Thursday, January 6, 2011

Q&A Series - State and Municipal Public Pension Obligations

This week's questions come from Dave, a client who would like a better understanding of the states’ public pension obligations .

Q: What is going on with state public pensions? Are the payouts sustainable, or are defaults among municipalities and states imminent?

Boy, has this topic been receiving a lot of press lately! While not all states are in dire financial conditions, California, Illinois, New York, New Jersey and several others have taken on obligations they simply cannot fund with their tax revenues. It is worthwhile for us all to understand the exact obligation these states are facing and why the problem is so severe.

I believe the root of the problem is public service unions. With public service unions, there is a direct conflict of interest between the unions and the elected officials since the unions can collectively raise funds from their membership and use their clout to get a particular political candidate elected. Then, if the candidate they support is ultimately elected, he or she is obligated to provide higher wages and more benefits to the union members. Unfortunately, this situation has grown worse over the years. Also, if that particular politician is voted out of office down the road, it then becomes someone else’s problem (i.e., the taxpayers’).

Using the most recent Presidential election as an example, Barack Obama indicated in his campaign that he would support public service union employees along with all other unions. Ironically, less than 9% of private sector U.S. workers are represented by unions, and as such, 91% of U.S. workers in the private sector have no union representation. However, the Obama Administration appears to be advocating mostly for the 9% minority represented by unions.

Almost immediately after President Obama was elected with almost universal support from union employees, he passed a failed stimulus bill that devoted approximately one-third of its amount back to state and local governments. This, in turn, paid many of the salaries of public service union employees. Even though it was clear from the beginning that this would not create employment, it was utilized to maintain state employees which everyone knew could not be maintained once the stimulus funds ended.

In the private sector, negotiations between labor unions and management are often adversarial. Therefore, the pensions and other benefits of workers covered by union contracts are negotiated in a manner that is typically fair for both the employees and for the companies. However, in the public sector, negotiations for pensions are much different.

In the U.S., roughly 36.8% of public sector employees are union members. Even though the total union representation for the private and public sectors in the U.S. is only 12.4%, they maintain substantial clout that has driven many states and local governments to the brink of bankruptcy. Government unions use their influence to elect those who candidates who accept their terms for higher wages and higher benefits.

In order to pay for the extravagant pension and other benefits of public service workers, the cities and states have no choice but to increase taxes. By virtue of increasing taxes, they run off local businesses. This is evident in the states in which these pension costs have become onerous. It is no coincidence that the states with the largest pension costs (California, New York, Illinois and New Jersey) are the very states that are facing massive unfunded pension costs and potential bankruptcy, and are also the states with the highest state income taxes.

The City of Atlanta currently has an unfunded pension cost of $1.5 billion. Given that there are only approximately 550,000 residents in the City of Atlanta, that works out to an unfunded pension cost of $3,000 for every man, woman and child that lives within the city limits. Since many of these residents are in the lower income bracket, they could not possibly pay this amount. As you can see, this cost could not possibly be raised through higher taxes, and therefore, these unfunded pension costs will have to be adjusted into the future.

Some states are even worse. New Jersey has grown their unfunded pension costs to close to $54 billion. Their problem is that the state is accruing the pension costs without funding the costs; they simply do not have the revenues to fund this cost. In 2010, the state did not pay its $3.5 billion accrued pension costs, and therefore, the obligation continues to worsen.

Part of the problem has been that the pension plans throughout many states have used unreasonable projected investment returns. For example, New Jersey projected annual returns at 8.25% when anyone who has been investing over the last few years knows that this rate is not attainable year-in and year-out. In fact, one calculation was completed assuming a more reasonable investment return of 3.5%, which made the state of New Jersey’s unfunded liability triple to over $173 billion. Ouch!

California, Illinois, New York and New Jersey all border on default at the current time. The low credit ratings on their debts will keep them from borrowing money without paying very high incremental costs. However, these situations are not similar to the private sector. States have a lot of flexibility in adjusting their pensions if they have the political will. Since state governments can change their own laws, they can easily change the law to reduce the pension benefits.

One thing the troubled states could do almost immediately is change their pension plans so that the employees’ pension amounts are rolled into a defined contribution plan that acts going forward much like a 401(k) plan for the private sector. While I seriously doubt many states will elect that option because of the overwhelming number of state employees under union contracts, it is perfectly possible for the state to reduce benefits by extending the retirement age or reducing the benefits when retirement is attained.

I was in France this past fall when the national debate was going on regarding increasing the government retirement age from 60-years old to 62-years old. There were riots in the streets, and many of the mass transit systems were completely closed down due to public service union strikes. It is hard to believe that the average retirement age in the country of France is only 55-years old. As we discovered in the Greek financial crisis, most employees in that country retire at the approximate age of 50. There is just no way that taxpayers can continue to fund these incredible pensions for public service employees.

It’s now time for taxpayers to rise up against this abusive obligation created by states and cities. While we want good state employees, it’s unreasonable to assume that taxpayers can fund this type of cost. Therefore, all cities and states should adopt the same plan as the vast majority of Americans – a defined contribution plan such as a 401(k) plan. If the cities and states were to adopt these types of plans immediately, the entire unfunded pension obligation would go away. The real question is whether our elected officials will have the political will to make such difficult decisions.

Unlike the private sector, the states have the ultimate weapon to get this matter under control – sovereign immunity. Since states have the ability to assert sovereign immunity, they do not run the risk of being sued by the unions. In the private sector, massive long-term litigation would occur if the companies unilaterally changed the union pension benefits, but in the public sector, the states could simply claim sovereign immunity and move forward.

Additionally, there is no overall governmental safety net for public service pensions. Essentially, if the public service employees didn’t like the changes, there’s nothing they could do about it. At some point, the government needs to be responsive to the taxpayers, and if the public service employers do not like their benefits, then they need to find new jobs in the private sector.

As a side note, and on the topic of private sector unions, I recently read about a situation concerning the salaries of Carnegie Hall stagehands. Carnegie Hall stagehands benefit from a powerful union – the International Alliance of Theatrical Stage Employees – and the average base annual salary of the top five highest paid employees is $359,000. Interestingly, aside from famous soloists, most artists performing on Carnegie Hall’s stage earn far less.

Dave, I hope my explanation and my opinions regarding unions have given you some understanding of state public pension plans and the potential repercussions of these plans on the country as a whole. There are many avenues for cities and states to take to avoid these gigantic, unfunded pension costs. But whether California, Illinois, New York and New Jersey will make those decisions before they go bankrupt remains to be seen.

I believe that at some point, the politicians will recognize the problem and will either terminate the public service pension plans or convert them to defined contribution plans. Personally, I do not see any reason for state or local governments to go bankrupt over public pension issues. My opinion is that they will deal with them prior to an ultimate financial disaster.

We encourage our clients and readers to send us questions for our Q&A series at And as always, we hope you will keep Rollins Financial in mind when seeking professional advice on financial planning and investing.

Best regards,
Joe Rollins

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