The Observer

State of disaster

Wednesday, March 21, 2012

Warren Buffet, America’s most famous investor, often says: “You don’t know who is swimming naked until the tide rollsout.” The Great Recession has revealed many different policy shortcomings in America that were hidden during the1990s and 2000s by a relatively strong economy. Some such shortcomings are the massive unfunded obligations that states face due to their retirement obligations for public sector workers. While it may not seem interesting or important, this situation is already having a devastating effect upon the states. If left unreformed, it could even lead to a new economic crisis.

According to the Pew Research Center, the 50 states have a combined $1.26 trillion in unfunded liabilities owed to retirees for pension and health care benefits. This crisis has materialized over past decades as state legislators, eager to gain the support of public sector employee unions, voted to increase pension and health care benefits while lowering the contributions that workers had to make and the age at which they could retire. Meanwhile, most states did not properly fund these benefit increases and promised unrealistic returns on investments made to pay for the benefits.

My home state, Illinois, is a prime example of how retirement benefits have not only put the state in a bad situation but have also paved a road towards bankruptcy. Currently, the state can fund about 51 percent of its benefit promises, much lower than the 80 percent that the Government Accountability Office recommends. The situation was so bad in 2009 that Illinois was forced to borrow money through bond sales to make the 2010 contribution as mandated by law. Recently, it was projected that the Illinois retirement fund would go bankrupt in 2018, meaning that in 2019, Illinois would be forced to allocate one-third of its budget to make its mandatory retirement benefit contribution. For Illinois and other states, these obligations may have been appropriate decades ago, but are simply unaffordable today.

The most important reform states can take is switching retirement plans from defined benefit (pensions) to defined contribution (401K). A defined benefit plan calculates future retirement benefits based on final salary, years worked and cost of living. Thus, it is possible for state legislators to promise huge benefit increases without allocating funding for them, creating future unfunded liabilities. A defined contribution plan is based on an employee making ongoing contributions to a retirement fund that the employer then matches. Because of the matching formula, it is not possible to create unfunded liabilities with defined contribution plans, because if state legislators decide to increase retirement benefits for their employees, they must cut spending or raise taxes in the present.

Other necessary reforms include raising the retirement age on state workers (some can retire as early as 50), amending state constitutions so that at least 80 percent of all benefit increases are covered by tax increases or spending cuts and having public employees pay more for their retirement benefits.

The recession and weak recovery has led many Americans who work in the private sector to lose their jobs or take pay and benefits cuts. As more Americans have learned about the perks that public sector employees receive due to the political clout of public sector unions — whether it is early retirement, protection from pay or benefit cuts, lush retirement packages or a job for life — many have begun to harbor bad feelings toward the public sector. This dissent will most likely increase as states raise taxes to pay for the cost of past unfunded promises.

Public sentiment against public sector unions helped propel Republican governors like Chris Christie (New Jersey), Scott Walker (Wisconsin) and Terry Kasich (Ohio) into power. Even some Democratic governors, like New York’s Andrew Cuomo, have taken on the perks and benefits that public sector workers receive.

Tough choices will be forced onto states concerning public sector employee benefits that have been decades in the making, whether states choose to embrace them or not. Public sector employees should work with state governments to solve the crisis. If citizens see this effort, they will be more willing to pay more in taxes. Fighting tooth and nail to protect outdated and unaffordable retirement benefits could be a tragic political miscalculation. It could create a road for bankruptcy for states like Illinois and California and produce more anti-union politicians like Scott Walker. My guess is that the public sector employees will not take this advice. Even still, it is important for them to remember (especially as states begin to make unpopular and painful decisions) that if you do not come to the table, you will eventually be placed on the menu.