Government Pensions: Who Will Go Broke First?

In terms of major issues to which not nearly enough attention gets paid, state and local government employee pensions are right at the top of the list.  Nationwide the potential unrecognized and/or unfunded cost of these pensions is probably around $3 trillion.  That may sound like chump change compared to the $17 trillion bonded debt of the federal government, let alone the perhaps $80 trillion of unfunded entitlement obligations of the federal government.  But this $3 trillion is not uniformly distributed around the country, and instead is concentrated in a few places, particularly the largest cites in the big blue states, that is, New York, Chicago and Los Angeles.  Also, the Feds can borrow and pay bills in currency that they themselves issue, and can hyperinflate the currency to get out of a deep enough hole; but the states and cities don't have those options.  Several California cities (Vallejo, Stockton, San Bernardino), along with (of course) Detroit, have already been pushed to the wall and filed for bankruptcy as a result of unsustainable pension obligations.

All three of the big three cities have outstanding pension promises that I would say are obviously unsustainable.  Terms of each pension plan differ, but the problems lie in some combination of youthful retirement ages, uncapped cost of living adjustments, "spiking" of pensions with overtime in final years, and "disability" systems subject to rampant systematic abuse.  The result is that pension costs soar relative to salary costs of active employees, until pension costs equal or exceed, and sometimes far exceed, the costs of the workers who are actually doing the work.  At that point, necessary services get squeezed out of the budget, and something has to give.  But the pension costs are back-loaded, and creep up gradually, often long after the promises are agreed to.  Nobody notices or talks about the problem until a city is very deep in a hole.

Thus, as an example, going back to the 90s and even earlier, New York City has set retirement ages based on 25 and even 20 year working careers, whereby many people can take their full pensions in their 50s, or even their 40s.  As recently as 2001 they were kidding themselves that all this could be paid for by the continuation of the big stock market run-up of the 90s.  But since 2001 the stock market has not cooperated, and has reverted to a more normal pattern of ups and downs, so New York City's required pension contributions have gone from $1.5 billion per year (about 4% of the budget) to over $8 billion (about 12% of the budget, and almost 15% of the city-funded portion).

Here is my big question:  Which one of the big blue cities will get taken under first by its pension promises? (Note:  In my opinion, it is nearly inevitable that one or all of them will be bankrupted by these promises within about 10 to 20 years, perhaps sooner.)   To some degree the answer to that question turns on how well-funded the plans are currently, but actually the more important issue is whether promises themselves can be brought back to a reasonable level.  And it turns out that that is much harder than you might think.

Here is an issue that you are almost certainly not aware of and that has something like $2 trillion riding on it for the citizens of these big cities:  When your city finally recognizes that its pension commitments are unsustainable, and wants to get them back in line, can it reduce its promises for all pension accruals going forward from that day, or can it only reduce its promises as to new employees who have not yet been hired at the time of the change?  In other words, must a city maintain its pension promises, no matter how unsustainably generous, for all current employees, even those who have worked for the city for as little as one day, throughout their entire career and their retirement; or can the city reduce the promises for everybody going forward from today, honoring all pension accruals made to this point but not committing to new accruals, even for long-term active employees?

Put that way, you may say that it is obvious that a pension sponsor such as a city must honor pensions earned to date, but should be able to cut back on its promises, and accruals resulting from those promises, starting from now.  In the world of private pensions, regulated by the federal government under ERISA, this is exactly how it works.  And as it has become increasingly obvious that defined benefit pensions lead to burgeoning and uncontrollable liabilities, many and even most private pension plan sponsors have reacted by what is called "freezing" their pension plans, meaning that all past accruals are honored but going forward all accruals cease.  It is a clear line that is easy to draw.

But none of the states of New York, Illinois and California has recognized this rule.  Here is the status of the law:

New York.  New York has a provision in its state Constitution, Article VII, Section 5, that provides that "membership in any pension or retirement system of the state or [city] shall be a contractual relationship, the benefits of which shall not be diminished or impaired."  Does that mean that pension accruals cannot be reduced even on a prospective-only basis?  I would argue that the constitutional provision does not mean that at all; but in a series of relatively old court decisions (pre-dating the federal ERISA statute) where the issue was not squarely presented or focused on, New York's highest court has rendered decisions seemingly standing for the proposition that any government employee with a pension promise is entitled to have that promise, and accruals arising from it, continued without diminution for his entire career.  For example, in Birnbaum v. New York State Teachers Retirement System, 5 N.Y.2d 1 (1958) the Court of Appeals determined that the pension plan could adopt a new mortality table (that had the effect of reducing monthly pension checks) for "only such persons as enter the system thereafter."  And in Kranker v. Levitt, 30 N.Y.2d 574 (1972) the same court invalidated, as to all current employees, a statute that would have removed pension credit for unused vacation time.  Nobody in these or other similar cases seems to have pointed out to the court the difference between pension benefits already accrued and those not yet accrued, a question of multi-hundreds of billions of dollars interest to the taxpayers. 

