October 26, 2011 7:27 pm

US pensions gap: Regions of rancour

Ted Strickland is “mad as hell”. The Democratic former governor of Ohio is one of the most high-profile voices in a struggle between public sector workers and cash-strapped state governments that is raging across America.

At the heart of the issue is an attack on generous benefits for public workers – in particular, pensions – by states now facing budget deficits. Ohio is the most pressing example. On November 8, voters will decide the future of a proposal – known as Issue 2 – that would increase state employees’ health and pension contributions, eliminate automatic pay increases, restrict collective bargaining and limit holidays and sick leave.

US pensions

US pensions

The measures have infuriated Mr Strickland and labour unions, who say the state’s Republican leaders are using the economic crisis as a smokescreen to attack workers’ rights. “Issue 2 has almost nothing to do with the fiscal circumstance that confront our state and local governments. It’s all about political power,” he thundered at a recent rally. “Issue 2 makes firefighters and police officers and teachers and nurses the scapegoats for the circumstances of this economy.”

The legislation, which polls suggest most Ohio voters oppose, has been championed by Republican governor John Kasich, one of a string of US state leaders who argue that long-standing benefits for public employees must be slashed if states are to get to grips with their budget woes.

Labour costs have become a focus for conflict between lawmakers and unions since the recession decimated state revenues and lifted the veil on chronic underfunding of benefit schemes for civil servants past and present. The issue has polarised opinion. For middle-class public sector employees, the reforms represent another way they are being squeezed to pay more towards their benefits, even as they face stagnant wages. For many of those in the private sector, however, the health and pension programmes public sector workers enjoy are an unjustified use of taxpayers’ money at a time of economic upheaval.

In the Midwest, particularly swing states such as Ohio, Indiana and Wisconsin, the debate has expanded to put under threat once sacrosanct collective bargaining rights.

The California case

California, the most populous of the 50 US states, already suffers from well documented budget difficulties and is seen by some as a harbinger of deeper problems with state and municipal finances across the nation. Its pension system will only add to those difficulties, writes Dan McCrum. The $154bn California Teachers Retirement System, the second largest in the US, has a $56bn funding gap that is set to widen next year – a “smoothing” of investment returns means it has yet to account fully for losses during the financial crisis. This month Jack Ehnes, head of Calstrs, told his board that it must ask for higher contributions. Such payments can be changed only by legislative action, which last happened in 2000 when the state cut its contribution from 4.6 per cent of teachers’ payroll to 2 per cent. At the time, the retirement system, like many across the country, was fully funded. But stock market returns have since been poor and Californian taxpayers remain on the hook should Calstrs ultimately run out of money. “Part of attracting people to public service is giving them something in return, because it’s certainly not salary” that wins them over, says Dean Vogel, president of the California Teachers Association, which argues that the average monthly retirement benefit for its members is a moderate $3,300. It is not as if Calstrs has skimped on contributions in the past. Those are in line with or slightly better than the national average: teachers have paid 8 per cent of their wages into the fund since 1972, with the school districts paying 8.25 per cent since 1990. But Josh Rauh, a professor at the Kellogg school of management and a prominent critic of current pension accounting, argues that just to meet the cost of new obligations as they arise, contributions to public plans should total around 28-30 per cent of state payrolls.

For most states, the gap between such liabilities and the assets states have amassed to pay benefits promised to civil servants does not pose an immediate threat. Left unaddressed, however, it is feared the pension hole could threaten whole chunks of revenues needed to fund essential services and repair rotting infrastructure.

Yet even quantifying the pension gap is a highly contentious political matter. Up-to-date data are hard to come by, while the accounting is notoriously complex, rife with assumptions and measures that critics say hide the true size of the gaps. The Pew Center on The States, a US-based think-tank, calculates that at the end of 2009 – the most recent date for which comprehensive figures are available – states had officially salted away $2,280bn to cover pension liabilities then estimated at $2,940bn, leaving a gap of $660bn. To that must be added the cost of healthcare and other promised benefits, for which the states had set aside only $31bn, leaving another $607bn to be found.

At the root of the problem is the way in which such schemes have been managed. For decades, it suited both politicians and public sector workers to resolve wage negotiations with promises that would not need to be fulfilled for many years. In times of economic plenty, it also proved easy for states to take holidays from contributing to pension plans.

In addition, states are permitted to estimate the size of their liabilities based on more optimistic assumptions about returns on assets (known as discount rates) than the private sector. The median return assumption of 126 state and local retirement systems is a rosy 8 per cent a year, according to the Public Fund Survey.

Professor Joshua Rauh of Northwestern University’s Kellogg School of Management, says public sector unions have resisted measures to make the costs of these schemes more transparent. “They have thrown their support behind a system that allows these benefits to be accrued off the balance sheet, accounted for improperly and left out of the plain view of taxpayers.”

