Illinois this year raised personal income taxes by a whopping 67 percent and the corporate income tax a nearly as whopping 46 percent to help pay for the state’s public employee pension obligations. The state has been borrowing billions of dollars to shore up its unfunded pension obligations.
Bond documents released in June 2010 showed Illinois had only $64 billion in pension assets but has promised its public employees pensions worth a cumulative total of $126 billion. The $62 billion discrepancy is called unfunded pension liabilities. Some experts say the quoted figure is too low—they put Illinois’ unfunded pension liability at more than $80 billion.
Illinois is but the tip of the iceberg nationally, as the 50 states as a whole have a gargantuan total of about $1 trillion in unfunded pension liabilities. Joshua Rauh, an associate professor of finance at Northwestern University, has studied state pensions and estimates 20 states’ pension obligations are less than half funded. He forecasts those state pension funds are on track to become insolvent by 2025, even assuming a highly unusual 8 percent rate of return on investments.
Model Bill Adopted
To solve this $1 trillion problem, the American Legislative Exchange Council (ALEC) is offering a proposal to readjust public employee pension contracts. In December of 2010, the organization of almost 2,000 state legislators adopted model legislation devised and presented by a Washington, DC group called American Principles in Action (APIA), based on research by its sister organization the American Principles Project (APP).
The APP, founded by Professor Robert George, who teaches jurisprudence at Princeton University, notes accrued retirement benefit obligations to state and municipal workers can constitutionally be immediately readjusted to levels comparable to those of private sector workers for positions of comparable responsibility and direct compensation.
Ralph Benko, a senior economic advisor at APP, explains his organization found two U.S. Supreme Court cases that clearly point out that public employee pension contracts are not as sacrosanct as public employee unions and their allies claim.
Precedent for Changes
“Constitutional law and precedent are very clear and show that state government can in fact readjust a contract,” said Benko. “In Energy Reserves Group v. Kansas Power, and also in United States Trust v. New Jersey, state governments can readjust their own contractual obligations: ‘An impairment may be constitutional if it is reasonable and necessary to serve an important public purpose.’ The Supreme Court has very explicitly held this,” Benko said.
Chris Prandoni, federal affairs manager at the Washington, DC-based Americans for Tax Reform, agrees with Benko. Prandoni maintains readjusting current public employee pensions would serve a “reasonable and necessary” purpose, at the very least, to save the recession-hit U.S. economy from multiple big new tax hikes to pay for these public employee retirement packages.
“If nothing is done to reform the current benefit packages promised to public workers, states like Illinois and California could go belly-up in the next decade,” Prandoni stresses.
‘Enormous Transfer of Wealth’
“The only way to keep Illinois and states like it solvent is to reopen these contracts,” says Prandoni.
The pension system in many states is an enormous political boondoggle, he explains,
“The current system was negotiated by lawmakers to appease powerful, politically connected unions and was never intended to be sustainable,” said Prandoni. “Facing trillions of dollars in liabilities, states, at the behest of unions, are asking taxpayers to prop up inflated public employee retirement packages,” says Prandoni. “Raising taxes to cover public pension plans would represent an enormous transfer of wealth to the politically connected government workers’ unions. Worst of all, raising taxes does nothing to fix the underlying problem inherent in these plans and is nothing more than the equivalent of kicking the can down the road.”
Jonathan Williams, director of the Tax and Fiscal Policy Task Force at ALEC, notes that it took the dedication of Bob Williams, a senior fellow of the Evergreen Freedom Foundation in Washington state, to push through the APIA model legislation to readjust public contracts.
“We have a standard procedure where a member of a task force can introduce model legislation. For [APIA’s] legislation over public employee pensions, Bob Williams was the sponsor. We debated it thoroughly; had a discussion between both our public sector group and our private sector group, and, ultimately their [APIA’s] resolution was passed overwhelmingly by both sectors—it cleared both hurdles,” Williams says.
‘Seeing Abuse of Pensions’
Williams maintains reforming public employee pensions is a pressing concern because it is a question of fairness.
“We are seeing the abuse of state pensions in which cities like Vallejo, California are being forced into bankruptcy,” he says. “So unless we address those costs, we are really going to be hard-pressed. But also, what about the fairness of state legislators who adamantly opposed profligate spending in their states, and yet California, which was a state that spent like a drunken sailor, is going to force all these responsible states to bail it out? That incentivizes bad behavior; there is a moral hazard there. We need a fair shake.”
