The Shadow of Detroit: Pension Gaps Threaten Cities and States

 by Lou Cannon

Detroit's bankruptcy made a brief splash last month before being driven from the headlines by terrorist warnings, congressional intransigence and the sexual shenanigans of a New York City mayoralty candidate and the San Diego mayor. But as a possible portent for other cities and states buried under mountains of pension debt, Detroit promises to be the enduring news story of the summer.
 
Sure, Detroit is in some ways a special case, dependent more than any other major American city on a single industry. In its glory days Detroit made most of the country's cars; it now produces less than half of them. The city has more often than not been dreadfully managed; its former mayor is in prison. 
 
With all that, however, half of Detroit's liabilities when the city filed for bankruptcy were pensions and health care benefits owed to retired municipal workers. The city had municipal debt of $18.2 billion, with the pensions and health benefits accounting for $9.2 billion of the total. These were supposed to be fully funded; in fact, there was a shortfall of $3.5 billion. Alas, that's not unusual. In underestimating its pension costs Detroit mirrors scores of U.S. cities, many of which have liabilities exceeding Motown's, as well as that of many states. 
 
Chicago is in especially perilous shape. The Windy City has attracted business and reduced its horrific crime rate under the leadership of Mayor Rahm Emanuel, the former congressman and White House chief of staff, but the pension fund for retired teachers is near collapse, and four other funds for retired city workers are $19.5 billion short. Overall, Chicago has funded just 36 percent of its pension obligations. Philadelphia, using 2011 figures, has funded just 50 percent. 
 
Thirty-six cities, counties or other local government entities in the United States have filed for bankruptcy in the past five years. The majority were small special districts, but the list also includes Jefferson County, Alabama, and the California cities of Stockton, San Bernardino and Mammoth Lakes. A recent state audit of Stockton, a city of 300,000 in California's central valley, blamed poor accounting practices and a series of misguided financial decisions. 
 
Looming larger than any municipal missteps are unfunded pension liabilities of the states, totaling an estimated $2.7 trillion or 17 percent of gross domestic product (GDP). The states themselves say their pensions are 73 percent funded, but the ratings agency Moody's says this considerably understates the magnitude of the problem. 
 
Dissatisfied with state estimates, Moody's did its own calculations in June and found the states have set aside just 48 cents for every dollar in pensions they have promised. In a view shared by many economists, Moody's claimed that states and cities were distorting pension numbers by failing to take proper account of market risks. For instance, California's state pension system, the nation's largest, assumes a 7.75 percent annual return on its investments in perpetuity, a rosy view that fails the test of history. 
 
But California comes out relatively well on Moody's scorecard, largely because much of the duty to pay pensions in the Golden State falls on local governments. The state that fares by far the worst in Moody's estimate is Illinois, where pension obligations amount to 241 percent of the state's annual tax revenues. According to the Moody's study, pension obligations are 190 percent of tax revenues in Connecticut, 141 percent in Kentucky, 137 percent in New Jersey, 133 percent in Hawaii and 130 percent in Louisiana. 
 
The current political flashpoint of the pension battle appropriately is Illinois, where Democrats hold the governorship and a super-majority of the Legislature. But the governor and legislative leaders do not see eye to eye. Gov. Pat Quinn has long been trying to prod the Legislature into passing a pension-reform bill. In July, he became so exasperated he used his line-item veto authority to strip legislative salaries from the state budget. Legislators promptly sued, claiming the governor had acted unconstitutionally. A court hearing is scheduled Sept. 18. 
 
Whatever happens in Illinois, unfunded pension costs are putting increased pressure on states and even more on municipalities. Former Los Angeles Mayor Richard Riordan and journalist Tim Rutten, writing in The New York Times, said that "emergency response times are lengthening in cash-starved cities" while libraries, parks and recreation facilities are shortening hours or even closing. Cities are also falling behind on street and sidewalk repair. 
 
