The Great American Ponzi Scheme

Do we want public pensions? There are compelling reasons why we do

In San Diego, fire stations are suffering brownouts. Library hours have been cut by a quarter, youth programs reduced by half. There are fewer cops on the street but more potholes, and because trimming of the city's 30,000 palm trees has been reduced, pedestrians face more risk of being knocked silly by a falling coconut.

The city has budget problems, just like every other major American metropolis. But as San Diego girds for a mayoral election next year, the biggest issue isn't the overstretched budget or the atrophy of local services. It's pensions. Councilman Carl DeMaio, who is running for mayor, is backing a ballot initiative to phase out the local pension system for city workers. Jerry Sanders, the current mayor, backs a weaker version. Rebecca Wilson, outgoing chief of staff for the system, which manages benefits for 20,000 members, worries that DeMaio's will pass. "People are very anti-pension," she says.

Why this is so in San Diego—and Trenton, Madison, and countless other cities and states—has something to do with the size of public employee pension checks and something to do with the evolution of the public and private workplace. Benefits in San Diego are undeniably sweet—firefighters and police can retire at age 50 after 20 years of service, other vested employees at age 55. A firefighter who retires after working 25 years collects a pension equal to three-quarters of his salary—again, a very good deal, although civil servants in San Diego don't qualify for Social Security and roughly half of their pensions reflect the sums that they, the employees, have been contributing.

The benefits are generous, but they're hardly so rich as to put the nation's seventh-biggest city—and the world's 33rd-richest, according to PricewaterhouseCoopers—at risk of bankruptcy. So how did pensions get to be Public Enemy No. 1? To understand the anger, it helps to answer a more substantive question: How did a conventional vehicle for retirement savings become a time bomb in public budgets?

San Diego provides a revealing case study. It costs a sum equivalent to 11 percent of the city payroll to keep the pension current each year. In other words, for every dollar that San Diego pays out in salary, it accrues 11 cents in future pension liabilities. If San Diego only had to set aside that 11 cents, people wouldn't mind. But it doesn't. It has to put 41 cents into the pension plan for every dollar of payroll. That's because the city fell far behind on funding its pension plan, which has been further depleted by successive Wall Street crashes. San Diego's future pension obligations are currently underfunded by one-third, according to a spokesman for the city's retirement system. Like a home dweller who skipped years of mortgage payments, the city has seen its servicing costs skyrocket: Its annual pension payments have jumped from $68 million in 2002 to $231 million.

The story's the same around the country. City officials in Costa Mesa, Calif., have informed nearly half of municipal workers that they can expect to be laid off in September. Fiscally strapped Republican governors such as New Jersey's Chris Christie and Wisconsin's Scott Walker, and even true-blue Democrat Andrew Cuomo in New York, are furiously trying to restrain pension costs. U.S. public pension systems are underfunded by about $1 trillion, according to the National Association of State Retirement Administrators (NASRA), and some estimates put the figure as high as $3 trillion. The gap is due to a bitter dispute regarding the proper rate at which to discount future pension liabilities. States arguably have used rates that understate their debts, although the question of what exactly is the proper discount rate is not easily resolved. The deficit, in any case, is huge—indeed, it dwarfs the losses suffered to date by the federal government in the mortgage crisis.

How the system became so underfunded owes in part to the perverse mathematics of pension plans and in part to the nature of public employment. This is not to say that pensions themselves are perverse. When people complain about Social Security being a "pay-as-you-go" system, they're lamenting that, rather than accumulating savings, Social Security is essentially a transfer scheme; the money comes in from current workers and goes to retirees. Pensions are more prudent: Benefits grow with each year of an employee's service, and funds are contributed annually, so that the increase in the future liability is matched by a rise in invested savings. The burden of contributing is shared by both employer and employee. Relative contributions vary widely—in Massachusetts employees contribute 11 percent of their salaries, the state less than 3 percent. In New York, employees with 10 years' service contribute nothing, a plum bestowed by the legislature in 2000, at the tail end of the high-tech bubble. Simultaneously, in California many localities were allowed to contribute zero, the expectation being that investments would levitate to the sky.

CHRONIC EXUBERANCE

The virtue of a conservatively tailored pension plan is that contributions, appropriately invested, will be sufficient to pay the promised benefits in perpetuity. The vice arrives, firstly, from that modifier, "promised." Unlike that of a 401(k), a pensioner's annual stipend is guaranteed. If the fund is insufficient, the responsibility to make up the deficit falls solely on the employer. The government—the taxpayer—is the party at risk.

