Structural Factors of the Municipal Pension Crisis

Public employee pensions are sinking local governments. Over the last four years, they have even pushed some municipalities into bankruptcy — from Vallejo, California, to Central Falls, Rhode Island. Now Stockton, California, threatens to join the bankrupt cities’ ranks.

While distressing, this shouldn’t be surprising, since many of the causes for the pension crisis are structural. Steven Greenhut, of the Manhattan Institute, explains in The Washington Examiner:

Stockton’s situation epitomizes the reality of local government in California today: City governments don’t exist to provide services to the public, but function mainly to dispense high salaries and pensions to the people who work for the government.

Ninety-four of Stockton’s retirees, for instance, receive six-figure pensions, placing them among a rapidly growing list of 15,000 California public retirees in the $100,000 pension club.

No wonder that 81 percent of Stockton’s general-fund budget goes to pay for employee costs, including a generous health care plan that pays the entire medical costs for city employees and spouses for life.

As is typical in California, the city’s police and firefighters can retire at age 50 with 90 percent of their final year’s pay, cost-of-living adjusted — and that’s before the pension-spiking gimmicks that often push their retirement pay above the pay they received while working.

Structural factor 1: Pension payouts based on final year pay

Pension spiking is made possible by pension funds setting payouts based on the retiree’s final year earnings, rather than a career average. This has led to employees racking up long hours of overtime during their last year on the job, boosting not only their pay for that year, but also their lifetime annual pension payments — sometimes even above salary.

How pervasive is pension spiking? The Los Angeles Times recently looked into the matter. While the state pension fund, the California Public Employee Retirement System (CalPERS) banned pension spiking in 1993, “20 of California’s 58 counties — including Los Angeles, Ventura, Orange and San Diego — do not participate in CalPERS and their employees may legally continue to spike their salaries.” Unfortunately, hard numbers for all of California are hard to come by, but the Times investigation indicates that the costs from spiking are enormous.

The scope of the practice is unclear because counties have resisted releasing complete pension data, citing the difficulty and cost of assembling the information.

But an analysis by The Times of partial data from Ventura and Kern counties — two small windows into the problem — shows that spiking is affecting pension systems already staggered by massive obligations.

In Ventura County, where the pension system is underfunded by $761 million, 84% of the retirees receiving more than $100,000 a year are receiving more than they did on the job. In Kern County, 77% of retirees with pensions greater than $100,000 a year are getting more now than they did before.

The Times notes that California Governor Jerry Brown is proposing basing payouts on a three-year average of final pay. That’s a slight improvement, but it’s still a narrow enough time window for spiking to remain viable. For such a reform to have teeth, it should be based on a career average, or at least on a much longer time period.

However, achieving significant pension reform requires overcoming major political obstacles.

Structural factors 2 and 3: Binding arbitration and collective bargaining 

With such large costs, it seems odd for elected officials to agree to create such an expensive retirement system and to keep it in place for so long. One major reason is the political clout of government employee unions, both in elections and at the bargaining table.

Government employee unions have a vested interest in the growth of government. More government programs means more government employees, which in turn means more government employee union members. Those union members pay dues, of which a large part go toward campaign contributions to politicians willing to increase the size and scope of government.

Once in office, union-friendly politicians have good reason to keep their union supporters happy. One way to do that is to give unionized government employees greater pay and benefits. And for politicians eager to please their union supporters while avoiding taxpayer ire, pensions provide the perfect tool, as they allow them to kick the can down the road in terms of costs.  When they payments come due, they’ll be out of office, and it’ll be somebody else’s problem.

But what if in the future a fiscally conservative administration tries to cut back those costs? Simple, establish legal mechanisms to make it easier for unions to gain further concessions in the future. Two important mechanisms of this sort are binding arbitration and collective bargaining. In my co-authored 2009 Cato Policy Analysis (with Don Bellante, David Denholm), “Vallejo Con Dios: Why Public Sector Unionism Is a Bad Deal for Taxpayers and Representative Government,” we explain:

To enforce their demands, the weapons that unions have at their disposal include strikes and mandatory arbitration. In the case of strikes, they can be especially disruptive in the public sector, where an interruption of public services causes severe pain among voters, who cannot simply shift to different suppliers for the public services that government provides in a monopolistic fashion. To avoid the threat ofsuch strikes, many unions and governments agree to submit to binding arbitration, which can impose costs on government finances as great as, or even greater than, strikes. An arbitrator will never award a settlement that is less than management’s final offer, so the union is guaranteed to obtain at least some of its demands, and will never come out worse than the status quo ante.

Public-sector unions’ upward-ratcheting effect on wages has reinforced itself wherever government employees have become unionized—as the economic literature indicates. As noted, the public sector is more amenable to union-based collective bargaining than the private sector. While unionism did manage to gain a significant foothold in the private sector at one time—due in large part to government intervention—it has nonetheless receded there, while it has grown in state employment.

To address this problem, we propose abolishing collective bargaining in the public sector, or at the very least, limiting its scope. By granting union officials the power to negotiate directly with government, collective bargaining gives unions a degree of influence over government decision making beyond that which private citizens enjoy. Reining in that excessive union influence can help bring another problem under control.

Structural factor 4: Politicized pension fund boards

Overly generous pension commitments have done much to put municipal finances in jeopardy across the nation. But the problem has been made far worse by poor management, largely due to politics. This week, The Economist highlights the problem, though indirectly, by profiling how such a system should be run — and actually is, north of the border.

Those seeking to understand how Canadians have pulled it off are given two answers: governance and pay. There is little political interference in the funds’ operations. They 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.

CalPERS is a case in point. While its pension spiking ban is commendable, its management is hardly a paragon of fiscal probity.  The California state constitution enjoins pension fund managers to seek the best returns for their investments. However, as  CEI’s Trey Kovacs points out in The Orange County Register, they often flout their fiduciary duty, for transparently political reasons, while hiding behind the flimsiest of excuses.

To mask their political and ideological investment agenda CalPERS board members use phrases like “triple-bottom line.” As The Institutional Investor explained in July 2011 the “triple bottom line” would “incorporate environmental, social and corporate governance concerns – so-called ESG issues – across the Sacramento-based plan’s entire $232.2 billion investment pool.”

CalPERS’ head of corporate governance, Anne Simpson, at a conference earlier this year hosted by the Investor’s Network on Climate Risk, reiterated enforcing ESG issues: “The theme of the day is how to move from warm words to action, to the realm of the practical, going to meetings and signing letters isn’t going to do anything unless we move the money.”

Past examples of ESG values influencing CalPERS investments highlight the dangers of alternative motives for investing other than profits. Prior to their “triple bottom line” strategy, in 2000, CalPERS and CalSTRS launched the “Double Bottom Line” initiative, which included social activist and tobacco-free investment policies. CalSTRS later revealed that its tobacco investment ban had lost the plan $1 billion in gains and in 2008 conceded that it “could no longer justify” avoiding tobacco stocks.

If there is a silver lining in all this, it’s the fact that budget deficits and bankruptcies bear no party label. Therefore, state and local elected officials across the nation are finally scrambling to pull their jurisdictions back from the brink, including in heavily Democratic New England.

For more on public sector unions, see here and here.