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Congressional Hearing Looks at State Bankruptcies

Pension experts point to state pension funding liabilities at a House Judiciary Committee subcommittee hearing.

Years working as a bankruptcy and debt-workout attorney have taught James Spiotto this lesson: Fixing it early is always better than fixing it later. States challenged to fund their public pension plans often disregard that reality, he says. “Up to now, many states’ approach has been to kick the can down the road, and not make a funding payment,” says Spiotto, a partner at law firm Chapman and Cutler LLP. “All that does is make the hole bigger, and the problem becomes more complex.”

On February 14, Spiotto joined three other experts in testifying at a House Judiciary Committee subcommittee hearing on whether states should be allowed to kick the can into bankruptcy court, which would require Congress to pass legislation that permits states to declare bankruptcy. None appeared to be big fans of the idea, and Spiotto and another expert subsequently talked in interviews about possible alternatives.

The core issue that needs fixing is an accounting loophole that lets states promise public employees pensions and then, in some cases, not set aside enough money to meet their promises, says Joshua Rauh, an associate professor of finance at Northwestern University. “The way that state and local governments account for their pension liabilities is not in keeping with the principles of financial economics, or even sound logic,” he says. “The accounting approach almost ensures that plans will be underfunded.”

Governmental Accounting Standards Board (GASB) rules let public pensions claim lower future liabilities on the premise that they will get an expected rate of return on their assets that the funds themselves set. While state and local governments have about $1.3 trillion of unfunded pension liabilities under their own accounting rules, Rauh estimates that the already-promised part of their unfunded liabilities actually exceeds $3 trillion. “In the financial world, one cannot measure liabilities by assuming returns on assets,” he says. “Debts are debts, and assets are assets.”

Establishing “carrots and sticks” for states could help the situation, Rauh thinks. For example, they currently can only issue taxable bonds to fund their pension liabilities, he says, and the federal government could let them start issuing tax-free bonds to do it — but only if they begin reigning in liabilities. That could mean requiring these states to start putting new state employees into defined contribution plans and putting all state employees into Social Security; 30 percent of state and local government employees do not participate in Social Security, he says. Or these states could be required to do a “hard” freeze of their public pension plans covering not just future workers but the future benefits accrued by current employees, and moving everyone to defined contribution plans.

Spiotto agrees about the need for more discipline. Congress has an impossible challenge to pass legislation allowing state bankruptcy, he believes, because of the dual sovereignty given to states and the Constitution’s 10th Amendment, which prohibits the federal government from interfering in states’ revenues, properties, government affairs, or decision-making. “States did not come in as appendages of the federal government,” he says.

Spiotto looks to “surgical” alternatives that address pension problems more directly. “One of the biggest issues is a determination between an unwillingness to pay and an inability to pay,” he says. “If it is a lack of willingness, then they need a supervising adult to say, ‘You can afford this, but you have to raise taxes.’ Or, if it is a lack of ability, they need someone to say, ‘There was an overpromise, and you have to make adjustments to the pension in the ways that we determine, and then provide a basis on which those benefits can be paid.’”

That third-party supervision could come in the form of a quasi-judicial pension authority created by individual states and made up of appointed independent, expert professionals, Spiotto says. Or individual states could establish a sovereign-debt-resolution mechanism such as a composition of creditors or arbitration process. Or Congress could establish a new federal court to deal solely with public pension issues. While this approach inevitably would lead to some decisions difficult for public employees and taxpayers to accept, an unsustainable pension system “ultimately is going to break down,” he says. “So you might as well fix it, as opposed to living a myth.”

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