Who pays the bill?

DETROIT may be an extreme case of fiscal incontinence. But its bankruptcy highlights a long-term problem faced by many American cities and states; how to fund generous pension and health-care promises that are no longer affordable.

The problem has been decades in the making. It has always been easier for politicians to promise generous retirement benefits to public servants than to raise their wages. The bill for jam today falls due immediately; the bill for jam tomorrow can be delayed for decades.

The same mindset once caused Detroit’s big three carmakers to strike deals with workers whereby they could retire as young as 48 with gold-plated pension and health-care packages. In the short term, this bought industrial peace. In the long term, it bankrupted GM and Chrysler; in 2009 the government had to rescue them.

Now Detroit, like other cities, faces a choice. It has made promises to creditors and retirees that it cannot meet in full. How should it share the pain?

For Motown, the question will be settled in court. The outcome will send ripples far and wide, affecting the holders of municipal bonds, the insurers that guarantee such bonds, state and municipal public-sector workers and, last but not least, taxpayers around America.

Detroit’s unfunded health-care burden is actually larger than its pension deficit. But the pension problem stands out. First, unlike health care, the city has put aside specific funds to meet very specific pension promises. (A promise of health insurance can be made cheaper in all sorts of ways, but a promise of $30,000 a year can be made cheaper only by breaking it.) And second, courts have made such pension promises legally very hard to break.

The issue also illustrates an emerging divide in American society. Most public-sector workers can expect a pension linked to their final salary. Only 20% of private-sector workers benefit from such a promise. Companies have almost entirely stopped offering such benefits, because they have proved too expensive. In the public sector, however, the full cost of final-salary pensions has been disguised by iffy accounting.

Pension accounting is complicated. What is the cost today of a promise to pay a benefit in 2020 or 2030? The states have been allowed to discount that future liability at an annual rate of 7.5%-8% on the assumption that they can earn such returns on their investment portfolios. The higher the discount rate, the lower the liability appears to be and the less the states have to contribute upfront.

Even when this dubious approach is used, the Centre for Retirement Research (CRR) at Boston College reckons that states’ pensions are 27% underfunded. That adds up to a shortfall of $1 trillion. What is more, they are paying only about four-fifths of their required annual contribution.

On a more realistic discount rate of 5%, the CRR reckons the shortfall may be $2.7 trillion. A similar calculation by Moody’s, a ratings agency, reckons that schemes are 52% underfunded.

The underlying economics of pension funds have deteriorated over the past 40 years. Americans are living longer. A 65-year-old woman can expect to live three years longer than her counterpart could in 1970; a 65-year-old man, four years longer. As the baby-boom generation (those born between 1946 and 1964) retires, fewer workers must support more pensioners. New York City now has more retired policemen than working ones, and spends more on cops’ pensions than cops’ wages.

Worse still, states and cities have used their pension funds as a way of offering supersized payments to senior managers and favoured workers. More than 20,000 former state or local employees in California have retirement incomes of over $100,000; a few enjoy more than $250,000.

Perhaps the best-known ruse is “spiking”. Public employees inflate their final-year salary (by, for example, working overtime, or cashing in unused holiday time) to raise the base from which their pensions are calculated. When she stepped down as chief executive of Ventura County in 2011, Marty Robinson was earning $228,000. But by cashing in $69,000 of unused holiday time and other benefits, she was able to retire on an annual pension of $272,000. Back in 2007 the Pacific Research Institute, a conservative think-tank, estimated that spiking cost California $100m a year.

Another ruse is “double-dipping”—taking a public pension and then returning to the payroll. The Little Hoover Commission, a watchdog, cited the case of a fire chief who retired in 2009 on a pension of $241,000, compared with his final salary of $185,000; he was then hired back as a consultant on $176,000 a year.

Some of the best-paid pensioners were once politicians. Illinois’s General Assembly Retirement System covers 286 ex-lawmakers, 9% of whom enjoy annual pensions of more than $100,000.

