Carnage in America: Public Employee Pensions

Carnage. Catastrophe. Budget Crisis. Black Hole. Grave Problem. Death Spiral. Sink Hole. Contract.

Let Me Explain.

There is a problem in Oregon but it is essentially the same problem in other states, so I will write generally.  There will be some nuances state to state on exact contract language but if there were easy "escape hatches" they would have been used already.  This is a general guide for why state legislatures are in a budget crunch.

Click for an article on Illinois' problem

The short answer:  State and local governments owe money from services rendered--but not paid for--in past years so now they have to pay both current and past expenses.


Condition #1.  In the 1970s and 1980s, during a period of high inflation, an assumption was thoroughly imbedded in the public mind that investment returns from safe, liquid investments of some 10% per year were normal and inevitable.  The economic climate of 1965 to 1980 of inflation and high rates of return on bank deposits and government backed bonds taught a lesson that clicked into the American mindset, and got locked in.   The lesson was welcome and reassuring.   It taught that investors were well rewarded, a moral lesson, and it taught that future obligations could be met by investing now and letting great returns pay the bills.

People loved the miracle of compounding:  At 10% per year returns, $10,000 today meant  $78,000 in 21 years.  At 12% per year the $10,000 meant about $120,000 in 21 years.

Condition #2.  Office holders, budget committees, taxpayers, union representatives, public employees, and pension administrators all welcomed and adopted the era of magical compounding.  The assumption reflected current reality and it solved a problem:  Elected officials and their citizen budget committees could meet present obligations with taxes and could make part of the employee pay in the form of a pension promise.  That promise of future payments would be paid with a small deposit to the pension account now, to be grown by the magic of that compounding at some reasonable level like 10% likely and maybe 12% with some luck and good management.  They thought paying future obligations would be easy.

Oregon, too, but less bad than Illinois

Condition #3.  The US Constitution, in Amendment Five, includes the words "nor shall private property be taken for public use, without just compensation."  The words are in the famous Fifth Amendment and they are in the context of prohibitions on the federal government--later to include the state governments--using the power of the government to take away life, liberty, or property unjustly, i.e. without a trial, or by forcing testimony against himself.  Or by taking stuff without paying for it.  And a contract clause guaranteed that states could not abrogate contracts.  People should not be surprised.  It has been in the Constitution for 230 years.

Condition #4.  It makes sense but it needs to be noted.  A government's promise to pay someone, for instance, their previous salary of $4,000 a month for life upon retirement at age 55, is property.   It is property in the same way that owning a piece of real estate is property.  Even though the real estate is physical and in hand and the promise is just an invisible contract, recorded on mere paper, each are things of value, owned by someone.  The courts have agreed: yes, they are both property.

Condition #5.  Representatives of the owners of that property, public employee unions, feel fully justified in getting what they bargained for.   Their employees were given a promise of future pension in lieu of some potential income in the past and they insist that the promise be paid, or be replaced with "just compensation", i.e. every penny owed.

Condition #6.  Current returns on safe, reliable government backed investments range from zero to about 2.3%.   The return on $10,000 at 2% compounds up to a value of about $15,000 in 21 years--a far cry from the $78,000 to $120,000 presumed when the pension contracts were written.

Condition #7.  This will vary by union and by situation, but public employee unions are more sensitive to the interests of their long time employees and retirees than they are to the new, young members.  New employees might well want to agree to changes which reduce the benefits of older and retired employees so that more money is available to newer ones and the current mission of the government service, but the unions won't accept that.  Unions are not interested in "letting government off the hook" of an expensive contract by voluntarily agreeing to change it.  Their older employees won't stand for it.  Older employees figure it is theirs.  They worked for it.  The contracted for it. They planned their lives around that benefit.

Click: serious author, wanting to cut pension benefits

The result of all this:  
Taxpayers today need to make up that difference by topping up the investment accounts which would support the pension promises.  This means that--depending on the state and the demographics of the pension participants--a significant amount of today's tax money goes to pay for services rendered ten and twenty years ago.  Moreover, it will get worse.

The politics are full of contradictions.   Democrats are generally the party supported by the employee unions and are the party that supports government services.  The result is that Democrats, by acknowledging the claim of the union to have their contract fulfilled, agree that current taxes pay for past service instead of current government services they want for today.  It bothers them that current services are curtailed.  They deal with the conflict by looking for more revenue--i.e. higher taxes.

More serious discussion

Republicans are generally the party that wants private property protected.  If it were an instance of government wanting to take away forest land or a factory from a timber company or individual citizen without paying for it then GOP advocacy for the property rights of the aggrieved owner would be in full battle mode.  

But Republicans also see themselves as the defender of the taxpayer an an advocate for lower taxes, and public employees are more often Democrats than 

Yet more serious discussion. Click here

Republicans.   Therefore, the pressure from Republicans is to figure out a way to get public employee unions to agree to take less and to test whether the pension contract is in fact utterly ironclad.  They work to hold taxes down to force service cuts so deep that unions will be challenged from the inside to agree to give up benefits--property-- owed to older and retired employees in order to allow more money to be directed to current services and newer employees and union members.  The political solution is to point the finger at "selfish and intransigent" public employee unions.  The public has observed something they don't like:  public employees retiring at age 52 and apparently living very nicely.  Taxpayers also want low taxes and high current services.   The politically acceptable solution is to call for lower taxes, higher services, and for older public employees to "be realistic."

A republican form of government.   This is one area of public policy where there is a lot of serious, informed discussion on policy and tradeoffs.  Unlike so much of the issue-free 2016 campaign talk and the blunt nonverbal messaging of Trump and others the pension debate has generated serious policy talk.  Why?  Billions of dollars are involved.  Lawyers are involved.  Fiduciary obligations are involved.  But the most important reason is that the decisions are being carried out by legislators, not the general public.   We are seeing republican form of government, not direct democracy.  The elected decision makers are forced to deal with reality-reality, not popular-sentiment-reality. It is not perfect, but it is serious. It is what the writers of the Constitution had in mind.

Down to 7.5%

Still, denial persists.  The easiest way out of this mess is more of the same:  investment magic.   It may not be the most realistic, but it is the easiest.

 The Oregon public employee board had considered that a long term return of 8% per year was plausible, which view they held notwithstanding failure actually to receive these returns in the past decade.  They resolved this, in the face of ten-year-US Treasury rates of 2.3%, by lowering the presumed rate of return all the way down to 7.5%.     In 21 years $10,000 compounds at 7.5% to about $44,000.   Assuming a rate of return of an amount that is actually reliably available (about 2%) or plausibly available with some risk and uncertainty (4%) is simply too terrible and expensive to accept.  $44,000 is better than the $15,000 actually available at about 2% returns.  But taxpayers should understand that it could easily get worse for them.  There is no readily available investment that would reliably pay 7.5% per year, not in the current environment of 2% treasury bonds.