VOL. 23, NO. 3
AUTUMN 2010
BENEFITS LAW
JOURNAL
From the Editor
The Big Lie: Unfunded State
Government Pension and Retiree
Health Benefits
W
hen Wile E. Coyote walks off a cliff, he doesn’t fall until he
looks down and realizes there’s nothing but air. That cartoon
image neatly captures the approach taken by state governments to
funding their employee pension and retiree health benefits. Generous
accounting standards, a lack of funding requirements, and politicians’
myopic focus on the next election have fueled a combined 50-state
unfunded governmental employee retirement obligation conservatively estimated at over $1 trillion. Before the money to pay benefits runs
out, state governments, unions, employees, and retirees should face
up to the problem and learn from the experiences of the corporate
world in confronting similar (albeit not as gargantuan) challenges.
Further delay will only lead to legal and financial chaos, broken
promises, and much suffering.
WHY THE PROBLEM?
First, government workers vote and second, promises to pay retiree
benefits in the future are not booked as a state liability or treated in
budgets as a current cost. Offering or increasing state-paid pension
and retiree health benefits is a reliable way to get labor peace and
the votes of represented and salaried government workers alike. As
a result, even as economic pressures drove the private sector to trim
coverage and switch to more predictable and lower-cost defined contribution programs, the retirement programs for government employees still look like a relic from the Eisenhower era.
From the Editor
Indeed, the typical public sector program has a relatively generous final pay pension formula, often including an automatic COLA
for retirees, “normal” retirement at age 60 or even 55, and heavily
subsidized lifetime health benefits. As an added kicker, some state
programs base pension benefits on the employees’ final year’s pay,
allowing hourly employees to bump up their pensions with overtime
in the 12 months before retirement. Granted, these benefits are offset
by the fact that state workers usually must contribute to their pension
plans and may not be eligible for Social Security. Nevertheless, most
private sector workers would swap benefits with a state employee in
a nanosecond.
Happily, for the politicians and bureaucrats, there are no federally imposed funding rules on state retirement programs. Instead
of ERISA, governmental plans are bound only by a watered-down
version of the pre-ERISA Internal Revenue Code rules that imposes
very few obligations on state governments other than cutting benefit
checks. The Government Accounting Standards Board (GASB) does
mandate that each state book its pension and (recently) health and
other retiree obligations, but the measurement rules are loose and
there has been little real consequence from reporting ever-larger
unfunded retiree liabilities. Unlike state bonds and other borrowings,
the benefit liability doesn’t affect deficits and isn’t counted as a debt.
All this makes it easy for governors and legislators to sweeten benefits
while still appearing fiscally prudent—until the day enough workers
retire and out-of-pocket costs overwhelm state budgets.
CALCULATING THE SHORTFALL
There are various estimates of the extent of the shortfall. In an
exhaustive study, the Pew Center on the States put the total unfunded
liability at the end of fiscal 2008 at $1 trillion: $452 billion in unfunded
pension liabilities and $555 billion for health and other benefit obligations. State pensions were calculated at roughly 84 percent funded
and retiree health was essentially completely unfunded.
But the Pew Study observed that its estimate actually understates
the size of the problem. Most states have a June fiscal year and use
“asset smoothing” to even out market volatility, so that the reported
aggregate plan asset levels do not fully reflect the ravages of the
2007–2008 market crash. Moreover, virtually every state assumes its
pension investments will earn 8 percent annually in estimating how
much money will be on hand to pay benefits; Pew’s numbers are
based on this rosy investment forecast.
To get a more realistic estimate, other academics have recalculated
Pew’s underfunding estimates using various market-based assumptions (e.g., yield curve on long-term corporate bonds, risk-free
Treasury yields, or expected interest rates on the state’s own bonds).
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From the Editor
For example, Novy-Marx and Rauh of the University of Chicago peg
the underfunded liability at an astonishing $3 trillion. And, the Pew
and other estimates exclude liabilities for municipal and local government entities that aren’t part of their state’s system, as well as future
accruals for state employees.
HOW BIG IS A TRILLION?
Even in these days of mega-bank and corporate bailouts, it’s hard
for us mortals to get our heads around $1,000,000,000,000. You could
think of it this way: if you invested $1 trillion at 6 percent interest,
you’d earn almost $7 million . . . an hour.
Using a different yardstick, the $1 trillion retiree benefit liability
exceeds both total state borrowings ($798 billion) and annual tax revenue ($781 billion). States today are contributing an average of about
$1 to their pension plans for every $10 in taxes they take in. To reach
just full pension funding, those contributions would need to grow by
75 percent for ten years, while pension investments somehow earned
8 percent annually. Right now, unfunded state pension promises in
the United States average an extraordinary $166,500 per participant.
STATE-BY-STATE
However, not all state pension messes are created equal. (Visit
pewcenteronthestates.org for a handy, interactive, state-by-state funding map.) Despite the massive political dysfunction that regularly
paralyzes my home state, I am pleasantly shocked to report that New
York’s pension system is pretty much fully funded (although its retiree
health programs are virtually unfunded). In contrast, states such as
New Jersey, Illinois, and Connecticut are on a trajectory that could see
them blow through their entire pension portfolios before the end of
this decade. But even those states that have squirreled away enough
to cover their pension costs will have to find a lot of extra cash to pay
for health benefits as baby boomers retire in droves over the next ten
to 15 years. And, of course, if investment performance doesn’t make
the 8 percent bogey, even more cash will be required to satisfy existing obligations.
