Fate of the States: The New Geography of American Prosperity

by Meredith Whitney

  Taxpayers are asking some very pointed questions. “Why is my neighbor’s pension payment more important than my daughter’s right to a good education in a class with a low student-teacher ratio?” “Why are we laying off police officers and letting crime rates spike to pay pensions for retired cops who now live out of state and don’t even pay local taxes?” Public employees have a reasonable response: If taxpayers don’t like the terms of their union contracts, then they shouldn’t have elected the mayors, school boards, and city council members who approved them. Of course, mortgage lenders had a similar type of response—if you don’t like the terms of your adjustable-rate mortgage, why did you sign the papers?—but their argument was overwhelmed by financial realities. In the aftermath of the housing bubble, the priority of payments got flipped. Consumers who had once paid their mortgage bills before anything else—they couldn’t risk losing the equity in their homes, after all—suddenly started giving precedence to car and credit-card payments over their mortgages since they no longer had any home equity to protect. The priority of payments for taxpayers is about to undergo a similarly dramatic shift.

  Years from now, 2008 will prove to be a turning point in American history. In just one year the Dow lost 33.8 percent and the S&P lost a staggering 37 percent. For many Americans this meant huge portions of their retirement nest eggs; their IRA and 401(k) savings suddenly evaporated after years of scrupulous saving. Factor in job losses and destroyed home values, and the retirement hopes of many Americans faced some serious downgrading. No more beach houses. No more summer homes on the lake. The dream now is just having enough money to live comfortably.

  But not all retirement dreams have been downgraded—certainly not those of state and local government employees and retirees. Not only didn’t they have to contribute much money, if any, to their retirement plans, but the payments they receive postretirement are guaranteed by tax dollars. The ups and downs of the stock market had little bearing on their retirement plans. As their neighbors wept over their year-end 401(k) statements, public employees barely even looked at theirs. Their retirement was money in the bank.

  For decades this divide wasn’t something broadly discussed because the trade-off seemed reasonable. Even as the private market largely abandoned pension funds in exchange for employee-driven and paid-for retirement plans, the fact that the public sector was still sticking to the same old system got little attention. Rather, most understood that there was a fair trade-off between working for the private sector, where benefits might be less generous but salaries were higher, and working in the public sector, where lower pay was offset by a more secure retirement. Moreover, being a police officer or a garbage collector can be dangerous, unpleasant work, so it makes sense to offer some incentives to get people into those jobs. After all, the work-related fatality rate for police officers (nineteen deaths per hundred thousand people) is four times higher than that of the average American worker.5 The problem is, the size and cost of those incentives seemed to grow exponentially. In 2012 the Bureau of Labor Statistics compared compensation (both salary and benefits) for state and local government employees with that of the private sector, and the differential was a staggering 34 percent—in favor of the government employees! Today, “pensions” are almost uniformly associated with the public sector and never discussed in the private sector—unless the topic is reducing or eliminating them.

  Generally, in the private sector an employee is on his own when it comes to retirement savings. Ironically, however, that same employee is on the hook for the public sector’s retirement savings. In other words, a dry cleaner working for himself is responsible not only for his own unguaranteed retirement but also for the retirement of his next-door neighbor, the county judicial clerk. The outrageousness of this guarantee became clear when, in 2009, under directives from the Government Accounting Standards Board, states first disclosed both the size of the pension obligations and how much elected officials had looted from pension funds—usually by borrowing money from pension funds and promising with IOUs to repay it in the future.6