Moreover, some public-sector employers cover their employees’ pension contributions. During a strike by transport workers in San Francisco this month, many stranded residents were shocked to discover that the authors of their misery contributed nothing at all to their pensions.

Gold for the old

Most public-sector workers do not benefit from such boondoggles. The average pension payment in California is around $29,000 a year; in Detroit it is $19,000. In some states, those who receive public-sector benefits do not qualify for Social Security (the federal pension scheme that applies to nearly all workers, public- and private-sector). So their pension may be their only income when they are frail.

Still, the typical public-sector worker gets a pretty good deal by private-sector standards. Matt Nathanson, a public-health nurse in California’s Santa Cruz county (and representative of the Service Employees International Union, a trade union) has a “2% at 55” deal. If the 52-year-old Mr Nathanson were to retire in three years he would receive an annual pension worth 2% of his peak salary (he currently earns around $80,000) multiplied by his 18 years of service. If Mr Nathanson lives to 82, as actuarial forecasts suggest he might, the state will pay him $864,000, before allowing for cost-of-living adjustments.

If Mr Nathanson keeps working till 63, his pension will rise to 2.4% of his final salary, multiplied by what would by then be 26 years of service; even assuming no wage increase, that would be almost $50,000 a year. Contrast that with a worker in a private-sector defined contribution (DC) scheme; figures from the Investment Company Institute show that the assets of those nearing retirement average $101,000, a sum that might deliver a pension of $4,000-$5,000 a year.

The pension burden varies from state to state (see table). Illinois is the worst funded; its pensions shortfall, on Moody’s calculations, is almost $133 billion. That represents 241% of the state’s revenues, a ratio 51 percentage points higher than Connecticut, the next-worst state.

One of the most problematic schemes is the Illinois teachers’ fund, which may run dry as soon as 2029 and is 42% funded (by the state’s numbers). Illinois is required to make contributions on behalf of teachers, even though they are not state employees. Local districts hire teachers and set their salaries, which then determine the value of their pensions. The end result is that the state pays over $600m a year on spending over which it has little control.

Many worry that Illinois is close to the point where its obligations to retired folk make it an undesirable place to do business. When companies or individuals move to the Land of Lincoln, they are immediately expected to help pay its debts. Many may decide to stay away. And if they do, the state’s ability to pay its bills will erode still further. Right now, says Laurence Msall of the Civic Federation, a budget watchdog, 22% of all state general funds are paying off pensions and servicing debt, and this is crowding out other areas in the budget, such as education.

California faces a similar problem. Greg Devereaux, chief executive of San Bernardino County, says that, thanks largely to pensions, fire-department costs in his jurisdiction have risen by $10m over the past three years, while the service provided has grown worse. At the state level, the share of the general fund devoted to pensions and pensioners’ health-care benefits has doubled over the past ten years.

The state has two giant funds: CalPERS, which administers a $260 billion investment portfolio for 1.7m past and present public-sector workers, and CalSTRS, a $166 billion fund that caters to teachers. CalPERS, the sixth-largest pension fund in the world, can unilaterally raise the contributions of public agencies; a phased rise of around 50% will begin in 2015. CalSTRS cannot do that, but has asked legislators to boost annual contributions by $4.5 billion over 30 years to plug its funding gap. If the fund runs out of money, which some predict could happen as early as the mid-2020s, school districts will be on the hook.

If you’re fit, work longer

After many years of complacency, politicians are at last moving to defuse the pensions time-bomb. California’s governor, Jerry Brown, has lengthened the peak-salary period from which pensions are calculated from one year to three, and capped the salary at which new recruits can earn pensions at $110,000. As part of the same package, Mr Brown also reduced the payout formula to 2% at 62. But the rules only apply to new hires.

The answer may seem simple. Public-sector workers should retire later, so that full benefits kick in at the same age as applies to Social Security payouts. An even bigger saving would occur if public-sector employees received DC pensions; under these, employers and employees contribute to a fund and the eventual pot (and thus the pension) depends on the investment return. If returns are poor, the risk falls on the employee; not taxpayers.