Williams says he believes “it is going to be interesting to see what happens when a lot of states take this up [APIA’s pension reform], and how the courts decide what then is permissible [to readjust] on the contracts. It is too early to tell how much the courts will allow the states to readjust benefits and deal with the unrealistic rate of return many of these pension plans projected, which serves to hide just how unsustainable and large these unfunded pension obligations are.”
Williams says neglecting this issue—or using big tax increases to treat it, as government worker unions and some other special interests want—will not work. Tax increases like those that happened earlier this year in Illinois do not happen in a vacuum, Williams notes.
“They affect your state’s competitiveness, the cost of capital, and it impacts jobs,” he explains. “Certainly one way to address the moral hazard issue, the main fairness issue, is to put all new hires on 401Ks and health savings accounts instead of these Cadillac government plans that are so costly and threaten to bankrupt the states.”
Benko agrees with Williams, stressing that states must ensure an independent panel conducts any readjustments to the contracts.
‘Jurisdiction for Federal Courts’
“Such adjustments must be calculated by an independent review panel appointed by and answerable to the state,” Benko says. “And why? Because the Supreme Court requires a demonstrably reasonable approach, and also, as pension beneficiaries, state judges have an inherent conflict of interest and so are prohibited by judicial canons of ethics from ruling [on the matter]. That’s why APIA’s model legislation proposes sole jurisdiction for the federal courts.”
Daniel Scarpinato, a spokesman for Arizona House Speaker Kirk Adams (R-Mesa), notes a pension reform Adams is working on may be strikingly similar to the APIA model legislation.
“We are not specifically looking at it here, but ultimately it may turn out there will be some parallels between ours and theirs [APIA’s model legislation],” Scarpinato notes. “Overhauling Arizona’s pension package is necessary because Arizonans are on the hook for what is turning into a ticking time-bomb. In just 10 years our pension program went from a $5 billion surplus to a $10 billion deficit, and it is getting worse.”
‘Benefit Increases, Raising Salaries’
He says the problems are “the result of benefit increases, raising salaries, and things we just can’t afford. We have not drafted legislation yet to overhaul Arizona’s public employee pension program, but it means going up against the unions and out-of-state groups who all will fight pension reform tooth and nail.”
Scarpinato says Adams is committed to the fight and “refuses to let the citizens of Arizona be at the mercy of ever-increasing pension liabilities. We are exploring different options to fix this, but first [it’s important to note] Arizona’s constitution protects [state workers from] a diminishment of benefits of people currently in the system. So any benefit change for current employees here in Arizona will require a constitutional change and voter approval. But for other changes, like for new people coming into the system, we would not have to have a constitutional change. The Speaker is definitely boldly leading the effort to solve this massive unfunded liabilities pension problem here in Arizona.”
Andrew Biggs, a pension expert at the American Enterprise Institute in Washington, DC, says a major problem with public employee pensions is the rate of return projected. Current public employee pension accounting rules effectively violate well-accepted accounting precepts, he notes, so public employee pensions can put taxpayers on the hook by contractually promising government workers huge rates of return on their pensions that are never met. When that happens, the shortfall has to be put on the taxpayers’ tab.
“What you need to do is look at the rate at which current public employees are promised to earn future benefits, and change that to match what they would realistically make in a 401K,” Biggs says.
Realistic Rate of Return
He says this “is a property rights issue. The benefits already earned should in general be honored—benefit earned, pay it. So let’s reduce the rate of return to what future benefits can actually be accrued. If we do not do that, I have calculated, as have others, that some of these public pension plans could go under in 10 years. . . . The states cannot possibly finance these things on a pay-as-a-you-go-basis with these stated high rates of returns.”
Biggs says states need accountants and actuaries to fix the problems and start fully funding for the more realistic rates of return.
“Some special interest groups do not want this to happen,” he said. “They basically say the accounting rules these public pensions use are fine, in which case the public pensions are not really that significantly underfunded. Or they say that we can make up the difference. But you really are not getting that type of talk from people on the serious public policy end of this issue.
“Among serious policy people, it is a difference between those who say this situation is dire and those who say it is slightly less dire,” he concluded.
Thomas Cheplick ([email protected]) writes from Cambridge, Massachusetts.