Pension Woes and State Government Largesse
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Earlier this week in a piece for e21, Stephen Goldsmith discussed the gravity of the pension shortfalls and the toll it will take on state governments. With the passage of the health care bill this week, and the long-term cost burden it may place on tax payers, we take another look at the state pension shortfall and the potential ramifications on both state and federal budgets in the near future.
Not so long ago, $1 trillion seemed like a lot of money. It still is a lot of money, of course, but in the wake of the bank bailouts, the stimulus package and the health care bill, the dollar figure does not engender the sorts of gasps it once did. That is good for state governments because $1 trillion just happens to be the Pew Center’s very conservative estimate of their pension shortfall. While it seems clear that many states will not be able to meet promises to current and future retirees, it is far from obvious who will bear the ultimate costs of closing this mammoth shortfall.
State government workers used to accept lower cash wages in exchange for more generous benefits. Now they get the best of both worlds. As private sector benefits have atrophied, the generosity of public sector employees’ benefits have grown substantially. At the same time, average pay has not only reached parity, but now exceeds that of private sector workers. According to the most recent Labor Department data, public employees’ total compensation is 45% more than private sector employees’: public sector pay is roughly one-third higher, but their benefits are 70% higher than private sector workers’. Included in these higher benefits are fixed income pension schemes that provide benefits that are equal to 6.95-times those of private sector counterparts, on average. Public employees’ health insurance benefits are roughly twice as generous. These disparities are the source of the pension shortfall.
How did public sector workers manage to get such attractive compensation packages? The answer is simple: elected officials are bad agents for taxpayers. Voters demand services from their state and local governments, but are poorly informed about the market-based cost of providing those services. Even if voters were better apprised of the appropriate wage rates, there is little transparency into back-loaded compensation packages that pay out when current officials are out of office. As Harvard’s Phil Greenspun explains, “a voter working at Walmart gets upset hearing that a bus driver is earning $130,000 per year. If instead the bus driver is paid $70,000 per year and able to retire at age 41 (MBTA here in Boston), it is tougher for a voter to figure out how much is being spent.”
Moreover, what interest group is as well organized and adept at influencing government as government itself? Unionized public employees represent the most powerful interest group in America today. As a recent City Journal article explains, it used to be that some states were “high tax, high benefits” while others were “low tax, low benefit” states. Today, differences in tax rates have more to do with the relative strength of public employee unions than the quality or quantity of government services provided. As page 32 of the Pew Report explains: “In a number of states, notably those with strong unions, public sector retirement benefit reform has been a struggle, whether the obstacles come directly from the unions or through elected officials who are committed to defending state workers’ benefits.”
In California, state employees are eligible to retire at age 50 and an employee with 25 years of service can receive over 50% of their highest final salary starting at age 55. Over 5,000 former public employees have pensions that pay out more than $100,000 per year, which costs the state $610 million. To consider how rich a benefit this is, consider that the present value of 35 annual $100,000 payments is $1.6 million (at the current 30 year Treasury bond rate of 4.64%). For private-sector workers to accumulate $1.6 million in retirement savings over a 25 year career, they would have to tuck away $35,000 per year. And these figures don’t even account for the inflation-protection afforded by the state’s generous cost of living adjustments.
Such generosity makes one wonder how the shortfall is only $1 trillion. Some analysts who have asked the same question have found that true pension shortfall would be closer to $3.5 trillion if more realistic return assumptions were used. For example, if one were to use an 8% discount rate in the example above – 8% is the average rate of return assumed by state pension funds – the present value of the $100,000 per year pension at age 55 would be $1.125 million or 30% less. To its credit, California is considering reducing its already lower than average expected rate of return to something closer to 6%. That is in sharp contrast to Illinois, which is only 54% funded, the lowest percentage in the nation. To make matters worse, this gap is calculated using an 8.5% return, an assumption the fund managers have no plans to change.
The political end game for pensions is difficult to forecast. In California, the state explicitly guarantees the solvency of the pension fund. In other states, the guarantee may not be legally binding but is just as real. The path of least resistance would be a continuation of current policy, where the Treasury partially assumes state and local governments’ shortfalls. The Obama stimulus authorized the transfer of $280 billion to state and local governments and the Senate approved $28.66 billion in additional transfers to states for Medicaid (which was also requested by President Obama). Money is fungible. If the federal government assumes more of states’ health care and infrastructure spending, more of their annual budget could be devoted to pension payments.
That such a strategy seems likely is evidence that one of the Obama Administration’s biggest policy shifts is the embrace of a new kind of federalism that involves greater federal funding for state government programs. Perhaps this is a way of combating the debt overhang phenomenon, where government spending becomes so great that the private sector chooses not to invest because the size of the government’s assumed share of any profits. Households cannot flee the high taxes of California, Massachusetts, New York, and Illinois if those taxes are instead imposed at the federal level. Businesses can leave the country entirely, however, which is why this policy shift seems destined for failure.