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Pension Shortfalls Force States to Consider Cutting Benefits

June 19, 2012 at 12:00 AM EST
As more and mores states struggle to keep their pension promises, a new Pew study released Tuesday painted a stark picture of just how big the budget hole has become in some states. Jeffrey Brown discusses the pension gap with the Pew Center's Kil Huh and Northwestern University's Joshua Rauh.
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TRANSCRIPT

JEFFREY BROWN: More and more states are struggling to keep their pension promises, as the ripple effects of recession erode their revenues. A new study painted a stark picture today of just how big the budget hole has become.

GOV. PAT QUINN, D-Ill.: This has to be the year of pension reform once and for all in our state of Illinois.

JEFFREY BROWN: For governors like Illinois’s Pat Quinn, the already-huge pension gap just keeps growing. It’s the difference between what they owe in public employee pensions and what’s actually set aside.

A new analysis reports that nationally the shortfall in funds covering millions of workers reached $757 billion in fiscal year 2010. That marked a 9 percent increase from the year before. All told, 34 states fell short of safe levels of pension funding, roughly 80 percent of long-term obligations.

The study said hard-hit states have redirected funds away from pensions to more immediate needs. In Rhode Island, for example, state treasurer Gina Raimondo highlighted the problem for NewsHour economics correspondent Paul Solman last year.

GINA RAIMONDO, Rhode Island treasurer: So I could promise you today in 25 years when you retire, you will have a very rich benefit, and by the time you come to collect, I’m long gone, I’m no longer in office. And I believe the time has come to fundamentally structurally fix the system.

JEFFREY BROWN: Rhode Island had one of the worst shortfalls in 2010 according to the Pew study, along with Kentucky, Connecticut and Illinois. Each had just 55 percent or less of the money needed for their pension plans.

Some states, including Illinois, are trying to reduce their massive obligations.

GOV. PAT QUINN: We have been talking almost daily on this issue with the various leaders.

JEFFREY BROWN: Elsewhere, Rhode Island has cut benefits and raised its state employee retirement age from 62 to 67.

PROTESTERS: Kill the bill! Kill the bill!

JEFFREY BROWN: In Wisconsin, Gov. Scott Walker also moved to limit benefits, helping spark a recall election battle that he won two weeks ago.

On the same day, voters in San Diego and San Jose, California, approved benefit cuts for city government workers.

And we take a closer look at the depth of the pension gap with Kil Huh, director of research at the Pew Center on the States, which released this latest report, and Josh Rauh, an associate professor of finance at the Kellogg School of Management at Northwestern University.

Kil Huh, I will start with you.

Fill in the picture a little bit more of what you’re seeing. Where do you see the widening gap and how serious is it?

KIL HUH, Pew Center on the States: Well, the widening gap has been growing.

As you mentioned, it has grown percent from 2009 to 2010 and collectively it’s $1.38 trillion between what states have promised their workers and what they have set aside to pay for these benefits. These promises include both pensions and retiree health care.

JEFFREY BROWN: A national problem. You referred to the number of states, but should it be thought of as a national problem?

KIL HUH: It is a national problem. More than 34 states were below 80 percent funded, which is a widely accepted funding level that financial experts have pointed to as a financial health measure.

JEFFREY BROWN: And were you surprised when you — you have been watching this over the years. We have seen the growth. Were you surprised by the jump this time or is this now at this point expected?

KIL HUH: Well, states have been digging themselves into this hole for more than a decade.

It wasn’t uncommon for state leaders to shortchange, or skip payments altogether, to increase benefits without looking at the price tag. And they had no plan in place to address this large funding gap then and have let it go for some time. You couple that with two recessions and you have got this enormous challenge in front of you.

JEFFREY BROWN: Well, Josh Rauh, what would you add to this just to help us understand where we’re seeing it and how serious it really is?

JOSH RAUH, Kellogg School of Management, Northwestern University: Well, $1.3 trillion is a lot of money. That’s about $9,000 for every U.S. household.

But in fact, those numbers are predicated on the assumption that all the of assets that states have in the pension systems are going to earn 8 percent compound annualized returns with certainty. Anybody who’s looked at their own accounts lately know that that’s very difficult particularly in an environment where bonds, 10-year Treasury bonds are yielding 1.6 percent.

So in fact, when one uses principles of financial economics that are used by insurance companies and used in Europe for pensions, it turns out the problem is a lot worse, $4.4 trillion, or almost $30,000 per U.S. household.

JEFFREY BROWN: So the underfunding is much — by that a multiple worse than even what — even with today’s bad report.

JOSH RAUH: Yes, a multiple of about three-and-a-half times worse. That’s because the accounting for public sector pensions is done in a way that doesn’t properly reflect the true cost of the promises.

