Reserve the rest for rainy days. The remainder of the budget surplus should then be formally earmarked to a rainy-day reserve fund (which governmental accounting standards now formally permit) so that there is money set aside to avoid future layoffs, furloughs and pay cuts in the next recession. A rainy-day policy should formalize and codify the conditions for releasing those funds. For instance, labor unions shouldn't be able to pick it apart in arbitration proceedings as the entitlement source for their next pay raise.