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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.

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