Human nature being prone to exuberance, the problem of pension insufficiency (or irrational expectations that lead to insufficiency) has proved chronic. In 1913, New York City commissioned a report on the finances of its then-depleted police pension fund. The authors, stretching to paint the picture in dire terms, warned that, from that moment to the distant year 2000, pensions for policemen would total $375 million. As it turned out, by the waning years of the century, police pensions cost more than that every year.

As miserably as pension funds have performed recently, the deficits cannot be chalked up solely to bad luck in the market. Sponsors, which is to say cities and states, have at times deliberately underfunded them. The system almost encourages bad behavior. As has often been demonstrated on Wall Street, the opportunity to issue a far-off obligation can sire a powerful temptation to promise more than one ought.

Consider an example from the private sector, Studebaker—after World War II a struggling automaker. Unable to increase wages from the mid-1950s through the early 60s, Studebaker struck repeated deals with the United Auto Workers, according to which pension benefits were raised no fewer than four times. This was cynical in the extreme; both sides knew the money to pay those benefits wasn't there. Studebaker rested its hopes on a sexy new compact, the Lark—a squarish yet sprightly model that enticed my father to buy. Our Lark, gleaming red, would cease its warbling on a family trip—it simply gave out on the highway—as did, in 1963, Studebaker's auto operation. This being prior to the era of federal bailouts, manufacturing ceased, and workers were informed that the bulk of their pensions would not be paid. The loss was devastating—some $15 million in benefits were just extinguished.

Studebaker's collapse went a long way toward reforming practice in the private sector. Shocked by the sight of destitute workers, Congress set about regulating pensions, which it accomplished with the Employee Retirement Income Security Act (ERISA) in the early 1970s. Among its other requirements, ERISA mandated that corporations that offered pensions also had to fund them. The law was hardly perfect: In the 1990s and '00s, various steel, auto, and airline failures left pension funds with huge deficits, which federal insurance only partly covered. One could argue that ERISA actually hastened the demise of the private system—that, in other words, once corporations faced the burden of supporting a pension honestly, they switched to 401(k)s, which impose no future commitment.

ERISA did not address public pensions. In the 1960s and '70s, as the private system was undergoing reform, municipal and state workers were rapidly unionizing, leading to a wave of demands for richer benefits—health care as well as pensions. Pensions had long been a staple of civil service jobs, but unions sought a raft of costly changes, such as an earlier retirement age, more liberal calculations of a worker's final salary, and lower thresholds for disability. Rather than raise taxes, government officials chose to mollify labor with pensions they did not always fund. Profligacy ebbed and flowed with the economic and political tides. In the liberal 60s, New York lavished benefits on subway, sanitation, and safety workers. In the 70s, on the brink of bankruptcy, the Big Apple cut back—only to succumb to a new round of hikes in the buoyant 90s. Illinois, on the other hand, made a practice of consistently rewarding unions without bothering to fund.

Legislators across the U.S. quickly grasped that, by the time the benefits they were voting on came due, they would be pensioners themselves. The burden of funding thus fell to their successors, creating an insidious moral hazard. Pensions became a "free" political favor—free to the officials in power, though not to future taxpayers. The pressure to ratchet up benefits was almost irresistible, since public unions hold considerable power to influence the elections of the very legislators who determine benefits.

In San Diego, such conflicts inspired a tawdry plot. In 2002, the deteriorating position of the pension required a step-up in funding, which the city was ill-prepared to make. The retirement system's board, dominated by union officials, agreed to let the city defer its required higher contribution in return for an increase in future benefits. Shamefully, the city council agreed. This left the pension system with both higher obligations and lower funding. The deal, when exposed, left San Diego scandalized and impoverished.

Although pension agonies are rarely so conspiratorial, the result is often similar: guaranteed pensions and ad hoc funding. State laws superficially mirror aspects of ERISA, but legislatures are free in any given year to abolish the requirement to fund. Thus, New Jersey's Christie, facing an unpalatable choice of either tax hikes or budget cuts, chose to balance the budget in 2010 by skipping the state's $3.1 billion contribution. Massachusetts, similarly, underfunded by $1 billion.