Unions say exaggerating the size of liabilities is part of an attempt to declare them unpayable. “For us this is not an academic discussion about discount rates, but more of a discussion about relative equities involved in solving what are obviously substantial problems,” says Steve Kreisberg of AFSCME, the largest public sector union.

It is rightwing politics rather than economics that are driving moves to clamp down on unions, according to many on the left. “The people who advocate this have an agenda, and the agenda is simply to collapse public pension plans,” says Mr Kreisberg.

. . .

Both Mr Kasich and Scott Walker, the Republican governor of Wisconsin, were elected last November on a tide of support from Tea Party activists – whose main aim is to shrink the size of government. Among Mr Walker’s main sources of campaign funding were Charles and David Koch, billionaire owners of Koch Industries – a conglomerate that is one of the world’s biggest privately held companies – who are also Tea Party donors.

Although Koch Industries denies it, some critics say Mr Walker repaid the favour with his “budget repair bill”, which curtailed public sector workers’ collective bargaining rights, raised their pension contributions and cut benefits for most. Opponents of the plan occupied Wisconsin’s state house for weeks in February.

Mr Walker, too, vehemently denies that legislation had any rationale other than making the cuts needed to balance the budget. The governor argues that to achieve lower labour costs, the state and unions would otherwise have had to agree new contracts, which he says would have taken too long given the need to close an immediate shortfall. Most US states must balance their budgets annually. “It was better than mass layoffs and reduced services,” Mr Walker says. He warned at the time that unless his plan became law, 12,000 state and local government jobs would be lost. Critics called that a hollow threat aimed only at raising the political temperature. Mr Walker says local authorities have already saved $450m this year because of his reforms.

Despite a bitter political and legal campaign against the proposal, the state’s supreme court ruled in its favour. The governor’s opponents have vowed to start collecting signatures next month for a recall election to unseat the governor as soon as possible.

Towns and counties can declare bankruptcy to renege on their promises to employees – and some have. Central Falls, Rhode Island, did so this year. Retired employees there face potential cuts to pay-outs.

Republican lawmakers in Washington this year floated the idea of allowing US states to declare bankruptcy, too. The concept was quashed, however, for fear it would create greater expense for states in the form of higher interest demanded as compensation for this new risk by the investors who buy their bonds.

Meanwhile, states including New Jersey, Illinois, Rhode Island and Minnesota have already taken steps to reform their pensions using measures such as suspending cost-of-living increases to benefit recipients.

. . .

The size of the holes, and the aggressiveness of the tactics state legislators propose using to shrink them, creates the prospect of scuffles with labour unions for years to come. The next battleground looks likely to be Illinois, which is on course to end the current fiscal year with unpaid bills of about $8.3bn. Officially, following years of short-changing public pension funds, its retirement scheme shortfall is $86bn.

However, Mr Rauh says Illinois’ state and local government pension liabilities gap is closer to $200bn because of gross under-reporting. Given that state and local tax revenues amount to about $55bn annually, the gap is going to be painful to make good.

Illinois passed legislation last year to cut benefits for its new employees, but that will do little to reduce its obligations to the pension fund. It also raised state income tax rates by 67 per cent and business taxes by 30 per cent in January, which will help it to pay its current contributions without borrowing, if not to tackle the liability gap and its growing public debt burden and backlog of unpaid bills.

The Commercial Club of Chicago, an Illinois-based think-tank, says the budget gap will be eliminated permanently only if the state moves its em­ployees from defined benefit schemes, where the employer has the burden of meeting pension promises, to defined contribution schemes, where the employee is responsible for the size of the pension pot. In addition, the state would need to raise the retirement age and cut spending. However, the Illinois Teachers’ Retirement Fund says a defined contribution scheme would not eliminate the effect of decades of state underfunding and would cost more to administer.

Such measures are also politically unpalatable. In spite of support from leaders on both sides in Illinois, unions have persuaded rank-and-file lawmakers to block an overhaul of public pensions. With presidential and state elections looming next year, legislators may not be in the mood for a fight.

For all states, the problem could worsen. The Governmental Accounting Standards Board is aiming to finalise a new set of rules governing public pensions by next June. The proposal would move pension liabilities from a footnote to the centre of a state’s balance sheet and require more conservative mathematics. “The pension expense is going generally to be higher than under the current approach,” says Robert Attmore, Gasb’s chairman.

With markets still in turmoil and the economy still struggling, there is little prospect of better investment returns or economic growth bailing out state retirement systems.

As the rhetoric becomes sharper, elected officials and unions appear to be finding it ever harder to reach the common ground required to solve the problem.

For their part, public workers just want the deferred compensation they were promised for services rendered, says Mr Kreisberg: “You would think that a government would figure out a way to stand by its obligations, but instead we have governments acting like common deadbeats.”

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