States, Cities Considering Drastic Measures to Manage Public Pension Crises

David Crane, an adviser to former California governor Arnold Schwarzenegger, declared in 2010 that public pension crises nationwide represent “the largest single financial issue facing state and local governments.” According to one estimate, state and municipal governments across the country have a total unfunded pension liability of $4.1 trillion.

Several states are on the verge of insolvency, and some cities have notoriously declared bankruptcy because of unmanageable debt obligations, including Stockton, California and Detroit, Michigan. Currently, states such as California, New Jersey, and Illinois, and municipalities across the country are considering drastic measures to allow them to stave off financial ruin.

The obvious question is, “” 

The problem largely began in the 1990s, when a soaring stock market convinced policymakers that high returns on investments could pay for an expansion of benefits to public employees.

For example, in California, the state adopted S.B. 400 in 1999, which boosted pension benefits for all workers and even provided retroactive increases. It allowed highway patrol officers, for instance, to retire at age 50 after 30 years of service and receive 90 percent of pay in pension benefits throughout their retirement.

Accountants and economists long warned about the unsustainability of paying such lavish benefits, but states relied on various gimmicks to conceal their indebtedness.

In New Jersey, for instance, the state increased its expended rate of return on investment in 1992, upping it to 8.75 percent from 7 percent. This method allows states to cut pension contributions in the present with the expectation that high yields on investments – such as from escalating stock values – will be able to cover future costs.

Then, in 1994, the state adopted a technique known as “backloading,” by which it postpones making pension contributions until the end of a worker’s career rather than incrementally throughout — another means of cost deferment.

While the state was masking its obligations through accounting gimmicks, it continued to expand its promises. Between 1999 and 2003, the state approved 13 pension enhancements, and by 2011, its unfunded liabilities reached $50 billion, up from just $2.9 billion in 1995.

However, re-election conscious politicians eager to appease government workers are not the only figures who bear responsibility for these runaway costs. The intransigence of unions and their influence on important government panels made pension reform especially unlikely.

In Illinois, the strong presence of AFSCME — the union representing federal, state, county, and municipal workers — on the state’s 13-member employee pension board has made confronting the state’s debt load politically difficult. The state consistently failed to meet its annual contributions according to the schedule it approved in 1995. Illinois now has unfunded liabilities approaching $100 billion and is the least solvent state in the nation.

Such fiscal irresponsibility in many states, however, did not become apparent or urgent until recently.

The catalyst that forced governments to confront their pension crises was the 2008 financial meltdown. As part of their investments, many state and municipal governments had purchased mortgage-backed securities that came with stellar ratings from rating agencies, but contained highly toxic assets, including subprime mortgages. Many of these home loans did not satisfy the underwriting standards of the Wall Street firms that sold these bonds to unwitting governments.

When the crisis hit, state and local governments nationwide lost $800 billion in pension investments.

However, the governments themselves are not without blame. The financial crisis also exposed the accounting gimmicks, unrealistic investment projections, and insufficient contributions that caused debt burdens to rise so precipitously. The Securities and Exchange Commission (SEC) has charged Illinois and New Jersey with fraud for failing to disclose the extent of their indebtedness to investors.

Now, some governments are taking drastic measures to defuse their debt bombs.

Most states regard pensions as constitutionally protected contracts that cannot be altered, but even that is changing. San Jose’s mayor, Chuck Reed, has proposed a ballot initiative that would revise California’s constitution and allow the state and its municipalities to renegotiate pension benefits.

Among the states, New Jersey has taken the most aggressive measures to control its pension crisis. In 2010 and 2011, the Christie administration raised the retirement age of government workers to 65, suspended the cost of living adjustment (COLA), and reduced the percentage of final salary that workers receive in retirement. In 2012, voters also approved an amendment to the state constitution that allowed the state to reduce judges’ salaries and pensions.

In Illinois, Governor Quinn signed into law a reform plan similar to New Jersey’s that would leave the system fully funded by 2044. Unions are challenging the reform in court, claiming it violates state and federal protections against “impairing” contracts.

In short, imprudent past promises, gimmicky accounting practices, and changing economic realities are finally forcing some governments to confront their pension crises, but whether they reach agreement with unions and achieve financial sustainability remains uncertain.

All citizens, even those with no direct connection to the fight over public pensions, could feel the effects of pension reform through the combination of higher taxes and cuts to essential spending and services.

Richard Ravitch, who has made a career out of studying state budgets and actuarial tables and brokering eleventh-hour budget compromises, notes that “fiscal stress runs downhill, making local governments the collecting point of the greatest fiscal stress.”

He cautions that this stress “adversely affects the public support systems on which Americans depend — core services for which local governments are primarily responsible, such as police and fire protection, safe roads, clean water, and disaster response.”

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