It's natural to wonder whether employees in such realms will discover that their pensions are worthless. That occurred last year in Prichard, Ala., a city of 28,000 that stopped sending retirees their checks. Aging retirees were forced to go to work; at least one declared bankruptcy. In other small cities, such as Central Falls, R.I., pension failure is a distinct possibility. Funds in more than a few large cities, including Philadelphia, are also in dire shape, as are those of at least a half-dozen states, including Illinois, California, and New Jersey. Puerto Rico's pension system is essentially bankrupt.

MEANS OF ESCAPE

Cities and states, unlike car companies, cannot simply liquidate. Even in bankruptcy, public pension obligations are generally assumed to remain in force. Such provisions have rarely been tested, so legal certainties are lacking. But Vallejo, Calif., which entered bankruptcy in 2008, chose not to challenge its workers' pensions. It's easy to imagine that the federal government will feel forced to bail out the most desperate cases. And yet the solvent (or nearly solvent) majority of the country will not take kindly to rescuing the likes of Illinois, which has let its pension system deteriorate to 50 percent funding, meaning it has assets to cover only half of its eventual liabilities. Another escape hatch—pursued by the Commercial Club of Chicago, no less—would be litigation. The club has solicited a rather wishful legal opinion from the Chicago-based firm of Sidley Austin arguing that if the Illinois pension system went dry, pensioners could not compel the state to honor its promises. Yet another "solution," a fantasy promoted by Newt Gingrich, is that Congress will amend the bankruptcy law to permit states to challenge their obligations. The idea has not gained traction.

The likelihood is that public pensions—the great majority of them, anyway—will be paid, though some may require higher contributions. They will also put more stress on local budgets. The parties feeling the pain aren't retirees; they are taxpayers, employees (due to layoffs), and citizens suffering larger classroom sizes and unfilled potholes. Pensions are a long-festering corrosion in the body politic, but they are not remotely the sole cause of budget pressure, for which the national recession is the most immediate source. Public employees who feel unjustly singled out for blame may have a point. A December 2010 essay in the online journal American Thinker is representative of a certain du jour vengefulness toward labor. In it, Gary Jason, an adjunct professor of philosophy at California State University Fullerton, promotes the idea of releasing the names of retired civil servants receiving six-figure pensions (New York State has 3,700 of them). Before we set a mob after schoolteachers and sanitation workers, it should be noted that the average public pensioner in the U.S. receives only $27,000 a year, according to the Center for Retirement Research at Boston College. That figure, however, is somewhat misleading, since it includes many people who spent only a fraction of their careers in public service.

The pension burden of states and cities is also less than one would suspect. On average, in 2008, actual pension expenditures soaked up roughly 4 percent of local budgets. That figure is climbing and could easily double, according to the Boston College center. Moreover, the average masks a wide individual variation. Benefits are generally lower in less urbanized areas, whereas in New York City annual pension spending is $7.5 billion, about 15 percent of the budget. Pittsburgh spends roughly 12 percent of its budget on pensions, which were agreed to during its heyday as a steel town, and which it can no longer afford. Of course the expense would be higher if localities were fully funding. If Illinois reckons with the need to pay down its deficit, it will have to devote at least 10 percent of expenditures to pensions for 30 years. Facing that kind of burden, it's hard to see how the public pension crisis doesn't lead to a fresh wave of municipalities considering the abandonment of pensions in favor of 401(k)s. Should they?

PENSIONS ON TRIAL

The arguments for terminating pensions are centered on the ways in which they have been abused. First is the moral hazard that leads to underfunding. Second, benefits begin at too young an age; as life expectancies have increased, pensions that kick in at 60 or below have turned into support systems that endure for two, three, and even four decades, creating a burden that the states never envisioned. Third are the sensational cases of individual abuse—employees who inflate their pensions by working overtime in their last year, or who change to a higher-salaried job at the end of their careers.

Such cases are infuriating. In Massachusetts, James DiPaola, sheriff of Middlesex County, filed for retirement in 2010 to start collecting his pension, then announced he would run for reelection, to stay on salary. The case had a tragic coda: Allegations of impropriety surfaced, and in November DiPaola committed suicide.

Headline-grabbing abuses matter less than the long-standing notion, often enshrined in state constitutions, that even ordinary benefits, once established, can't be reduced. Thus, regrettably, it takes only a single moment of exuberance by legislatures to gift-wrap higher benefits forever. Finally, there is the political question of whether taxpayers should support richer retirements for government employees than most enjoy for themselves.

