Detroit’s recent bankruptcy filing highlights the perilous financial condition of many state and local governments. Some of the contributing factors are not readily within local control: industrial decline, falling population and recession. But one common reason for the distress is very much of the governments’ own making: explosive growth in unfunded public pension liabilities.
Across the country, states and localities are facing staggering costs for promises of retirement benefits made to government workers. Nationally, state and local governments acknowledge accumulating unfunded pension liabilities of about $3 trillion and are estimated to owe another $1 trillion for retiree medical benefits. These numbers are undoubtedly low because state governments rely on suspect actuarial calculations, including assumption of very high annual returns on their investments, typically between 7 percent and 9 percent.
Detroit — facing a $3.5 billion pension deficit — is not alone in its misery. A handful of other municipalities have already filed for bankruptcy because of unbearable pension liabilities, and more are contemplating a filing. Public pension issues have led to bitter state legislative battles, most recently in Illinois where legislative salaries have been suspended pending action on a $100 billion pension liability.
Many other state and local governments exist in a state of denial. Despite having accumulated substantial unfunded pension obligations — sometimes amounting to tens of thousands of dollars per taxpayer household — politicians continue to promise public workers generous retirement plans, substantially funded with IOUs.
Such a state of affairs cannot exist in the private sector. A federal law, the Employment Retirement Income Security Act (“ERISA”), requires most private employers offering defined benefit retirement plans to make conservative interest-rate assumptions and to resolve any pension plan funding shortfall. As a consequence, most private employers have abandoned defined benefit plans in favor of pay-as-you-go defined contribution retirement plans.
Unfortunately, ERISA does not apply to state and local governments, which are free to make their own assumptions and to fund retirement plans as they see fit. Unsurprisingly, politicians and public employees have agreed to compensation packages that provide for very generous future retirement compensation, but which are designed to impose no current political costs. Defined benefit plans — having almost disappeared from the private sector — not only proliferate among states and localities, but have grown more generous over time.
Today, state and municipal employees enjoy benefits packages that far outstrip those of the private sector. In Florida, the most generous benefits packages are offered by municipalities, especially to police and firefighters. Retirement may be permitted after as little as 20 years of service, with retirees receiving a lifetime of benefits based on the year or two of highest wages perhaps including overtime, unused vacation and sick days. The terms often include escalator clauses that grow the payments over time.
In Miami Beach, for example, 26 of the 38 firefighters who retired in fiscal year 2009 were in their 40s. The average initial annual benefit was more than $100,000 per year, and will grow at an annual rate of 2.5 percent. A Miami Beach 911 call operator retired in 2002 at age 54 with an initial pension of $150,000 per year, after inflating her $60,000 salary with massive overtime during her final two years. If she lives a normal life expectancy, including the escalator, Miami Beach taxpayers will pay her a pension of $8.6 million.
In the city of Miami, 154 police and firefighters retired on a single day, Sept. 26, 2010. Of those, 55 had initial annual pensions above $100,000 and 10 had initial pensions of more than $150,000. Many of the retirees were in their 40s.
The situation is less critical at the state level. Florida state retirement plans tend to be less generous than municipal plans, and the state has benefited from Florida’s sustained population and economic growth. Nevertheless, the Florida Retirement System reports being underfunded by more than $20 billion, a figure that grew by $1.3 billion in the most recently reported fiscal year. This number is low — Florida assumes an unrealistic 7.75 percent investment return — and is certain to grow.
There are two potential solutions to the problem of unfunded liabilities. One would be to adopt conservative funding rules similar to those imposed on private employers by ERISA. Introduction of conservative pension accounting would have a devastating impact on state budgets, and, predictably, has no support among state legislators.
Another would be to mandate defined contribution plans. Such proposals have been bitterly and effectively resisted by public worker unions. In the last legislative session, a proposal to mandate a defined contribution plan for new Florida government employees died in the Florida Senate, unanimously opposed by Democrats joined by one-third of Republicans.
In coming months, pension crises will surface in many more states and localities across the nation. Without significant change, Florida communities will follow.
Stephen K. Halpert is a professor of law at the University of Miami and a former senior staff economist on the President’s Council of Economic Advisers.