LEGAL PROTECTIONS
Absent ERISA protections, eight states’ constitutions protect retirement benefits, while 22 others have passed statutes restricting their
ability to curtail benefits. Additionally, the Contract Clause of the U.S.
Constitution prohibits states from impairing a contractual obligation to
provide benefits unless reasonable and necessary to fulfill an important public purpose. Translation: It’s unconstitutional to reduce vested
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From the Editor
retirement benefits unless a state is so broke it would otherwise be
forced to fire every cop, firefighter, teacher, and sanitation worker.
Even when benefits can be legally altered, changes still must be made
through the very same cumbersome legislative process that got them
into the mess in the first place.
TOMORROW’S PROBLEM
Faced with the more immediate problems of filling budgetary holes
through furloughs; layoffs; school, hospital, and park closings; and tax
hikes, most state governments are reluctant to worry about a retirement crisis five or ten years down the road. Unfortunately, delay will
only make the problem worse and the eventual solution more costly.
Even if benefits are protected by federal and state constitutions, when
the money runs out (and it will: taxes can only be raised so high and
services cut so deeply), benefits will have to be cut. It’s estimated that
in some states over half of state revenues will be needed just to cover
out-of-pocket pension and retiree health payments. Faced with an
unexpected and severe cut in benefits caused by their state’s financial
meltdown, retirees and near-retirees will find it difficult, if not impossible, to adjust. Employees and retirees in the weakest states have an
added risk that a tax hike may not be an available solution to garner
additional money for plan contributions; able-bodied taxpayers can
move to less fiscally troubled and lower-tax jurisdictions, negating any
revenue boost from higher taxes. Indeed, it’s not a coincidence that
the low-tax states generally have higher population and job growth
rates than high-tax states.
Some states such as New Jersey have sought to postpone the
day of reckoning by issuing pension obligation bonds (POBs) and
contributing the proceeds to its pension plan. Since the POB bond
proceeds are tucked away in the plan, they somewhat protect retirees
by increasing funding ratios, but do nothing to improve the state’s
finances as a whole. Really, this is just buying stocks and bonds on
margin. As with all leverage, pension investment returns must beat
the state’s bond interest expense, or the state’s financial problem
will worsen. If it wasn’t obvious before the leverage-fueled Great
Recession, it should be clear that POBs are toxic.
LEARNING FROM THE PRIVATE SECTOR
It wasn’t pretty, but the private sector has worked through many of
the issues of restructuring unaffordable legacy benefits. (Or, like GM,
Chrysler, and a number of steel and airline companies, failed to adjust
in time and went broke.) Some states have raised retirement ages
and employee contributions, or closed their pension plans to new
hires. Despite politicians’ crowing about the money being saved, such
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From the Editor
changes alone won’t do the trick. Most new employees are young and
haven’t built up years of service. Pension and retiree health promises get truly expensive close to retirement, when final pay formulas
and the like ratchet up benefit levels. Indeed, putting new hires in
a 401(k) or other defined contribution program can actually increase
costs because those new benefits are more valuable than a pension
that won’t begin for another 30 years.
The solution lies where the costs are: outsized legacy programs
for current workers. Reducing earned benefits would be unfair and is
unlawful in most cases. But formulas for future pension accruals can
be amended to extend the period over which final pay is averaged,
or switch to career average or a cash balance approach. Raising the
retirement age to 65 would reflect both increased longevity and economic reality (although cops, firefighters, and other public workers
in physically demanding and dangerous jobs will need exemptions).
Employee contributions may need to be increased and, wherever possible, COLAs should be eliminated. (With inflation near zero, this is a
perfect opportunity.) Retiree health programs can increase the years
of service required for eligibility and switch to defined contribution
plans in which a fixed amount of money is set aside for each worker’s
benefit and when the money’s spent, the benefit ceases. And, of
course, pay-as-you-go has got to go. Every retiree program needs to
be funded on an actuarially sound basis.
GETTING REAL
There has been a colossal failure of leadership by government
heads and union bosses who have promised unsustainable retirement
benefits. Like AA, step one is admitting there’s a problem. In this case,
step two is to stop cooking the books and reasonably determine the
expected costs to satisfy existing benefit programs. With those numbers, all constituents—employees, retirees, unions, and taxpayers and
government, can begin a dialogue over possible solutions. It will not
be a pleasant discussion. Retirees will claim they’ve already earned
their benefits; employees and unions will claim their benefits are
fair compensation for lower salaries; cops and firefighters will state
that risking their lives entitles them to a rock-solid retirement; and
teachers will play the “we dedicate our careers to your kids” card.
Taxpayers will point out that they’re paying too much to fund their
own retirement to be paying extra for someone else’s golden years
and vote (literally, or with their feet) accordingly.
IF NOT NOW, WHEN?
Doing nothing will doom state workers and retirees to a sudden
and unexpected loss of benefits and the public to the chaos of a
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From the Editor
financial crisis and possible state insolvency. Ask Wile E. Coyote:
Once over the cliff, it’s too late to look down.
David E. Morse
Editor-in-Chief
K & L Gates, LLP
New York, NY
Reprinted from Benefits Law Journal Autumn 2010, Volume 23,
Number 3, pages 1-5, with permission from Aspen Publishers, Inc.,
Wolters Kluwer Law & Business, New York, NY, 1-800-638-8437,
www.aspenpublishers.com
Law & Business
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