A little while back I was interviewed by a reporter from the Minneapolis Star Tribune for a story about public-sector pay and benefits. In response to a question about just how bad the fiscal conditions of state and local governments really are, and how government promises related to public employee pay and benefits have affected this, I said,
We certainly are approaching a crisis with public employee costs and benefits. . . . The recent economic troubles only revealed what had been concealed by a period of exceptional growth, fueled by the housing and financial bubbles. . . . Many governments are still in a state of denial.
Due to the limited column space and the need to address multiple facets of a very complicated issue, this was all I contributed to the column. The reporter, Baird Helgeson, asked a number of excellent questions during his interview, however, so I am copying the full Q&A below.
BH: Do you believe state governments are at a point of crisis with employee costs and benefits? How do you think the tanking economy changed the climate or terrain?
AS: Yes, I think we certainly are approaching a crisis with public employee costs and benefits. Some states are worse than others, of course. Some states, like California and Illinois, are already deep into a crisis. The original justification for offering government employees iron-clad job security and substantially better benefits than for comparable positions in the private sector was that government salaries were lower than private-sector salaries, so employee compensation had to be sweetened in other ways to attract qualified government workers. If that was true 50 years ago, it certainly is not the case today, though. Now, as numerous analyses of government statistics show, government employees typically earn significantly greater salaries than their private-sector counterparts and they continue to enjoy those greater benefits and job security. (See, for example, this USA Today analysis of U.S. Bureau of Labor Statistics, which found that just among jobs that exist in both the public and private sectors, government workers make higher salaries in 5 out of every 6 cases, and that government workers earn salaries 20% higher than those of private workers, on average—and benefits four times as much.)
Moreover, government employees are largely sheltered from job losses during economic corrections due to the political influence of their labor unions. (The private sector adjusted rather quickly, albeit painfully, when it was forced to shed 8 million jobs during the recent recession. Meanwhile, the number of government employees actually grew by a couple hundred thousand. Talk about out of touch with economic realities. It is no coincidence that the states in the biggest fiscal trouble are generally the ones with the strongest public employee labor union influence: California, New York, New Jersey, Illinois.) This simply is not sustainable.
Employee costs and benefits were on an unsustainable path even before the onset of the recession, however. The recent economic troubles only revealed what had been concealed by a period of exceptional growth, fueled by the housing and financial bubbles. In other words, recent public pension funding problems related to the economic downturn are a symptom, not the disease itself. I noted the growing problem of public pension sustainability six years ago, long before the economic bubble burst, when I co-authored a study on public pensions called The Gathering Pension Storm: How Government Pensions Are Breaking the Bank and Strategies for Reform.
There is a reason that the private sector has been switching away from volatile, expensive defined-benefit pension systems for the past 30 years or so. The industries that haven’t—namely, the legacy industries with large labor union presence such as the steel, airline, and, more recently, the domestic auto industry—have suffered greatly and many of those companies have been driven into bankruptcy. I think governments face a similar future if they do not recognize this and make significant changes to their employee salaries and benefits costs. It has already started at the municipal level. Just look at the bankruptcies of Vallejo, CA and Prichard, AL, and at a number of others that are on the brink of insolvency, primarily due to unsustainable employee benefits costs.
BH: What’s at stake if states like Minnesota continue adding government workers and pension obligations; what’s the landscape look like in the future?
AS: Barring a significant change, citizens face severe cuts in government services and/or tax increases, as government employee costs consume a larger and larger portion of state and local budgets. Note that this is not a partisan issue. Regardless of one’s spending priorities—whether it is to reduce the size and scope of government and return more of the taxpayers’ money to them or to spend on programs for public safety, transportation, or whatever—the fact is that the more that must be paid in salaries and benefits to government workers (and in benefits to retired employees that don’t even work for the government anymore), the less is left for everything else. As the bond markets realize how much unfunded obligations are going to affect the government’s finances, government credit ratings will decline, raising borrowing costs in the process and making it that much more difficult to balance budgets in the future.
In my home state of California, several academic studies have pegged the state government’s unfunded pension liabilities at around $400 billion to $500 billion. This does not include unfunded retiree health care obligations of over $50 billion. These growing liabilities, and the legislature’s and governor’s unwillingness to seriously address its [the state’s] spending problems, have driven the state’s credit rating to the lowest in the nation, just a few rungs above junk status. Some people say, “As goes California, so goes the nation.” For everyone else’s sake, let’s hope that, in this case, this isn’t true, and that other state and local governments learn the lessons California failed to and change to a more fiscally responsible path, lest they suffer the same fate.
