There is a ticking time bomb that could devastate state and local governments across the United States and leave tens of thousands of senior citizens in poverty. That time bomb is the generous pensions that some state and local governments promise to their employees to buy labor peace.
“Local and state financial problems are accelerating, in large part because public entities promised pensions they couldn’t afford,” Warren Buffett warned in his annual letter to Berkshire Hathaway shareholders earlier this year. The Oracle of Omaha also did a good job of describing the origin of the problem:
“Citizens and public officials typically under-appreciated the gigantic financial tapeworm that was born when promises were made that conflicted with a willingness to fund them,” Buffett wrote. That tapeworm now threatens to devastate dozens of American communities and ruin tens of thousands of lives.
Public pensions are a problem because many governments simply lack the funds to make the promised pension payments as Buffett noted. Unfortunately, those governments are legally and morally obligated to make those payments, even if they don’t have the money. The crisis is already leading to tough decisions and nasty political battles.
Some of the places hardest hit by the pension crisis include:
- San Francisco – So far, in 2014, the City by the Bay has paid out $357 million in employee pensions. Within four years, that number could nearly double to $600 million, and Mayor Ed Lee predicts it will bankrupt the city. The city’s Chief Investment Officer, William Coaker, is trying to stave off disaster by proposing investing up to 15% of the fund’s money in hedge funds.
- Illinois – The Illinois Teachers Retirement Service’s pension fund only contains enough money to pay 40% of the pension obligations. That means the organization’s pension fund could be out of money by 2029, its Executive Director, Dick Ingram, told the press. Pension payments are now one of the five biggest expenses for the average Illinois school district, political activist Adam Andrzejewski told The Washington Times. The state legislature tried to fix the situation by passing a law designed to limit expenditures, but a court recently blocked it with an injunction.
- Detroit – Employee pensions are one of the main factors that pushed the Motor City into bankruptcy. City employees and pensioners voted for 4.5% cuts in pensions and lower cost of living increases in an effort to preserve the system over the summer.
Public pensions are a potential catastrophe for several reasons that are often poorly understood. These reasons are:
- Many public pension systems are funded directly by tax revenues, not by the stock market-like 401Ks or the insurance industry like annuities. This puts retirees at risk when tax revenues fall or government diverts funds elsewhere.
- Unlike 401Ks or IRAs, a pension is a defined benefit plan. A defined benefit plan is legally obligated to pay the pensioner a specific amount of money on a regular basis, no matter what the revenues are. The plan is obligated to pay even if its coffers are empty. 401k and IRA payments are determined by the amount of income available.
- Many public pension agreements contain cost of living increases. The amount paid out increases, even if the money in the fund does not.
- Unlike private pensions, public pension plans are not guaranteed by the Pension Benefit Guarantee Corporation, or PGBC. The PGBC takes over private pension plans that fail and makes payments to pensioners based upon the amount of revenue available. The payments are smaller, but at least employees get something. That means there is no system in place to deal with the situation if a public pension fund cannot meet its obligations. Instead, the issue is left up to the courts, legislators, and voters, which can lead to destructive legal and political battles.
- Many people on public pension plans did not pay the Social Security payroll tax. That means they could receive little or no Social Security income, unlike most private pensioners.
- The pension payment is the only source of income some retired government employees have. Many of them did not save or invest because they thought they could rely on the pension.
- Some pension funds have made extremely risky investments. Pennsylvania’s state auditor, Eugene DePasquale, has questioned the amounts retirement systems for teachers and state employees in the Keystone State have made invested in hedge funds. Hedge funds are often more risky than regular stock market investments. In June 2014, around 9.8% of the Pennsylvania Public School Employees’ Retirement System funds were invested in hedge funds. Such risky investments are often made in a desperate attempt to increase the amount of money available to fund pensions.
Basically, tens of thousands, if not hundreds of thousands, of Americans could lose their retirement income in the next decade. To make matters worse, hundreds of local governments, and even some states, could be thrown into bankruptcy by this crisis.
Congress and the President need to deal with this crisis now. One potential solution would be to simply allow governments to turn pension funds over to the PBGC, which would at least give pensioners some money and get taxpayers off the hook. Giving bankruptcy courts the ability to turn pension plans over to the PGBC or the corporation the power to take control of failing public pension funds would also help.
The problem is neither Congress nor the President wants to touch this issue because it would lead to a bruising political battle with powerful public employees’ unions. The unions oppose any reform because they want to keep the checks flowing to their members.
The pension catastrophe exposes a fundamental inequality in American society that is not being discussed or dealt with. Why do certain Americans (namely government employees) enjoy rights and benefits that the majority of their fellow citizens don’t? The situation is inherently unfair and perhaps morally wrong.
It is also threatening the stability of society. Why should taxpayers lose basic government services, such as police, public education, and libraries, simply so a tiny minority can enjoy a comfortable retirement? Worse, the crisis it generates pits Americans against each other; for example, taxpayers find themselves in conflict with public employees or retirees.
These issues need to be addressed before the pension time bomb explodes. One thing is certain: the public pension crisis is going to get worse before it gets better.
“During the next decade, you will read a lot of news – bad news – about public pension plans,” Buffett predicted. Hopefully, that bad news will spur our leaders to act on this critical issue.