Credit-rating firms resist political appeal of public pension funds
When a California judge ruled in October that the city of Stockton could exit bankruptcy protection without cutting its public-sector retirement obligations, the decision drew the ire of creditors and highlighted the outsized role public pensions play in municipal finance.
Although some view these programs as a vestige of a previous era, public-sector pension plans still cover around 20 million individuals and control about $3 trillion in assets. With many cities across the country dealing with mounting debt and dwindling revenue — results of the Great Recession and more permanent economic shifts — many are taking a hard look at these pension funds and asking how do we get out.
It is natural to wonder how we got here. No single factor explains the growth of unfunded pension obligations. The stock market declines at the start of the new millennium, and then again during the Great Recession, were both significant contributors. Increases in longevity have also played a role as employers support more years of retirement for their pension plan participants than ever before. But an important contributing factor is promises by political candidates to raise pension benefits without tax increases or cuts in services.
States and local governments generally operate under balanced budget requirements. In such an environment, pensions have become a popular workaround, enabling politicians to promise workers increasing benefits in the future without having to pay for them today. In fact, some policymakers have been able to extract short-term wage concessions in exchange for pension expansions that are due long after they have left office. This strategy enables elected leaders to pass the costs of generous pensions onto the next generation of taxpayers and avoid the electoral consequences of unpopular moves like cutting spending or raising taxes.
While incentives to pass the buck are nearly universal, my research finds this tendency is most prevalent in politically competitive jurisdictions where both parties have a realistic shot of coming into office during the next election cycle. Empirical analysis confirms linkages between high levels of political competition and the low levels of funding for state pension plans and also for local plans operated by various municipal governments in Pennsylvania.
As it turns out, reforming public pensions requires political will and finding a counterbalance to the short-term preferences of voters. One constituency that seems successful in holding politicians' feet to the fire is investors in municipal bonds and credit-ratings agencies. Repeated downgrades for the state of Illinois by Moody's Investors Service Inc., Standard & Poor's Financial Services LLC and Fitch Ratings Inc. led to Illinois having the lowest credit rating among all 50 states. Its general obligation debt is rated A3 by Moody's, A- by S&P and A- by Fitch. Additionally, the state has a negative outlook from each of these rating agencies.
The resulting increases in borrowing costs spurred the Illinois General Assembly to pass some reforms at the end of 2013. Those modest reforms notwithstanding, the continuing poor state of Illinois' public finances, coupled with a mixed track record during his term in office, contributed to incumbent Gov. Pat Quinn's loss in the November elections.
The most significant pension reforms in recent times have been enacted in Rhode Island, where the state General Assembly and Gov. Lincoln Chafee agreed in 2011 to modify benefits for both current and future retirees. Reflecting the improvement in the state's pension obligations, Moody's upgraded the outlook for Rhode Island government's finances in October from negative — where it had been since May 2011 — to stable. Moody's also kept the state's general-obligation bond rating at Aa2, the third-highest level on the Moody's scale. Although these efforts at tackling unfunded pension obligations were controversial when enacted, the state treasurer who pushed these modifications in Rhode Island — Gina Raimondo — went on to not only win a Democratic primary, but general election in November as governor. Mr. Chafee did not seek re-election. Ms. Raimondo's story ought to serve as an inspiration for would-be reformers to make the tough, but prudent decisions needed to provide long-term financial stability to cities and states around the country.
Illinois and Rhode Island are only two examples of enormous unfunded public pension obligations that are a national phenomenon. The fiscal stress associated with funding defined benefit pension plans and paying out benefits to public-sector retirees were instrumental in the filing of bankruptcy protection by a number of cities within the last several years, including Detroit; San Bernardino, Calif.; Central Falls, R.I.; as well as Stockton. Cities like Chicago; Lexington, Ky.; and Syracuse, N.Y., have not been forced to bankruptcy court but have experienced significant levels of fiscal stress from the burden of pension liabilities. At the state level, unfunded pension liabilities have ballooned in Kentucky and Connecticut as well as Illinois, each of which has less than half of the assets necessary to back up the promises they have made to current and future retirees. Notwithstanding the increasingly large share of their revenues that most states have been contributing to their pension funds, some estimates put the magnitude of unfunded liabilities at more than $4 trillion for state pension plans.
The problems that we observe today with unfunded public obligations arise when policymakers hide the true costs of increasing public-sector benefits and shift the obligation to pay for them onto future taxpayers. One can only hope that a growing awareness by the public and by the credit rating agencies of the true magnitude of pension obligations can spur meaningful reforms by state and local governments around the country in addressing these issues.
Sutirtha Bagchi is assistant professor of economics at Villanova University School of Business, Villanova, Pa.
This article originally appeared in the December 22, 2014 print issue as, "Promise now, pay later".