Again, anybody looking at their own accounts and imagining how much you would have to set aside today to pay yourself an index benefit, annual benefit when you retire, in some cases at the ages of 55, 60, 62, that’s a lot of money. And you can’t simply assume that any money you set aside is going to grow at 8 percent and budget accordingly.

That’s what state and local governments have been doing and that’s what’s led to this problem.

JEFFREY BROWN: And, Josh Rauh, just to stay with you, the question of the role of the recession vs. other factors, how do you make the equation?

JOSH RAUH: Well, on the state’s own accounting that assumed 8 percent return, there wasn’t a problem until the recession. Then a hole of a trillion or $1.3 trillion was blown in these pensions, but really this problem has been brewing for a very long time because the entire systems have been predicated on these unrealistic assumptions about what assets in the fund are going to earn.

Now you have bond yields that are very, very low and how have systems responded? Well, they have responded by investing more and more in public equities, in private equity, real estate, hedge funds, risky investments in order to try to target an 8 percent expected return that may or may not be realized. So, it’s kind of a coin toss for whatever we’re going to make it or not.

JEFFREY BROWN: So, Kil Huh, what are the consequences that we’re seeing play out in various states? We referred to some of them in the setup, but what do you see states doing to deal with the underfunding situation?

KIL HUH: Well, 43 states in the last three years have enacted some form of reform to actually increase employee contribution to their own retirement accounts or to reduce benefits in some form or fashion.

And states like Rhode Island, Kansas and Louisiana have actually switched systems altogether and are offering some kind of a hybrid system that is some form of traditional pension or guaranteed benefit along with a more 401(k)-style retirement.

JEFFREY BROWN: Switching systems for future employees, current employees?

KIL HUH: Mostly for future employees. But one of the things that Rhode Island also did was suspend its cost of living increase for current as well as — current employees as well as current retirees and that saved the state about $3 billion in 2011.

JEFFREY BROWN: Each one of those kinds of acts is clearly a big political battle. Right?

KIL HUH: It is. Lawmakers have to find the delicate balance between recruiting the talent that they need to deliver services like education, health care and public safety, while also having a fiscally sustainable plan that they can afford over the long run.

JEFFREY BROWN: Josh Rauh, what do you see in terms of the political tradeoffs and fiscal tradeoffs that are playing out? Well, you’re in one of those states.

JOSH RAUH: Right.

Well, I think it’s very difficult for elected officials to make these kinds of changes. Illinois kind of stepped away from the brink of making the changes. The reality is that it takes a really, really big impact of pensions on the budget before something happens. You have seen San Jose, Rhode Island. These places that have taken action, it’s been at a point where pension contributions have taken up around 20 percent or more of the general fund budget.

So it takes an awful lot to move to action and California is a very interesting case, because it’s a place where voters have a lot of direct say. And they’re often more willing to make these kinds of changes than elected officials.

JEFFREY BROWN: You mentioned San Jose. And we mentioned San Jose and San Diego in our opening piece.

So, Josh Rauh, this is more than state level. This is playing out at every level, right?

JOSH RAUH: Absolutely. And one of the tools at the disposal of states that has been proposed is to try to cram the problem down onto municipalities and to have them pay for more. So it’s unclear how the relative burden of teachers’ pensions and public employee pensions is going to be shared between taxpayers at the municipal level, taxpayers at the state level or if things continue to go the way they’re going, a federal bailout.

JEFFREY BROWN: Well, Kil Huh, you mentioned the political fine line that government — politicians have to walk.

I was just in Wisconsin, for example, covering the recall election, and I remember teachers saying to me that public employees were being demonized in the state. That’s how he felt. There were very strong feelings about the public employees in the state on both sides. You’re suggesting this is the very sort of thing that we see because of these budget shortfalls.

KIL HUH: Well, I think lawmakers have to navigate a delicate balance between making these plans fiscally sustainable over the long run, making sure that taxpayers aren’t on the hook for unpaid bills, while also offering a retirement benefit that attracts and retains the teachers, the firefighters and the policemen.

And it’s a fine line that they have to walk. But 43 states have enacted some kind of change in order to create these fiscally sustainable plans. The last kind of scenario you want to see is a situation like Central Falls, where the city had to go into receivership and into bankruptcy proceeding and essentially wiped away a lot of benefit that the retirees have come to count on and expect.

JEFFREY BROWN: And just a brief last word from you, Josh Rauh, on that? Do you expect to see much more of this?

JOSH RAUH: Well, no state or local government in the U.S. when you consider pension accounting has actually run a balanced budget for a very long time.

And I think that probably the California votes are a reflection of voter opinion. But whether really meaningful reforms are going to get into state and local government policy remains to be seen, whether elected officials are going to move on this.

JEFFREY BROWN: All right, Josh Rauh, Kil Huh, thank you both very much.

KIL HUH: Thank you very much.

JOSH RAUH: Thanks very much, Jeff.