Public pensions at the state and local level are underfunded by more than $1 trillion; in many cities, pension obligations will soon consume a quarter or more of the annual budget — money that will be unavailable for parks, libraries, street maintenance and public safety.
Part of the problem is that pension funds need significant new financing to cover the growing number of retirees. But the real issue is the lack of incentive to improve pension performance. What we need, then, is a federal program that combines stimulus with serious fund reform.
The pension-fund crisis is rooted in the intersection of excessive optimism by fund managers and the funds’ influence on the political process. Funds regularly overestimate their future performance: Calpers, California’s giant state pension fund, assumed, and still assumes, it will earn 7.75 percent annually on its investments; in fact, its returns over the last decade were, on average, less than half of that.
But Calpers wasn’t left holding the bag. Instead, it was able to force the state to increase its contribution to the fund; indeed, the state’s 2010 share will be about five times what it was forecast to be in 1999.
The Calpers case is hardly unique; the same story has been repeated across the country. Often, though, pension funds — including, until recently, New Jersey’s — have been able to hide their liabilities behind clever, nonstandard accounting methods.
This charade can’t last. Eventually debt-heavy governments will begin to default, which will disrupt the municipal bond market by blocking access to new capital for even the most credit-worthy public institutions. Ultimately, Washington may have to add local governments to the list of institutions it must bail out, next to banks and car companies.
But given how poorly pension funds have managed themselves, the federal government can’t simply hand out checks. Instead, borrowing a page from the Education Department’s Race for the Top initiative, which provides money to states that propose significant reforms for their public school systems, it should strike a grand bargain with city and state pension funds: in exchange for capping their liabilities and adopting better management practices, they could cover their costs through tax-free, federally guaranteed securities.
Here’s how it would work. A city, county or state facing insurmountable pension costs would appeal to the Department of Treasury for relief. As a first step, it would have to adopt standard accounting practices to accurately portray its current and expected financial health, including realistic projections of its investment returns and the discount rates on its debt.
Second, the applicant would have to take action to assure it can meet the debt service on its bonds, including placing a permanent cap on its pension liabilities. This means raising the retirement age, increasing employee contributions and preventing employees from manipulating their salaries in the last years before retirement to increase their pensions; it would also mean restructuring the fund’s health-care spending, which has been a significant drain.
Finally, the fund would have to move all new employees to 401(k) retirement plans, which have fixed employer contributions and therefore reduce future taxpayer liabilities.
In exchange, the Treasury would authorize the fund to issue tax-free “pension protection” bonds which, for a fee, would be guaranteed by the federal government. Proceeds from the bond sales would cover its liabilities, providing a quick resolution to the underfunding crisis.
Today’s bond market is the perfect environment in which to introduce a new security like pension-protection bonds. With their tax-free status, a federal guarantee, accurate accounting and the promise of a permanent fix, these securities might even be priced lower than Treasury bills, which are yielding 3.8 percent for 30-year bonds.
A Race to the Top for public pensions would offer something for everyone. The federal government would get a voluntary, low-cost way to avoid paying trillions down the road. Cities and states could cap their pension liabilities and close their funding gaps with inexpensive long-term debt, allowing them to get back to the business of providing needed services. And public-employee unions would get a federal guarantee behind their increasingly uncertain pension benefits.
The Obama administration’s Race to the Top initiative has been a bold experiment in education reform. The White House and Congress now have the opportunity to apply the same idea to the public-pension crisis. Otherwise, chaos is just around the corner for our cities, counties and states.
Richard Riordan, the former mayor of Los Angeles, was the California secretary of education from 2003 to 2005. Alexander Rubalcava is the president of an investment advisory firm.
Source: http://www.nytimes.com/2010/09/16/opinion/16riordan.html?ref=opinion
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