Riordan was frustrated last year by public employee unions, who opposed his attempt to put a pension reform initiative on the Los Angeles ballot. Lacking sufficient backing, he withdrew the proposal. Now Riordan and Rutten are calling for a public employee pension reform plan patterned after a proposal by economist Joseph Rauh, a professor of finance at Stanford's business school and senior fellow at the Hoover Institution. 
 
Riordan and Rutten want President Obama to propose and Congress to enact a program in which cities and states could sell bonds to cover pension liabilities with repayment guaranteed by the federal government. The program would be financed by fees charged participants. In exchange for federal bond insurance, which would provide access to low-cost capital, cities and states would have to agree on certain reforms of their pension and health care programs, including a single national standard for projecting returns on pension investments. 
 
It's an intriguing idea but one that most public employee unions would be likely to resist based on their previous insistence on lofty investment projections. It's also unlikely that a divided, do-little Congress would be willing to dive into the pension thicket — at least unless or until there are more bankruptcies on the scale of Detroit. States are of necessity more willing — 30 of them have enacted pension-related legislation in 2013 — but in most cases the reforms do not go far enough to close the pension gaps. 
 
Public employee unions are the handiest scapegoat for those who deplore the pension mess, and they certainly deserve a hefty share of the blame. But what has happened is not entirely the fault of the unions. Indeed, a principal reason that pensions are underfunded is that Americans are living longer, which makes pension promises much costlier to keep. Another main reason is political. As The Economist puts it in a recent report on the U.S. pension crisis: "Governors and mayors have long offered fat pensions to public servants, thus buying votes today and sending the bill to future taxpayers. They have also allowed some startling abuses. Some bureaucrats are promoted just before retirement or allowed to rack up lots of overtime, raising their final-salary pension for the rest of their lives." 
 
This practice is known as "spiking" and has been modified, although insufficiently, in a few of the state reform bills. In California, another state where Democrats boast the governorship and a super-majority in the Legislature, Gov. Jerry Brown last year proposed a bold reform backed only by Republicans and eventually settled on a lesser one that won legislative approval. It lengthens the peak salary period from one year to three and caps the salary at which new employees can earn benefits at $110,000. 
 
California has two mammoth funds: the California Public Employee Retirement System (CalPERS), which administers a $260 billion investment portfolio, the sixth largest pension fund in the world, for 1.7 million past and present state workers, and the California State Teacher Retirement System, CalSTRS, a $166 billion fund for teachers. State Controller John Chiang (D) last year said that CalSTRS had failed to control spiking and provided so little oversight that each of the state's school districts faced an audit only once in every 48 years. The teachers' pension fund says that it has since sought to increase oversight and eliminate spiking abuses. 
 
Although limiting spiking and other rip-offs will help at the margins, states and cities face a daunting task in trying to reform their pension systems. The U.S. Constitution forbids states from passing a law impairing contracts, which some states interpret as meaning that pensions are a contractual promise that can't be altered. But these promises mean little if a city defaults, as Detroit workers are now learning. 
 
Voters have gradually become aware of the squeeze on services caused by excessive pensions: in many cities they are paying far more to compensate retired police officers and firefighters than current ones. Last year voters in San Jose and San Diego rebelled, passing initiatives that made drastic cuts in pension benefits and were widely hailed as the dawning of a new day. Instead, public unions sued and the initiatives in these two California cities are mired in litigation. 
 
The simplest way to reduce pension obligations would be for state and local governments to do what private industry has done and shift from a defined-benefit plan, in which a pension is based on seniority, to defined-contribution plans such as the 401k in which employees are required to underwrite a significant portion of their requirement. But although the pension battle does not break down along strict party lines, many Democrats would oppose such a solution, which in any case would face the legal challenges that have enmeshed the San Jose and San Diego initiatives. 
 
So the likelihood, politics being what they are, is that most jurisdictions will cut back on pensions for new hires, which pose few legal obstacles, and hope to muddle through. Perhaps they'll make it, but it's no sure thing in the shadow of Detroit.

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