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Vallejo, a working-class community of 120,000 northeast of San Francisco, has long been a strong union town. Like many cities, it gives its workers generous retirement benefits: Police and firefighters can retire as young as age 50 with a pension equal to 90 percent of their final salary, and they enjoy free health care for life. Salaries, which serve as the base for determining pension levels, have also been generous: Forty-four percent of the city’s 613 employees had gross wages in excess of $100,000 in 2008.

Financing such largesse isn’t easy in the best of times. But in the midst of the worst economic downturn since the Great Depression, such salaries and benefits are becoming unsustainable. So facing an $8 million budget deficit and nearly $200 million in unfunded pension and health care liabilities, Vallejo filed for bankruptcy in May 2008, making it the largest governmental body to go bust since Orange County did so in 1994. In March a federal bankruptcy judge ruled that the city could tear up existing contracts as part of its reorganization, a landmark verdict that paves the way for cuts in once-sacrosanct public sector salaries and retirement benefits.

Earlier this year the city reached a deal with police to cut salaries by 18 percent through June 2010 and cap medical benefits; the agreement also imposes a 6 percent pay cut on managerial employees and requires new hires to contribute 20 percent of the cost of their medical insurance. City negotiators are playing hardball with other unions that have yet to settle; they rejected a firefighters’ proposal to take a 6.5 percent pay cut, forego previously agreed-to pay raises of 13 percent and cap health care benefits.

As goes Vallejo, so may go the nation. The cost of public sector pensions is set to soar in coming years because the recent meltdown in the financial markets has worsened the health of systems that were already badly underfunded. Municipal and state governments across the country are struggling with massive budget shortfalls, leaving them in no position to fill the pension gap. As a result, public workers look likely to bear the burden through cutbacks in their salaries and benefits and increases in their pension contributions.

“No one can isolate themselves from the effects of the economy,” Gray Davis, the former governor of California and currently counsel at Los Angeles law firm Loeb & Loeb, told Institutional Investor in a recent interview.

Pension benefits enjoy constitutional or statutory protections in many jurisdictions, and reducing them may not be easy or straightforward. But analysts say governments can use a variety of means — freezing or cutting salaries, requiring higher pension contributions, delaying retirements and reducing retiree health care benefits, among others — to yield immediate budget savings and dramatically reduce pension costs in the long run.

“The majority of the pain will ultimately be borne by people who will see their pensions cut,” says Jacob Funk Kirkegaard, who studies pension issues at the Peterson Institute for International Economics in Washington.

Change is already under way in a number of states. Under an agreement reached in April, public employees in New Mexico will kick in an extra 1.5 percent of their salaries next year to pay for pensions and contribute more to the cost of their health benefits. In February, California adopted changes that will require most of the 114,000 employees of the University of California to begin paying 2 percent of their salaries to fund pension benefits, with the contribution rate rising by 1 point a year until it reaches 5 percent in 2013. It will be the employees’ first contribution in 20 years to what had been an overfunded pension plan. Connecticut’s state workers made wage and other concessions in May that will save the government about $700 million through mid-2011.

California, which faces a $24 billion projected shortfall over the next year, has already begun slashing salaries. In February, Governor Arnold Schwarzenegger began furloughing the state workforce two days a month, which effectively reduces pay by more than 9 percent. Now he wants the legislature to cut salaries by a further 5 percent and fire 5,000 workers, about 2.5 percent of the total. The state’s largest public employees’ union, the Service Employees International Union Local 1000, is proposing to give up previously negotiated pay hikes of 4.6 percent for 17 months in exchange for having only one furlough day a month, but the legislature has twice voted down the suggestion.

Imposing cuts on existing workers isn’t easy, given the strength of public sector unions in many parts of the country. Many governments have therefore been reducing salaries and benefits for new employees. Kentucky last year adopted changes that will allow public employees to retire as early as age 57 if they have worked for at least 30 years; previously, they could retire at any age after 27 years of service. New York Governor David Paterson has proposed setting a minimum retirement age of 50 and requiring workers to put in at least 25 years of service, up from 20 currently. He also wants to limit annual cost-of-living adjustments to 1.5 percent and require new hires to contribute 1 percent of their salary for retiree health benefits. And several states, including Florida, Illinois and Oklahoma, have begun to replace traditional defined benefit pensions with defined contribution accounts for new hires.

Union leaders believe that defined benefit systems are a shared responsibility and that workers are willing to fairly share the cost of maintaining adequate funding. “In a critical situation when budgets need to be balanced, to the extent we need to contribute something — particularly to preserve traditional defined benefit plans — you’ll find that our members are realistic about the situation,” asserts Richard Ferlauto, director of corporate governance and pension investment for the American Federation of State, County and Municipal Employees, the nation’s largest public employees’ union, with 1.6 million members. But Ferlauto and others are adamant that workers shouldn’t bear the full burden of fixing the pension problem. They contend that some of the most severe budgetary and pension shortfalls, in states such as California, Illinois and New Jersey, reflect inadequate tax revenue and a failure by government to make necessary contributions. “Our state income tax is only 3 percent. It should go up,” says Ken Swanson, president of the Illinois Education Association. Late last month state lawmakers rejected a proposal by Governor Patrick Quinn to raise the tax rate to 4.5 percent.