  Aside from suffering dramatic declines from the equity markets over the past decade, pensions have also been the secret slush fund of elected officials. Monies from pension funds are not withdrawn all at once; it’s an ongoing payout as employees retire. Therefore, as long as the retiree is getting his or her check on time, nobody worries about where the money is coming from. By design, officials can offer grand promises of future benefits with little sacrifice today. For example, rather than give a public-employee union a pay raise, which could affect a city’s ability to balance next year’s budget, mayors can offer future cost-of-living adjustments on employees’ retirement plan. These COLAs are effectively built-in annual raises on pension benefits. Over the past decade, while real wage inflation has been just 2 percent annually and closer to 1 percent more recently, many retirees have gotten annual increases of 3 percent or more from their pension payouts. So in reality, pensioners have done a whole lot better than workers. But at some point, when those future promises become current-day realities, there won’t be enough money. That time may be upon us sooner than you think. Josh Rauh, of Northwestern’s Kellogg School of Management, believes that by 2025, over half of states’ pension funds will run out of money.7

  There are other examples of abuse in the pension system that I will describe later, but first here’s a quick primer on how pension accounting works. Today states owe nearly $3 trillion between bonded debt, unfunded pensions, unfunded health insurance, and other benefits. Over half of this relates to benefits for past and current state and local government employees. But even among neighboring states conditions vary greatly. For example, in Illinois the total tax-supported debt per capita is $20,000, but next door in Indiana, that number is a mere $2,000—one-tenth of the pension debt Illinois taxpayers are on the hook for.8

  Under most private-sector retirement plans in the United States, postretirement payouts depend upon how much an employee has put into the plan—usually a 401(k)—how long the employee has been contributing to the fund, and how well the underlying investments have performed. Weakness in any of those three variables reduces the ultimate payout. Of course, how much an employee contributes to a fund and for how many years are factors under the employee’s control, depending upon how much money he can afford to put aside. And as we have learned over the past “lost decade” of zero market returns, investment results are highly volatile. The market crash of 2008 wiped out a decade’s worth of gains for some employees. There are no guarantees under these plans; the employee bears all the risk. How well the fund performs and how much the employee puts in are often the only determinants of how much money will be left at retirement.

  Government pension plans work very differently from private-sector 401(k)s and IRAs. Under government pension plans, the employee contributes little, typically less than 10 percent of the total contribution. The taxpayer is responsible for the rest, and those contributions start on the very first day of employment, whether there is money available or not.9 There are imbedded annual COLAs meant to be buffers against inflation, yet those adjustments are not tied to any particular inflation metric. In a low-inflation environment, they’re akin to pay hikes. The average COLA is around 3 percent per annum. Note that average wage growth has been 2 percent for most of the past decade—and 1 percent more recently.10

  Maybe the most outrageous difference, however, is the fact that unlike the market-dependent results of private retirement plans, government pensions set return assumptions that are guaranteed by the taxpayer. Particularly outrageous are return assumptions that fly in the face of the actual performance of the market over the trailing ten or twenty years. The average annual-return assumption used by government pension funds today is 8 percent, despite the fact that the actual returns of many pensions funds over the past decade have been closer to zero.11 Understanding this makes it easier to see why unfunded pension liabilities have been growing at such a meteoric pace.
For a $30 billion state pension fund, the gap between 8 percent and 0 percent represents $2.4 billion per year that has to be made up by taxpayers. No wonder that inside of just one decade, government pension funds went from being fully funded to being underfunded by nearly $1 trillion.

  Compounding the problems of lower-than-expected returns, imbedded COLA increases, and low employee contributions are irresponsible politicians who too often treat the funding of pensions as a choice rather than an obligation. By not funding pensions in one year, a state could save money for another program, effectively robbing Peter to pay Paul. All this really accomplishes, of course, is adding to taxpayer debt down the road. Failing to make a payment or an actuarially recommended contribution is often justified as a temporary solution to a shortfall in tax revenues, one that will be made good in the following years. However, a state like New Jersey has been inadequately funding its pensions for over a decade and today is underreserved to the tune of $42 billion.12

  Over the years, some states have been playing the equivalent of credit-card roulette with their pension funds. They pay the minimum owed—some shirk even that—hoping to outrun the debt being accumulated. If only they can get one great year of stock-market returns, perhaps their pensions can recoup some lost or withheld funds. If only there’s a pickup in their economies, then a tax-revenue surplus can be tapped to replenish their depleted pension funds. The worst kind of rationalization may be this one: If only we can get a market-thumping return on money borrowed through pension-obligation bonds—the equivalent of taking out a margin loan to buy stocks—then maybe we can make up for the shortfalls in what we owe. In Vegas they call this problem gambling. In state capitals it’s everyday accounting.

