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Pension Liabilities Bite in the Present, Too

Politicians often like to kick the can down the road when it comes to debt. Few things illustrate that better than the large pension deficits many state and local governments around the country are now facing. That’s not surprising, given the temptation to pass the bill on to future office holders.

Yet, the pain isn’t all in the future. As a new study from Stanford University’s Institute for Economic Policy Research shows, increasing pension payments are straining California cities’ finances in the here and now. Steven Greenhut of the California Policy Center describes the extent of the problem:

[T]here’s a huge, current problem even for the bulk of California cities that are unlikely to face actual insolvency. They are instead facing something called “service insolvency.” It means they have enough money to pay their bills, but are not able to provide an adequate level of public service. Even the most financially fit cities are dealing with service cutbacks, layoffs and reductions in salaries to make up for the growing costs for retirees.

For instance, the Stanford study reports that pension costs now consume 13.4 percent of the budget of Alameda County (which is home to Oakland), up from 5.1 percent 15 years ago.

What can be done about this?

First, stop hiding the problem through fuzzy math. Many state pension funds used discount rates based on overly optimistic investment return projections that make pension funds appear healthier than they really are. The same Stanford think tank has drawn needed attention to this problem. Ed Mendel at the blog Calpensions notes:

The Stanford institute drew national attention in 2010 when graduate students calculated state pension debt was much larger than reported. To discount future pension debt, they used earnings forecasts for “risk-free” bond rates, rather than stock-based investment portfolios.

Second, appoint non-interested parties to state pension boards. Pension board members are entrusted with spending taxpayers’ money and should be as free as possible from influence from politicians or public employee unions.

In this regard, Canada offers a good example. As The Economist noted a few years ago, Canadian pension boards “attract people with backgrounds in business and finance to sit on their boards, unlike American public pension funds, which are stuffed with politicians, cronies and union hacks.”

As Greenhut’s colleague Ed Ring describes, such political influence encourages public pension boards to adopt the discount rates based on overly optimistic investment return projections, which in turn enables current office holders to pay less into the pension fund, thus kicking the can down the road:

The reason the normal contribution has been kept artificially low is because the normal contribution is the only payment to CalPERS that public employees have to help fund themselves via payroll withholding. The taxpayers are responsible for 100% of the “unfunded contribution.” CalPERS has a conflict of interest here, because their board of directors is heavily influenced, if not completely controlled, by public employee unions. They want to make sure their members pay as little as possible for these pensions, so they have scant incentive to increase these normal contributions.

Third, to get out of the hole, stop digging. Close underfunded pension funds to new enrollees and offer new hires other options, such as defined contribution or hybrid plans.

For more on principles for public pension reform, see here.