Pensions: How states and local governments indulge in deficit-spending

I’ve finished While America Aged, whose last third is devoted to San Diego. GM was bankrupted by foolish executives, convinced that the auto market would continue to grow, that GM would continue as the leader of an oligopoly for North America, that health care costs would remain low, and that American life expectancy at age 48 would not grow. The New York transit system and then city were bankrupted intentionally by politicians, who were sure that handouts to public employee unions would win them reelection and that the collapse would come at a time when they’d moved on to higher offices. The City of San Diego is sort of the same story as New York, with public employees retiring earlier and earlier and the pension system not being sufficiently funded (though in reality it is almost impossible to fund a defined benefit pension for people who retire at age 50, especially if the benefits are adjusted for inflation; how can anyone know what interest rates or the economic situation will be like 50-80 years from the present?). Both New York and San Diego set up fenceposts every year. If between the fenceposts the stock market had done exceptionally well, the pension “surplus” would be paid out to retirees. If the market later fell back there was no way to recover the money. Given sufficient stock market volatility, both cities’ pension funds would have been reduced to zero within a few years (because after a big random upswing all of the money would have been paid out and then the remaining assets would have shrunk down to almost nothing).

New York City was bankrupted by Democrats who taxed their residents at some of the highest rates in the nation, spent all of that money, and then spent a lot more in the form of unfunded pension promises. The taxes were so high and services and crime in the city so bad that businesses and residents began migrating to Connecticut and New Jersey even before the financial house of cards collapsed in the mid-1970s. San Diego was bankrupted by Republicans who taxed their residents at comparatively low rates. The city kept growing but not at a rate fast enough to keep up with the growing unfunded pension liability. The problems were exacerbated by fraudulent disclosures in bond offerings, e.g,. “we are not underfunding pensions”, and conflicts of interest, e.g., the president of the fireman’s union was on the board of the pension fund and proposed then approved changes that would add $30,000 per year to his pension and have no effect on any other city employee, past or present.

One message of the book is that the corporate managers who agreed to massive pension commitments were uniquely short-sighted. They were mostly in industries with little competition, either due to oligopoly or government regulation. As soon as competition developed (autos, steel) or government deregulated (airlines), the companies would go bankrupt, a disaster for the shareholders but not for the country. Smart modern companies don’t offer pensions because they’ve have figured out what should have been a simple fact: the only enterprises that should be offering to send people a check every year for the rest of their lives are insurance companies (if they write annuities and end up paying twice as much as planned because of an innovation that extends human life they will save a corresponding amount by not having to pay out life insurance claims) and ones that have a printing press for money (i.e., the federal government).

Cities and states have a tougher time escaping pension commitments and traditional bankruptcy protection may not be available to them. If every household in San Diego owes $6,000 for unfunded pension liabilities, property owners and residents will have to cough it up in the form of higher taxes. If the pension fund does poorly in the stock market, the households will have to pay again.

We the people share a lot of responsibility for pushing our towns and states into insolvency. We vote for politicians who promise the moon but don’t immediately tax away all of our income and wealth. A politician who promises $2 in benefits and $1 in taxes will win an election over one who promises benefits equal to taxes. The federal government respects voters’ wishes by running a visible deficit, borrowing or printing money to cover shortfalls. The Federal government can’t become insolvent because it can simply print money to pay everyone back.

Local and state governments, however, are generally prohibited from running deficits. If they borrow, it is supposed to be for capital projects such as building roads or schools. They can do some Enron-style accounting to make it look like they are borrowing to build a new library and then skim money off to pay operating costs, but a city or state cannot simply say “We’re going to spend more than we’re taking in.” They can’t say it, but they can do it. The key is offering and then underfunding pensions for governnment workers.

If a worker is eligible to retire at age 41 (Boston bus driver) or 50 (many California state workers) and receives a lifetime pension comparable to final year’s salary, actuarially roughly half the cost of employing that worker is from the pension. If payroll is half of a state or local government’s budget, not funding the pension at all is financially equivalent to spending $1.50 for every $1 of taxes collected or running a deficit of 33% of total spending. By choosing a funding percentage every year, a government can elect to engage in deficit spending between 0% and 33% of its budget.

The early retirement ages agreed to by governments inevitably exacerbate the financial challenge. Because health insurance is tied to employment and our 41-year-old retired MBTA worker won’t have a job, the MBTA’s customers are now responsible for his health care up to age 65 when Medicare takes over most of the cost. For a worker who is currently aged 20, the MBTA is promising to pay whatever health care costs prevail in the years 2030 through 2054, both for the worker but also anyone whom he chooses to marry and for any number of children that he chooses to have. How can they possibly know what this will cost? Blue Cross won’t sell insurance for more than one year ahead. What does the MBTA know about health care costs in the year 2054 that Blue Cross doesn’t know?

A lot of newspaper ink and television time is spent fretting about Social Security and Medicare/Medicaid. These programs, however, cannot implode. The government at any time can raise the age of eligibility for Social Security and immediately any funding problems disappear. It might be 75 in 2020, 80 in 2030, and 85 in 2040. Similarly the government can decide not to cover expensive procedures or drugs under Medicare/Medicaid. Alternatively, the federal government can print money and hand it out to those entitled to Social Security and Medicare/Medicaid.

The more serious problem is with state and local governments. Their obligations for pensions cannot be ducked and will fall on the shoulders of residents unlucky enough to remain within the taxing jurisdiction that owes the money.

What hope does the author give us for a solution? Precious little. You know that a problem is tough any time that hundreds of pages of descriptions of the problem flow easily and the suggestions seem tacked on as an afterthought. He says that public employeers unions are now so large, entrenched, and politically powerful (literally able to vote their bosses out of a job) that it is hopeless to consider reducing pensions for government workers. The only hope is to put massive amounts of money aside at the time pension commitments are made, relying on actuarial calculations. He fails to note that actuaries are forced to make a lot of assumptions, all of which proved to be untrue in the Crash of 2008. The stock market might collapse. Interest rates might fall to zero. The U.S. economy might go into a prolonged period of decline and deflation. All of these contingencies could be insured or hedged against, but the counterparty risk would be significant. What good would it do for a state to get an insurance company to agree to pay $100 billion in pensions thirty years in the future? The insurance company might not be solvent in 30 years and the federal government might not decided to bail them out. The state or local government is promising to protect the lifestyle of a present-day 19-year-old worker in the year 2100 when he turns 110. “State government” here includes basket cases such as Michigan and “local government” includes Flint, Michigan (very likely to have be reclaimed by forest before 2100).

More postings on the same book: “History of Public Employee Unions”; one on the General Motors section.