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State and local retirement shortfalls will trouble us for many years [ClearOnMoney]
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State and local retirement shortfalls will trouble us for many years

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Commentary

State and local retirement shortfalls will trouble us for many years

18 Feb 2010 by Jim Fickett

Pew released a report today on the funding shortfall for state retirement benefits. The shortfall is a trillion dollars, even before recent stock market losses are fully factored in. Municipalities are not covered by the report, and many also have serious pension and healthcare funding issues. This is a bigger problem than the much-publicized current budget deficits of the states. It is certainly possible that some of the obligations will never be paid, so choose municipal bonds with great care and, if you are expecting state benefits, consider backup options in case they could be reduced.

Pew Center on the States released a research report today entitled The Trillion Dollar Gap, on retirement obligations of states and the extent to which they are funded. As with the federal government, the unfunded pension and healthcare obligations of states are considerably greater than their current budget shortfalls, much as the latter are making the news, so this is a topic that will be hitting the headlines regularly for many years. The whole report, well put together and worth reading, is 66 pages, but the executive summary gives the key messages and is only 12 pages. (Is it just my imagination, or have “executive summaries” grown significantly in the last 10 years?)

Here are a few highlights:

[In a nutshell]

Of all of the bills coming due to states, perhaps the most daunting is the cost of pensions, health care and other retirement benefits promised to their public sector employees. An analysis by the Pew Center on the States found that at the end of fiscal year 2008 [for most states, Jun 2008], there was a $1 trillion gap between the $2.35 trillion states and participating localities had set aside to pay for employees’ retirement benefits and the $3.35 trillion price tag of those promises.

To a significant degree, the $1 trillion gap reflects states’ own policy choices and lack of discipline: failing to make annual payments for pension systems at the levels recommended by their own actuaries; expanding benefits and offering cost- of-living increases without fully considering their long-term price tag or determining how to pay for them; and providing retiree health care without adequately funding it. …

The funding gap will likely increase when the more than 25 percent loss states took in calendar year 2008 is factored in. …

according to the National Conference of State Legislatures (NCSL) … [state] revenues are expected to continue to drop during the next two years. …

[Health care is a bigger problem than pensions per se]

Health Care and other Non-pension Benefits … states have an average funding rate of 7.1 percent—and 20 states have funded none of their liability. …

one way to understand the magnitude of the unfunded liability is to compare it to the current annual payroll that is covered by the plan. … For fiscal year 2008, the unfunded liability exceeded covered payroll in 22 states. In four of these states, the excess was less than 10 percent. In seven states, the unfunded liability was more than twice the covered payroll. …

For many years, states offered their retirees health care benefits without ever identifying the long-term costs. That changed in 2004 when the Governmental Accounting Standards Board created statements 43 and 45 that required governments to report on their long-term liabilities for retiree health care and other non- pension benefits. …

[A few examples of egregious gaming of the system]

For a long time, New Mexico periodically granted benefit increases in lieu of salary increases, creating a benefit structure that became one of the most generous in the country. one notable aspect of New Mexico’s pension systems has been its early retirement age: general employees can retire with full pensions after 25 years of service at any age, and law enforcement personnel can retire at any age with only 20 years of service. … In addition, a significant lobbying push by the state’s municipalities led to the removal of the cap on what individuals could earn if they retired and returned to government work. Without the cap, workers could earn both a full salary and a full pension simultaneously. The case to permit retirees to return to work was strengthened by shortages in police departments. But the legislation was not limited to public safety—the income caps for retirees who returned to work were removed for everyone. …

In Vermont … In 1991, the state began to allow employees to retire at age 62 with no vesting requirement. This meant an employee could work for the state a few months, and as long as he or she retired directly from state employment, Vermont would pay 80 percent of medical premiums for the employee and spouse for the rest of their lives and for other dependents until they reach an age at which they are no longer covered …

Pension benefits are supposed to reflect the employee’s salary level and are thus based on the worker’s wages in the final years of his or her employment. Workers have found ways to boost their salaries in those final years, greatly increasing the level of benefits to which they are entitled. Common ways to boost salaries include ensuring that overtime goes to the most senior workers, saving sick leave and getting temporary promotions or last-minute raises. …

[A fundamental tension: government workers are still getting defined benefit plans, while most taxpayers are not]

According to the Bureau of Labor Statistics, 86 percent of state and local government employees participate in a retirement plan compared with 51 percent of private sector workers. Defined benefit plans also are far more prevalent in the public sector. While only 20 percent of private sector employees have access to defined benefit plans, 90 percent of public sector employees do. …

the fact that taxpayers are asked to fund benefits that they often lack themselves, has created a politically potent push to alter the status quo. …

[A common but foolish way to try to get out of the difficulty is to borrow more]

One of the options many states consider when their pension obligations appear to be careening out of control is the use of pension bonds. With these instruments, a state or local government can borrow money from investors in the bond market for up to 30 years and put it in its pension fund. The lump sum the government receives from the sale of the bonds is then invested with the intent of generating a high- enough return to adequately fund the pension plan and perhaps even raise additional cash. (Similar bonds can be used to pay for retiree health care benefits.) Of course, states run the risk that their actual returns will be lower than expected—and lower than their borrowing costs. In that case, they may end up losing billions on these deals. …

[And this is just the states, not the local goverments]

this study includes plans for municipal workers or teachers when those plans are run by the state and the state maintains a financial interest. Locally run pension plans were excluded.”

The report did not cover separate municipal plans.

Anecdotal evidence (cf. the bankruptcy of Vallejo, CA) suggests the problems in municipalities are as bad as those for states, with the same motivations for postponing costs and perhaps even less capacity for professional funds management.

The resolution will take many years, and will involved considerable tension – Mike Shedlock details 16 cases where towns have fired the police department, and ABC news reports that some fire and police departments have shocked beneficiaries by billing after the fact.

Local and state budgets are significantly intertwined – 40% of municipal receipts were transfer payments from the state in 2008 (National Economic Accounts, table 3.21), and those towns firing the police department were instead relying on county or state resources. State and local budgets are going to be in crisis for a long time, and it won't be only the bond markets that are affected.

As a policy advisor, Pew tries not to be alarmist and to make constructive suggestions. As an investor, I rather doubt, in many cases, that the obligations will be paid. This is one more reason to worry about inflation, which may appear to many economists and policy makers as the only way out of the dilemma. In any case, choose municipal bonds with great care, and if you are expecting a state pension, consider backup options in case benefits are somehow reduced.