  How could all of this happen in plain sight? Just consider the incentives behind sustaining a broken system to the bitter end. When it comes to pensions, politicians are like the guy at the party who orders pizza but then disappears when the doorbell rings and someone has to pay. Many of the pension guarantees were negotiated by elected officials who knew they would be long gone from office before anyone realized that the promises they had made were completely unaffordable for their constituents. Contractually negotiated pension benefits tend to grow during the good times, when the presumption is that the good times will last forever. They don’t, of course. But by the time that’s apparent, there’s usually a new mayor or new governor who has to deal with the consequences. It’s not unlike what happened in the financial industry: Few of the CEOs responsible for feeding the housing bubble are still in charge. “It is much easier for them to use a temporary solution and let the next set of government leaders tackle the problem,” said Edward Mangano, county executive for Nassau County, New York. “This ‘kick the can down the road’ policy has to stop.”13

  There’s also a huge incentive for politicians to make aggressive, unrealistic assumptions about pension investment returns. After all, the more aggressive the accounting assumptions, the smaller the unfunded pension liability appears to be. Pension funds use gimmicks like averaging actual returns over several years so that the real status of the funds doesn’t look so bad. Additionally, by using high-return assumptions—remember, the average today is 8 percent—states hide or understate unfunded liabilities. Simply by assuming high, 8 percent compound rates of return on pension investments, the state can lower the amount of money it is required to contribute to the pension fund. The market does all of the hard work—at least on paper—and those cost-of-living adjustments suddenly become more affordable. States like Connecticut, Louisiana, and Massachusetts have investment-return assumptions of at least 8.25 percent, the highest in the nation. When a fund can assume its returns will be higher, its contributions, naturally, can be lower. In the case of Rhode Island, the state estimated that the contribution, or cost, for a state employee would be over 50 percent higher if the government were to move from an 8.25 percent investment-return assumption to a 6.2 percent investment-return assumption. The actual returns over the period in question turned out to be just 2.28 percent a year. And the lower the return, the higher the required contribution. It’s completely absurd, yet this is not a problem unique to Rhode Island. These games are played all across the country.14

  State and local governments have underfunded—even nonfunded—their pension funds for years now, and they can’t seem to break the habit. As a result, taxpayers are now waking up to unfunded pension liabilities whose size rivals that of their municipal bond debt. When combined with the cost of health insurance promised to current and former state employees, the total obligation is almost 40 percent higher than the bonded debt. In other words, a muni investor or concerned taxpayer poring over state budget documents will end up grossly underestimating the amount of debt the state truly owes if all he’s looking at is bonds. In New Jersey actual debt is at least four times greater than bonds outstanding.15

  But again, not all states are created equal. Collectively, as of 2011, the states are on the hook for nearly $800 billion of unfunded pensions, and when combined with other debts secured by tax receipts, total future obligations exceed $2.5 trillion. Drill down into the numbers and what you find is that some states have been especially reckless, whereas others have actually been strong fiduciary stewards for their taxpayers. So let’s review the good, the bad, and the ugly when it comes to pension policies and how those track records will shape the future of those states.

