We need compromise on public pensions

Last week I went all Aaron Carroll. This week I go all Don Taylor to mention cash balance pensions in state and local public finance.

Leaders of a local nonprofit went to a bank asking for a line of credit. Asked about their cash flow and accounts receivable, they showed on their books some pretty hefty reimbursements due from the state of Illinois. The banker frowned, and said: “What else you got?” That’s the shape Illinois is in right now because of recession, political gridlock, high health care costs, insufficient taxation, and poor financial practices at several levels of government.

One additional concern must be mentioned, too: Our state’s $100 billion+ unfunded liabilities for public pensions and retiree benefit obligations. This is a problem that must be quickly addressed. Otherwise, as is happening with the related problem of rising health care costs, these unfunded liabilities will cast dark shadows over everything else we need to do in state and local public policy.

It’s easy to overstate things here. $100 billion is a stock not a flow. Illinois’ gross state product exceeds $600 billion. A permanent, one or two percentage-point increase in the state’s too-low and too-flat personal income taxes would basically cover the problem. Sadly, that’s a hard sell in a state that has seen four of the last nine governors spend time in prison. (I tell my students that Illinois is the only state with a driving-while-governor profiling problem….)

It’s also easy blame the wrong people for the pension liability problem, and to let others off the hook. Around the country, conservatives seek to blame public workers and unfunded pension liabilities for states’ budget woes. The great recession has stressed state tax revenues at precisely the moment that rising numbers of people need costly services. Rising health care costs, declining private health coverage stressing Medicaid, the end of the federal stimulus, and stock market booms and busts play important roles.

Then there’s what New America Foundation’s Mark Paul and Micah Weinberg  call “pension envy.” Millions of Americans understandably resent public employees who have generous defined-benefit pensions and retiree health benefits. These have all but disappeared in the rest of the economy. The statistics on 401(k) plans are sobering. All too often, these fail to provide employees with secure retirements. Jonathan Cohn rightly notes that this envy more strongly reflects the erosion of private retirement benefits than it does any genuine excess provided to government workers.

Public employees have fared better. Yet at least in part, they have done so by foregoing outright wage increases for benefits in retirement. When one considers total compensation—including the fact that many public employees don’t receive Social Security—the overall compensation of public workers is reasonable.  Unfortunately, these generous benefits were not properly funded in states such as Illinois. This is a serious and chronic failure of our political marketplace. Virtually every stakeholder bears some responsibility for it. Virtually every stakeholder will need to give up something to solve it.

Elected officials faces obvious incentives to back-load employee compensation to show superficially disciplined budgets. Public employees face similar incentives, knowing that outright wage increases are decidedly unpopular with an electorate that wants to pay red-state taxes while receiving blue-state services. The electorate is also non-too-happy to provide true market wages to public workers.

Despite some sweetheart deals that receive outsized media attention, most public collective bargaining agreements have been reasonable. At least these would have been reasonable had they been properly financed. Yet of course the same political incentives that lead both sides of the table to back-load compensation encourage elected officials in both parties to under-fund these financial obligations.

Public employees bear some responsibility, too, because they are major political players. Their votes and organization provide considerable sinew for the modern Democratic Party. Especially in low-turnout elections, public-sector unions matter. There’s nothing wrong with that. They have earned their seat at the table. Precisely because they have done so, they bear some responsibility for the results.

Political pathologies undermine professional budgeting practices in other ways, too. Governor Quinn sought to restructure state debts to reduce the backlog of unpaid bills and lower borrowing costs. He could not move these eminently sensible measures through a sclerotic legislative process. Few states have professional, politically independent budget agencies with the street cred and clout of (say) the Congressional Budget Office. Couple these deficiencies with a political marketplace that strongly focuses on short-term surpluses and deficits. The predictable result is a serious long-term budget problem.

Especially worrisome are the unrealistically high rates of return projected for many public funds that makes them appear more in-balance than they really are. Here in Illinois, many funds project annual returns of 7.75 percent. (Thirty-year federal securities currently return about 3.2 percent. ) At best, such presumed returns reflect wishful thinking. At worst, these projections reflect a dangerous temptation for managers to chase high returns in a volatile financial market.

In my view, public employees should receive a new kind of pension, whose benefits are more secure and transparent to them, to their employers, and to the voting public than is true under the current system. Mark Paul and Micah Weinberg  have examined California’s equally severe financial and political challenges in that state’s public pension system. These authors tout an alternative called “cash balance pensions.”

These provide a reasonable compromise between private 401(k)s and the existing public pension system. As occurs in the private sector, government would contribute some agreed percentage of an employee’s income to a pension account.  This brings needed predictability and transparency to public budgets. At the same time, employees would be guaranteed an annual rate of return on real money actually set aside for this purpose. A crucial feature would be to base these returns on actual market rates offered by private market products.

A well-designed cash balance pension system would enjoy economies of scale, and could therefore implicitly impose low fees. It should also be structured to protect workers from behavioral-finance pathologies that lead so many of us, such as Joe Nocera, to screw up our own retirements. Paul and Weinberg note that these pensions would be portable, and could provide a valuable framework that could be implemented in the private sector.

I’m not much of a bipartisan guy these days. I make an exception for this issue, which requires good-faith bipartisan negotiations. Everyone has gotten us into this mess. Everyone has to help finding a way out.

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