The scale of the public sector pension problem is making reform increasingly urgent. According to the Center for Retirement Research at Boston College, state and local pension plans have seen their portfolios plummet since October 2007 as a result of the stock market collapse — assets are down $1.2 trillion from what the total would have been if the market had produced the 8 percent annualized returns that most actuarial calculations assumed. These plans now have some $2.3 trillion in assets and $3.6 trillion in liabilities. To achieve full funding over a typical 30-year amortization period, the plans would have to increase aggregate contributions by a total of $205 billion from 2010 to 2013. By contrast, actual contributions to the plans amounted to $107 billion in the year ended June 30, 2007.

The full force of last year’s market collapse won’t be felt until 2014. That’s because pension plans typically smooth their asset values, which actuaries rely on to determine contribution rates, over five years. So the cost of amortizing last year’s market losses would require an extra $102 billion a year in contributions from 2014 to 2039.

The growing cost of providing pensions has been borne almost entirely by employers in recent years. From 2002 to 2006, for instance, public employees who also have Social Security paid an average of 5 percent of their salaries in pension contributions. Employers, meanwhile, saw their contributions rise from an average 6 percent of payroll in 2002 to 8.5 percent in 2006, according to the National Association of State Retirement Administrators. Girard Miller, a benefits consultant with PFM Group, reckons that employer costs would have to rise to 12 percent of payroll by 2012 to keep up with obligations. “Unless there’s a dramatic rally in the stock market, we could see a doubling of employer costs from 2002 to 2012,” he says. “That’s unsustainable. There will have to be a rebalancing. We’ll clearly see a paring of benefits for new employees, layoffs, and in some cases the only way will be to gouge younger workers to pay benefits to older employees.”

The situation in some localities is particularly dire. The Cincinnati Retirement System’s annual contributions for pensions and health care for city employees could jump from 86 percent of payroll this year to 132 percent in 2013 to put the system on track to achieve full funding, Cavanaugh Macdonald Consulting of Kennesaw, Georgia, told the system’s board last month. San Jose, California, projects that its pension contributions for police and firefighters will jump from 23 percent of payroll this year to as much as 58 percent in fiscal 2011 and 70 percent in 2013 to close a funding gap. In Detroit contribution rates for police and fire pension plans are projected to double, to 50 percent of salary, over the next three years. Most of these governments lack the resources to make such increases and are likely to boost contributions by less than their actuaries recommend, which would only exacerbate the funding shortfall.

State budgets are also squeezed. Sixteen states have enacted tax increases this year and 17 more are considering them, according to a May report from the Center on Budget and Policy Priorities in Washington. At the same time, at least 36 states have cut funding for public services, including education and assistance for low-income residents. Notwithstanding these measures and an influx of some $140 billion in federal stimulus funds into their coffers, states face a combined budget gap of more than $350 billion over the next two years. “The stimulus program has given the states the wherewithal to weather the worst of this,” Governor Ed Rendell of Pennsylvania, who also is chairman of the National Governors Association, tells II in a recent interview. “Where the rubber will hit the road for states is when the stimulus drops off. If the economy hasn’t recovered by then, it’ll be a tough situation.”

There are practical limits to raising more revenue. Many states, including California and New Jersey, have laws that limit property tax increases. Nor can cities and states do much about slumping sales and income taxes. “Municipalities will face a challenge in revenue collection,” notes Mike Ross, a municipal credit strategist at Memphis-based investment firm Morgan Keenan & Co. “Unemployment is rising. Corporations have tax-loss carryforwards. Consumers are tightening up, hurting sales tax revenues.” Then there are politics to consider. Taxpayers, their retirement savings ravaged and their job security threatened, are in no mood to reach deeper to support public workers with benefits far better than their own. “Politicians who raise taxes will be voted out of office,” asserts Davis. He should know. In 2003, following a spike in energy costs and an increase in California’s vehicle registration tax, he became only the second governor in U.S. history to be recalled.

Cutting budgets to finance public sector salaries and benefits is not likely to be any more popular, particularly as the biggest source of potential cuts is education.

Hence public employees are likely to face the biggest squeeze. Although the basic pension benefits formula — how the number of years an employee works and his or her final salary translate into a monthly annuity — can’t be changed for active workers in most jurisdictions, governments can carve out important savings from other compensation elements. Freezing or lowering salaries, eliminating cost-of-living adjustments and requiring workers to contribute more for pensions and retiree health care benefits can produce immediate budget savings and yield major reductions in long-term obligations. Marcia Fritz, vice president of the California Foundation for Fiscal Responsibility, a group dedicated to reigning in pension costs, says encouraging workers to stay on the job longer would produce some of the biggest budget benefits. The cost of providing benefits is cut in half if an employee works an extra five years, she says, thanks to added employee contributions and reduced benefits payments.