In fairness, governments are better equipped to handle pensions than private employers are. For a worker hired in his or her 20s, an employer's pension commitment will endure, potentially, for 70 years. No private corporation can pretend to know if it will be around that long. As Keith Brainard, head of research for NASRA, points out, "States and localities are perpetual." There's also an actuarial reason for preferring properly funded pensions over 401(k)s: Pensions benefit from the insurance feature of collective savings. If you save for yourself, you have to worry about living to 99, and conservatism may well lead you to oversave. A pension fund merely must provide for average longevity.

For all the problems of pensions, 401(k)s have hardly covered themselves in glory. One of the great fictions of the past two decades, promoted with gusto by the mutual fund industry, is that the typical wage earner is able to manage his own portfolio. In fact, private accounts are pitifully insufficient. In 2007, before the crash, the average 401(k) for people nearing retirement held only $78,000—a formula for old-age penury.

Since the bust, the public pension industry has so far defied forecasts of its demise. North Dakota and California considered and rejected switching to 401(k)s. Since last year, Utah has been giving new employees a choice of a 401(k) or a traditional pension. In Florida, where employees have enjoyed such a choice since 2001, the vast majority of employees have stuck with pensions. Only Alaska has abolished pensions outright for new employees. Michigan has done so for state—not local—workers.

Given the presumption that pensions are immutable, reforms have attacked the benefits of mainly future employees. This is a slow way to save money, since someone who starts work tomorrow would likely not collect a pension until the middle of the century. Recently, though, states have also started to snip at existing workers' pensions by raising their required contributions or cutting inflation adjustments. San Diego is exploring a new tack: defining more narrowly how much of an employee's pay is pensionable. The reforms are difficult to quantify—some are merely proposed, while some have been adopted but challenged in the courts, and they vary from state to state.

A looming issue, technical but important, concerns governments' ability to slow the rate at which employees accrue benefits. A private corporation can slow or even "freeze" accruals. In a freeze, workers who stay on the job no longer add to their benefits. (Benefits already earned, of course, remain.) But for public employers, such adjustments have been considered off-limits legally, even when labor contracts expire: You can cut a cop's salary, you can lay him off, but don't touch his accruals. Public pensions, in this regard, loom as an oddly out-of-date institution, as rigid as the codes of a medieval guild. If pensions are to survive, public employers need the same freedom as others. The current straitjacket, argues Alicia Munnell, director of Boston College's retirement research center, is unreasonable. Given that companies can freeze their plans at a moment's notice, she says, "It's a real inequity" that government sponsors are locked in.

Besides pushing the courts to give ground on accruals, what would make pensions more viable in the future? The answer has been obvious for 30 years. Public pensions need an equivalent of ERISA—federal regulation that would keep public employers on the straight and narrow. Congress could mandate that localities that did not fund at a pace consistent with accruals would lose the right to issue tax-exempt bonds. That would cure the temptation to promise too much and fund too little.

The broader question, though, is: Do we want public pensions at all? There are some pretty compelling reasons why we do. Public servants are still, in the main, careerists. It's in the public interest for fire departments, schools, and the like to retain their workers; pensions are an unmatched tool for doing so. Ideally, pensions would be combined with 401(k)s, so the government pension would guarantee only a portion of retirement income, enough for a decent living standard but not more. The burden of providing retirement income above that level would fall on the employee, through a 401(k). And consistent with the aim of supporting retirees when they are no longer able to work, pensions should kick in no earlier than age 60 in blue-collar professions and 65 in white-collar ones.

Finally, employers must be free to negotiate changes to pensions over time. In no other area of public policy are governments beholden to decisions made decades ago. The above reforms are readily achievable. The highest priority—lest a federal bailout become necessary—is a federal prod to full funding, similar to ERISA. That might induce legislatures to reduce benefits; then again, it might not. It would be up to officials to weigh the exigencies of the labor market, knowing that each dollar spent on pensions will deplete the budget for competing programs or require additional taxes. This is the type of political tradeoff that legislatures are elected to make. What cannot endure any longer is the legislative fantasy that pension benefits are free.

Lowenstein's latest book, The End of Wall Street, was just released in paperback.

Lowenstein is a columnist for Bloomberg News.