Pension promises get people into trouble. But it makes a great deal of difference if we are talking about private versus state and municipal government pensions. (I save discussion of the federal government’s Social Security program for another day.)
When defined benefit pensions are promised by publicly-held corporations, those commitments are scrutinized by auditors, stock market analysts, the government’s Pension Benefit Guarantee Corporation and the Securities and Exchange Commission, among others. If it looks like a company is going to be unable to meet its commitments, the media gets excited. Politicians start to accuse corporate chieftains of either incompetence or putting the interests of shareholders ahead of the rank and file. Not infrequently, heads roll and bankruptcy beckons. But eventually a solution which roughly apportions pain among the directly interested parties – shareholders, retirees, and taxpayers – is usually found.
Not so for municipal government pensions. The release this past August of the Kroll report on San Diego’s pension fund debacle, which has left the City with a $2 billion hole in its finances, makes this abundantly clear. As Arthur Levitt, Jr., former SEC Chairman and overseer of the independent audit put it in the Los Angeles Times,
The evidence demonstrates not mere negligence, but deliberate disregard for the law, disregard for fiduciary responsibility and disregard for the financial welfare of the city's residents over an extended period of time.
The central problem with state and municipal government pensions is that powerful employee unions are frequently instrumental in electing the politicians. There has been a growing (and understandable) tendency for unions and elected officials to agree to substitute pension promises for outright wage and salary increases in many bargaining situations. Whereas 100% of the wage and salary increases would show up immediately in operating budgets (and thus require a tax increase or expenditure cuts elsewhere in the budget), pension promises typically require very small immediate outlays. Instead, the estimated cost of the promise is buried in a financial footnote. The Reason Foundation's 2005 study demonstrates clearly the perverse incentives inherent in defined pension plans for public employees.
Estimating the financial implication of a promised pension is a murky combination of art, science and assumptions. To keep required outlays for funding future pensions as low as possible, elected officials frequently use highly optimistic assumptions about future returns on pension fund investments, or longevity assumptions about their retirees.
When the reality of a large gap between the value of promises to retirees and assets on hand to meet those promises looms too large to ignore (as was the case in San Diego), elected officials sometimes decide, with great encouragement from investment bankers, to “double up.” They do this by issuing long term general obligation bonds, putting the cash into the pension fund and investing the proceeds in the stock, corporate bond and “alternative asset” markets. So funding pensions now becomes a bet between the cost of the bonds (which do not enjoy tax-exempt interest rates) and the return on the invested cash. (If you want to know about pension bonds, see my article for the Government Finance Officers Association.)
The poster child for bad bets on pension funding is my local government – the City of Pittsburgh. In the late 1990s the city issued roughly $275 million in pension bonds and tossed the cash into a woefully underfunded pension plan. Interest payments on the bonds to date have been roughly $144 million. Total returns on investments made with that cash are on the order of $98 million, meaning City of Pittsburgh taxpayers are about $46 million worse off for having their elected politicians play the stockmarket with borrowed money.
There is more bad news to come. Starting in 2007, financial statements of state and municipal governments will have to reflect the cost of promised retiree health benefits (corporations have had to do this for the past ten years or so). The yawning gap between politicians’ promises and government’s ability to meet them will widen precipitously for communities like Pittsburgh. The temptation to “double up” with pension bonds will be even stronger, particulary where they haven't been tried before.
Isn’t is about time for political leaders to level with employees, retirees and taxpayers, and start the painful process of designing better ways to save for retirement that the private sector has been engaged in for the past decade?