Some public pension fund officials urge patience, arguing that the markets and the economy will improve in time, averting the need for major changes in benefits and contributions. “Required increases will be forestalled by a couple of years, and the hope is that markets and fiscal conditions will recover by then,” says Keith Brainard, research director for NASRA.

The idea that public funds can earn their way back to health seems unlikely, though, especially as many funds are looking to invest less aggressively than they have in the past. Many funds ran short of cash last year and had to sell stocks at depressed levels to finance benefits and meet capital calls from private equity and real estate funds. Going forward, more funds are likely to put a premium on liquid assets, including cash, even though they pay lower returns. The board of the California Public Employees’ Retirement System was due to approve plans this month to allocate 2 percent of its $185 billion portfolio to cash. The Pennsylvania State Employees’ Retirement System and the South Carolina Retirement Systems are decreasing risk by reducing exposure to equity futures in their portable-alpha strategies. Liquidity concerns will only grow as a spike in baby boomer retirements makes a growing number of public funds cash-flow-negative.

Imposing cutbacks on workers’ pay and benefits may be the obvious solution to the funding crisis, but it won’t be easy, given the clout of public sector unions. In May, for instance, teachers in Illinois forced Governor Quinn to withdraw a proposal to increase their pension contributions by 2 percent of salary, to 11 percent. “We made a full-scale effort, with thousands and thousands of calls and e-mails and hundreds of members meeting with legislators,” says the Illinois Education Association’s Swanson. Other politicians, daunted by the size of the pension problem, have sought to defer action, a step that may only exacerbate the chronic underfunding of some systems. In New Jersey, Governor Jon Corzine in March won passage of a bill that will allow cities to defer half their pension contributions from this year until 2012; in May he slashed the state’s pension contributions by $150 million, notwithstanding the fact that the system’s $60.5 billion in assets represents just under half of its liabilities. Philadelphia’s pension fund used actuarial sleight of hand to save $172 million in pension contributions, lengthening the period for smoothing asset values from five years to ten and stretching the amortization period for paying off the unfunded liability from 20 years to 40.

It’s a tactic that Rendell says he’d like to see emulated by struggling pension systems across the state. “It doesn’t help them in the long run, but it certainly helps them get by over the next couple of years,” he tells II. “Without it, I don’t know if municipalities can survive.”

To critics, delaying contributions is a step in the wrong direction, and cutting future benefits — as drastic a measure as it might be politically — doesn’t come close to what’s necessary financially.

Indeed, Kirkegaard believes that the funding situation is far graver than official estimates, which are based on the assumption that assets will grow by 8 percent a year, with liabilities discounted by 8 percent annually. “In general, public accounting for pension and health retirement benefits uses constructs that might be regarded as economic fictions,” notes Orin Kramer, chairman of the New Jersey State Investment Council. “We use discount rates for which people in the corporate world would go to jail.”

Plug in more realistic numbers, financial economists say, and unfunded obligations explode. Valuing liabilities at the risk-free U.S. Treasury rate of less than 4 percent, reckon Robert Novy-Marx and Joshua Rauh of the University of Chicago Booth School of Business, the amount of pension promises made by states will more than double, to approximately $7.9 trillion, in 15 years. Unfunded liabilities of state pensions are north of $3.1 trillion, they estimate.

Kent Smetters, an associate professor of insurance and risk management at the University of Pennsylvania’s Wharton School, whose estimates of Social Security funding as a deputy assistant secretary of economic policy in George W. Bush’s Treasury Department earned him a reputation as “Dr. Doom and Gloom,” expects states and cities to begin lobbying for a federal bailout of pension obligations by the end of this year. “They’re going to have to start reaching out for dollars, and as the midterms approach there will be political pressure for this to happen,” he predicts. Smetters expects that a federal pension bailout could reach $1 trillion — or more than the $787 billion economic stimulus package that Congress approved earlier this year.

Some states have already begun appealing to Washington. California is lobbying federal officials to backstop at least $13 billion in short-term municipal notes this summer. In November the mayors of Atlanta, Philadelphia and Phoenix appealed — unsuccessfully — to the U.S. Treasury to be allowed to use a portion of the Troubled Asset Relief Program funds to provide loans to cover unfunded pension liabilities.

In April, South Carolina Governor Mark Sanford won approval from President Barack Obama’s administration to channel some of the state’s $2.8 billion in federal stimulus money toward closing the $27 billion unfunded liability of the South Carolina Retirement Systems.

A large-scale federal bailout of state pension funds, though, appears highly unlikely. Aside from mounting worries over the federal deficit, there’s the fact that some states have succeeded in funding their pensions and won’t want to see Washington bail out others. “It wouldn’t be responsible just to shovel money to California and not the other states,” notes Davis.

In past decades public employees have used their considerable political clout to boost wages and benefits. Now the pendulum has begun a long swing in the opposite direction.

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