Unfunded Public Pensions -- the Next Quagmire

Thursday, August 19, 2010

The next big issue on the national political horizon may be whether the federal government should bail out the many budget-strapped states and municipalities across the country, especially their overly generous and badly underfunded pension plans.

My home state of Illinois is in the deepest quagmire of all. We are essentially broke and getting by in the near term by borrowing and not paying our bills. Our longer-term problem is even more serious, as some of our pension plans may run out of money within about 10 years. Our unfunded pension obligations approach $80 billion, and our unfunded retiree health obligations add approximately $40 billion more.

The troubles in Illinois and other states may soon force the federal government to choose among three options. The first is to do nothing -- in which case some pension plans will go bankrupt, retirees will suffer, and many local governments will face emergency cost-cutting and taxing scenarios that will drive out businesses and jobs.

The second option is to yield to the pressures, especially from state officials and organized labor, for condition-free bailouts and loans. Finally, the feds could choose to pressure ("incentivize") states and cities to straighten out their own affairs through loans to which they attach stringent conditions.

The consequences of doing nothing would be painful. But they would be far less harmful than the consequences of an unconditioned federal bailout, which would mean massive new fiscal commitments at the federal level.

Unfortunately, leaders in Illinois and elsewhere are now talking quietly about the possibility of a federal bailout. Such speculation undermines state and local efforts to reform pension systems or make other hard choices. Why agonize over unpopular budget cuts or tax increases if the feds will ride to the rescue?

Bailing out state pensions would be astronomically expensive. According to a Pew Foundation estimate this year, the total unfunded liabilities of the 50 states' pension funds amounted to about $1 trillion in 2008. Another recent study, by Josh Rauh of Northwestern and Robert Novy-Marx of the Chicago Booth School of Business, estimated that the unfunded liability was closer to $3 trillion. Adding the liabilities of municipal pension funds makes the total even larger.

The downside consequences of such expensive bailouts would be governmental as well as financial. Among other things, bailouts would seriously corrode one of the relief valves within our federal structure. Today, when a state manages its affairs in a particularly ineffective or costly way, its citizens can move to other states. If Washington were to take responsibility for state and local pensions, all taxpayers -- in all states -- would bear the burden.

A better approach would be for Washington to offer states support coupled with sustained pressure over the next decade. Participation by each state would be voluntary.

One form of support could be low-interest federal loans. An alternative could be federal authorization to issue tax-subsidized bonds, as suggested in June by Messrs. Rauh and Novy-Marx in The Economists' Voice electronic journal. Either way, federal support should be conditioned along the following lines:

-- State and local pension funds -- and not the federal government or state and local governments (except where state or municipal guarantees have already been made) -- would be responsible for pension obligations already incurred for past service.

-- Current defined benefit pension plans would be "frozen," meaning no new benefits would be accrued under those plans.

-- Participating states could set up new retirement programs for both current and new employees in the form of defined contribution plans such as 401(k)s. Under this approach, the money contributed by employers and employees would be used solely to generate savings for those employees; it would not be used, Ponzi-style, to pay pension benefits to current retirees under the old underfunded plans.

With defined contribution plans, states and cities would not bear the risks associated with underfunding or the underperformance of fund assets. Most state and municipal workers would be able to start taking their money out of the plans at the same age as private-sector employees (police and firemen could retire earlier, e.g., at age 60).
As an alternative to a defined contribution plan, states could adopt new, lower-cost defined benefit programs, subject to the requirement that funding be adequate to cover the costs.

These reforms would still leave the state plans with their current underfunded, defined benefit pension liabilities. Though state laws vary, many states and cities may be able to take the legal position that they are not liable as guarantors if and when a pension fund goes under. In Illinois, a retiree's contract claim would be against the pension fund, not the state. In any event, practically speaking, it is not likely that retirees would be able to recover tens of billions of dollars in past pension claims against their states.

Where do they go? The federal Pension Benefit Guaranty Corporation (PBGC) covers only private-sector plans, not state or other public-service plans. These could not easily be brought under the PBGC umbrella, and indeed, the last thing we need would be another, separate PBGC-type federal guarantee program for state and municipal pensions.

But when a major state pension fund runs out of money, there will be no good choices. Saddling states with billions in pension-fund debt is unattractive, but so is leaving retirees who are not under Social Security (like Illinois teachers and most Chicago workers) with busted pensions and no relief.

States might consider adopting one element of the federal PBGC plan. When a troubled private pension plan is administered by the PBGC, the agency pays less than 100% of what pensioners would receive if their plan were solvent. These reduced amounts vary with the retirement age: the earlier the retirement, the lower the maximum payment. In Illinois, where state employees can retire at 55 with enough years of service (and Chicago employees can retire at 50), such an approach would lead to significant haircuts.

Retirees and employees would not be happy with any amount less than the full annuity owed by their plans. But when plans are headed toward bankruptcy, such PBGC-type protection would be better than nothing, which is what they would get from a bankrupt fund.

Public pension funds are in dire need of change, but state and local hopes for a federal bailout now stand in the way of change. Quashing that hope -- which the Obama administration could do with an explicit statement that it will not bail out state and local pension funds -- would spur the reforms we need.

Mr. Martin is of counsel at the law firm of Sidley Austin and president of the Commercial Club of Chicago.