The Stockton, Calif., municipal bankruptcy may provide a dangerous precedent for how public pension plan members are treated relative to other obligations, such as bondholders.
Stockton has proposed to impose large losses on bondholders while making no cuts to what is owed to the California Public Employees' Retirement System, Stockton's largest single creditor. Peter Mixon, CalPERS general counsel, as quoted in the Aug. 20 Pensions & Investments, argues that this position is correct, that “obligations owed to the public workers of the city have priority over those of general unsecured creditors including bondholders.”
I believe that the CalPERS position is incorrect. Pension promises are, economically, equivalent to debt. The employing entity promising the pension benefit has “borrowed” from employees. Employees accept lower wages than they otherwise would in exchange for a pension promise. In turn, the employer, if a company, uses this savings to grow the business faster, or, if a governmental entity, to provide more services.
In a corporate bankruptcy, a pension plan deficit is treated as an unsecured claim alongside others made by vendors and bondholders. Private-sector pension plan members are covered by the Pension Benefit Guaranty Corp., which was set up under the Employee Retirement Income Security Act of 1974. It is funded by premiums paid by private-sector plan sponsors. The PBGC guarantees benefits up to a cap, currently $55,840.92 per year for a retiree age 65. Any benefits beyond this coverage are at risk of being lost in a bankruptcy. Public pension plan sponsors, like Stockton, which are not regulated under ERISA, do not participate in the PBGC program and are essentially self-insured.
CalPERS is arguing that there is effectively no cap on what pension benefits should be protected and that taxpayers should fully insure all benefits that have been promised, no matter how extravagant. The $200,000 annual pension for a retired police chief is 100% protected right alongside the $20,000 annual pension for a retired school custodian. In a corporate bankruptcy, executives and other highly compensated employees are hurt most in a bankruptcy. The PBGC benefit caps are typically high enough that many rank-and-file employees are not adversely impacted at all.
Government employees should not be treated differently than private-sector employees when it comes to pensions. While it may be emotionally unsatisfying to cut the pensions of police officers, firefighters and teachers, they are no more entitled than pilots, engineers and managers.
If public pension plans wanted to protect benefits of plan members in case of a default, a more rational way to do so would be to set up an insurance program like the PBGC. This program would at least have the benefit of spreading the risk across many plans and jurisdictions. Properly constructed, such an insurance program would force higher premiums onto weaker systems or those that take more risk and, perhaps, help to enforce some discipline on various systems to actually put in the proper amount of contributions.
Bankruptcy is a process designed to reset various contracts and promises that were made at a time the outlook was rosier than today. It is also designed to make sure that the pain that results from this resetting process is shared in a rational, if not always perfectly fair, manner. Not allowing public pensions to be touched means that pain is disproportionally placed onto other creditors and, most importantly, taxpayers. Putting too much pressure on the tax base can create, or exacerbate, a vicious negative feedback loop: higher taxes lead to lower property values and business activity, leading to a lower tax base and fewer jobs, keeping pressure on housing and the tax base and so on.
A bankruptcy is supposed to leave the bankrupt entity on a sustainable footing going forward. Runaway employee benefit costs are a primary reason why so many municipalities, and a few states, are facing such serious financial distress today. It is appropriate and reasonable that the beneficiaries of these past cost overruns should share in the burden of restructuring the debt of governments like the city of Stockton.
Ryan McGlothlin is a managing director with P-Solve, a unit of Punter Southall LLC, Waltham, Mass. The views he expresses in the commentary are his own and not necessarily those of P-Solve.