  In 2000 seventeen states did not meet the “recommended” funding contribution of 80 percent; by 2010 that number had grown to twenty-nine states. If you entered the millennium underfunded, odds are that you are in bad shape today. However, for states that got hit hard by both high exposure to the housing downturn and the 2008 market crash, refilling pension coffers will be a huge challenge. Further tax hikes and budget cuts are political nonstarters in states like Arizona (73 percent funded, with a $10.3 billion unfunded liability), California (79 percent and $104 billion), and Connecticut (53 percent and $21 billion). Nevada began the millennium with a funded ratio of about 85 percent; today that ratio is just over 70 percent, with a $10 billion unfunded pension liability. Which states have managed pensions most responsibly, even in the face of declining tax revenues and weak investment returns? Leaders include Delaware (92 percent, $1 billion), Nebraska (83 percent, $2 billion), Oregon (86 percent, $8 billion), and Washington (92 percent, $5 billion). But the standard setter is clearly New York, which has the only fully funded pension plan in the nation.16 In a state known for political dysfunction, New York has been surprisingly proactive when it comes to pensions. Reforms New York has enacted include raising the retirement age from fifty-five to sixty-two for state workers and from fifty-five to fifty-seven for teachers; requiring higher pension contributions for some public workers; and capping the impact of overtime on pension payouts.17

  As if not contributing to their pensions weren’t bad enough, some states have essentially doubled down on their unfunded liabilities—taking out margin loans, via issuance of pension-obligation bonds, in the hopes of turbocharging their investment returns. Pension-obligation bonds work like this: If a state doesn’t have the money to contribute to its pension funds but doesn’t want to cut money from other spending projects to get it, it has the option of issuing pension-obligation bonds. The idea is that the proceeds of these bond sales can plug big holes in the state’s pensions, so long as the investment returns earned on the bond proceeds exceed the coupon payments to bondholders. The biggest and best example of this “logic” was in 2003, when Illinois issued $10 billion in pension obligation bonds.18 The governor at the time, Rod Blagojevich, sold the bonds as “no-risk, no-new-debt”19 and likened the transaction to a mortgage refinancing. In reality, it was high risk, and it was new debt. It was just a transfer of debt in the form of unfunded pension obligations to the bonded debt of the state. The arbitrage didn’t work: At a staggeringly low 45 percent, Illinois’s funded ratio is 9 percent lower today than it was before the issuance of the $10 billion in pension bonds
, and the state’s bonded debt has tripled from $8.4 billion at the end of 2002 to over $28 billion in 2011—$17 billion of which stems from pension bonds.20 Today Illinois has a staggering $160 billion in unfunded pensions and bonded debt. It also owes an additional $44 billion in unfunded health-care and related benefits.21 This works out to almost $13,000 per capita, the fifth highest in the country but the fourth highest as a percentage of gross domestic product. Add up all the various obligations—pension-bond debt, unfunded pension liabilities, and unfunded retiree health-care costs—and Illinois finds itself in the deepest pension hole in the country.

  Illinois is one of a handful of states that owe more to their pension funds than they do on their tax-supported municipal bond debt. Ohio and New Jersey owe more than twice their tax-supported municipal debt in unfunded pension obligations. Neither has adequately contributed into its pensions for over a decade, so the hole has gotten deeper with each passing year. All three states are in desperate need of pension reform. In fact, the recent teachers’ strike in Chicago seemed to reflect a go-for-broke, get-it-while-you-can negotiating approach by the Chicago Teachers Union. The union had to know that a day of reckoning was coming for its retirement plan—only 60 percent funded and saddled with $10 billion in unfunded pension and health-care liabilities. Rather than pick a fight over pensions, Chicago’s 30,000 teachers went on strike early in the 2012–13 school year to demand huge pay hikes and to protest teacher evaluations and provisions dealing with jobs for laid-off teachers. The strike closed over 400 of the city’s 578 schools, put about 350,000 students in limbo with no supervision and no place to go, and left parents desperate to find some type of accommodation. With the average public-school teacher salary in Chicago at $74,839—versus $56,069 nationally—striking for a 16 percent salary increase over four years seemed outrageous to many Chicago parents, particularly when general wage growth had been barely 1 percent per year.22 But perhaps Chicago teachers felt they needed to get what they could now, knowing that they’d have to give back on pensions later.23