Some states have managed to switch to DC for new employees. They include Alaska, Utah and, surprisingly, Michigan (cities and states often provide separate pension plans; this is the case for Detroit and Michigan). Nebraska, which has the healthiest pension finances, moved to a DC model for new hires as early as 1967.

But making changes to pension promises is easier said than done. As Amy Monahan points out in a paper for the American Enterprise Institute, a conservative think-tank, it is hard to say what is permissible; the legal protections granted to employee pensions are a matter of state, not federal, law. Courts have tended to treat pension rights in two ways: either they are deemed to be “property interests” or they are subject to the law of contract. If they are property interests, the courts seem willing to allow rights to be reduced, particularly in the case of a financial crisis.

Where pension rights are regarded as contracts, however, change is much more difficult. The federal constitution says no state shall pass a law impairing contracts. Some courts have interpreted this to mean that pension benefits are sacrosanct. Some states, including Illinois, have constitutions saying that public-sector pensions cannot be diminished or impaired. What does this mean? Some courts have ruled that while benefits already earned must be protected, future benefits can be reduced. Others have ruled that the pension promises made when an employee starts work must be kept for the rest of his life.

This is one reason why pension reforms usually involve changing the benefits of new hires, not existing employees, let alone the retired. The savings from such reforms are small in the short term. However, some progress has been made in two areas; some states have increased employee contributions to the pension scheme (in effect, a wage cut), and others have reduced the regular cost-of-living adjustments built into pension payments.

Reformers draw hope from the examples of San Diego and San Jose, California’s second- and third-largest cities respectively. A year ago voters approved radical changes to both cities’ pension schemes (neither belongs to CalPERS). The San Jose reform raises contribution rates for city workers, or allows them to choose less generous pension plans. In San Diego, new employees will be placed in defined-contribution plans. Predictably, both reforms have become ensnared in litigation: a lawsuit filed by San Jose’s police union reached court on July 22nd.

On May 22nd Carl DeMaio, a Republican congressional candidate and driving force behind San Diego’s reforms, convened a group of like-minded souls to kick-start an effort to reform state pensions. Reforming CalPERS will require a change to the state constitution, and that will in practice require a public vote—in November 2014, at the earliest. In Illinois the governor, Pat Quinn, has made pension reform a priority, but has not yet convinced lawmakers to put a comprehensive deal on his desk.

In the end, as with Detroit, it may take a financial crisis for states and cities to face up to the scale of their pension shortfalls. When a crisis occurs, public-sector workers are more likely to accept the need to sacrifice. “You are an employee of the city and if the city goes down, so do you,” says Jason Brinker, a policeman in Harrisburg, a bankrupt city in Pennsylvania where benefits have been slashed.

Last summer Stockton and San Bernardino, two medium-sized Californian cities, declared bankruptcy. Both cities are enrolled in CalPERS, but they are treating their pension obligations very differently. Stockton is upholding its CalPERS payments even as it slashes expenditures elsewhere; stopping pension payments, argue officials, would make it impossible to recruit essential public-safety workers. But last August San Bernardino decided in effect to treat CalPERS like any other creditor and suspended its contributions (they have now resumed). CalPERS says this violates state law, but while the city’s bankruptcy case is proceeding in federal court the outcome is hard to predict.

When seniors sue

Detroit is arguing that both pensioners and bondholders should suffer. Its plans have already been challenged in court, and may take years to sort out. Bondholders will fight to protect their investments, particularly if they hold “general obligation” bonds, which are usually deemed to offer the best security. The judge, Steven Rhodes, will have to decide whether and how federal bankruptcy law trumps the rights of Detroit’s pensioners, and whether the city filed too hastily for bankruptcy.

Municipal bond markets have so far shrugged off the Detroit bankruptcy; investors seem to think it an exceptional case. But the long-run problem of closing that $2.7 trillion pension gap remains. The legal precedents set in Detroit will help answer a big question. When politicians promise too much to creditors and pensioners, who ends up footing the bill?