Today, given what might be seen as strong headwinds from the courts, nobody in New York seems to have the appetite to take on this issue.  In a major pension reform of the state employee pension funds enacted in 2012, changes were made as to new employees only.  That means that it will take 30 years for meaningful savings to be realized, as new employees gradually work their way through the system.  Meanwhile, New York City has not really tackled this issue at all, although to be fair to outgoing Mayor Bloomberg, the issue is controlled by the state legislature rather than by bargaining between the city and its workers.  Bloomberg has made multiple speeches warning incoming Mayor de Blasio that he must pay attention to this, but, to all observation, de Blasio continues to ignore the issue completely.

California.  California does not have a state constitutional provision analogous to the one in New York.   Nevertheless, California's Supreme Court has adopted a judge-made rule of "vested rights" that has been found to protect pension plan obligations to state employees.  A fair description of the California case law is that it is highly protective of employee pensions without ever making the critical distinction between already-accrued and yet-to-be-accrued benefits.   In 2012 the citizens of San Jose (third largest city in California and 10th largest in the U.S.) passed, by a 70-30 margin, a ballot proposition called "Measure B."  That Measure had the effect of immediately reducing ongoing pension accruals for city employee pensions, while preserving pension obligations accrued to date.  Many of the city unions immediately challenged the Measure.  In a Tentative Decision on December 19, 2013 (follow link here for a copy of the opinion), Judge Patricia Lucas of the Santa Clara County Superior Court would invalidate much of Measure B.  In its decision, the court would find that the employees have a "vested right" in the city's obligation to pay "unfunded actuarially accrued liabilities" of the plans -- a concept that includes both already-accrued and to-be-accrued benefits.  The court also would find a "vested right" in future cost-of-living adjustments.  This decision is subject to change before becoming final, and then to appeal.

Meanwhile the backers of the San Jose ballot measure, led by San Jose Mayor Chuck Reed, now have underway an effort to get a measure on the statewide ballot to make clear that "changes in the future pension benefits of current public employees" are allowed.  A dispute has now erupted because the Attorney General of California, Kamala Harris (thought to be closely allied with state employee unions) has produced the summary of the initiative to appear on the ballot, and it characterizes the initiative as "eliminat[ing] constitutional protections for vested pension and retiree healthcare benefits for current public employees . . . ."  I guess for the unions, it helps to have friends in high places.  So California cities and towns, let alone the state itself, have some very serious problems trying to get these costs under control.

Illinois.  Illinois and its big city Chicago together have the worst current pension funding problem of all the states and cities, much of it stemming from simply not making actuarially required pension payments for many years.  According to data from Moody's reported here by Reuters, Chicago currently spends about 9% of revenues on pensions, but it would be about 28% if they made the actuarially-required contributions.  A contribution at that level would squeeze out huge amounts of other spending.

In early December 2013 the Illinois legislature, after years of wrangling and delay, passed a major pension reform measure that claims to save some $160 billion over 30 years.  The changes are mainly to retirement ages and cost of living adjustments.   The changes apply only to the state pension systems, not to the city of Chicago.

Illinois has a state constitutional provision (Article XIII, Section 5) almost identical to New York's:  "Membership in any pension or retirement system of the State [or any city] shall be an enforceable contractual relationship, the benefits of which shall not be diminished or impaired."   According to this article from the Springfield State Journal-Register on December 27, a group of school administrators and teachers immediately filed suit to invalidate the state pension changes.  Meanwhile, the situation in the case law in Illinois is more ambiguous than in the other states, leading to dueling opinions from the Illinois legislature and from a major Chicago law firm (both available here) as to whether pension accruals can be changed prospectively under the Illinois constitution.

Since the lawsuit has just been filed, it will be a while before there is a decision, and even longer before appeals are resolved.  Meanwhile, Chicago, which has the worst problems of all, hasn't yet started to address its problems.  Although any fix requires action from the Illinois legislature, this Reuters article is highly critical, and in my view rightly so, of the failure of Mayor Rahm Emanuel to even try to address the problem:

This is a picture of a politician too timid to address a core issue that faces his city. . . . Pension problems will not fix themselves, especially when the black hole is as big as Chicago’s.

Same is true as to de Blasio in New York, until we see any evidence to the contrary.  Anyway, given the huge hole they have already dug for themselves, and the complete refusal of their Mayor to address the issue, I say that Chicago will be the first of the big three cities to be brought down by its pension promises.

Funny how the so-called "progressives" talk a good game about helping the poor and disadvantaged, but when you look at what they actually do, it is to pass out the big money to their union friends who helped put them in office, while using the pension mechanism to hide the problem from the taxpayers and voters as long as possible.