BH: Do you think government unions, nationwide, have seen the current path is not sustainable? Do you think the public anger over public employees has caused a tipping point with unions, at least in their positioning?
AS: I think some unions understand that the current system is unsustainable, and are more willing to negotiate, but I fear that many, if not most, of them are still willing to fight tooth-and-nail to get everything they can out of the state, that is, out of taxpayers’ wallets. Some are even willing to strangle the host. Even in Vallejo’s bankruptcy, they were unable to agree to reduce public pensions, for example. Incredibly, even though excessive and unsustainable pensions were the primary reason for the city’s insolvency, the pensions were left untouched and city services—even critical services such as public safety—were decimated. The taxpayers and residents were the ones who suffered.
And even many governments are still in a state of denial. Those that have tried to address the problem have mostly just tinkered around the edges of the current system by increasing retirement ages by a couple years or slightly reducing benefit levels for new hires. The notable exception is Utah, which is switching to a 401(k)-type defined-contribution system like almost everyone in the private sector has. I think this is the way for governments to go. It is not without precedent, either. Michigan went to a defined-contribution system in 1997 and Alaska switched in 2005.
The defined-benefit system is simply too unpredictable, too volatile, and simply unsustainable. In a defined-benefit system, government contributions rely on a number of actuarial assumptions, such how much average annual pension investment fund returns, inflation, and pay raises will be, how soon employees will retire, how long retirees will live, how many employees will take disability pensions, etc. This is educated guesswork at best, especially when you consider that these assumptions must be projected decades into the future. (If you think the meteorologist on the local news is bad a predicting the weather next week, just try asking an economist or an actuary to predict the state of the economy 15 or 30 years from now.)
Notice that this means that since government/employer contributions are largely dependent on pension fund investment returns, this means that when the pension fund performs poorly the government has to kick in greater contributions to make up the difference during the very times it is most struggling to balance its own budget. Moreover, these actuarial numbers can easily be fudged to make the pension system look more healthy than it actually is. Add to this the moral hazard problem of the incentives of politicians and union leaders increasing benefits today, knowing that the true costs won’t be realized until they are long out of power.
By contrast, under a defined-contribution system, the government puts in a flat, agreed upon percentage of an employee’s salary, perhaps with a matching contribution up to a certain level, and the employee has the freedom and responsibility of investing his retirement fund as he sees fit. This makes it much more predictable and transparent for the government, and taxpayers are not on the hook for any discrepancies—intentional or not—in actuarial assumptions. Put simply, there is no such thing as an unfunded liability in a defined-contribution system.
For these reasons, and others which I get into in more detail in the Gathering Pension Storm study I referenced above, I think governments will ultimately have to follow the lead of the private sector and switch to defined-contribution retirement systems for new employees. (Serious spending cuts and budget reforms such as privatization/outsourcing, asset divestiture, and priority-based budgeting will be needed to tackle the sizeable liabilities that have already been racked up—and will continue to rack up for employees in the current system.) In addition, I think states should adopt constitutional measures to prohibit retroactive benefit increases (as happened in California in 1999) and require public votes to approve future benefits increases in order to allow the taxpayers, who are the ones that must pay for those government workers’ salaries and benefits, to act as a final check against unreasonable benefit increases.
I think we are reaching a tipping point, as taxpayers are getting increasingly frustrated as they realize that they are being forced to pay more and more for government workers whose pay and benefits eclipse their own, and at the very time when they are being forced to take salary freezes and cuts and scale back contributions to their own retirement plans. When they see that, for example, 12,000 government retirees in California are earning pensions of over $100,000 a year—on top of free health care and 90% health care coverage for their spouses—and they see public services deteriorating as governments struggle to pay for increasing employee salaries and benefits, the unfairness and inequity of the wealth transfer to unionized government workers becomes clearer. That is why even though there is no political will at all to reform public pensions in the California State Legislature, which is dominated by union interests, there is a ground swell of public support for reform, and I expect to see taxpayers take matters into their own hands and put a pension reform initiative on the ballot soon. I think the same will be true in many other states as well.
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