Public Pensions Face Underfunding Crisis

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Two professors of finance are giving a sharp rap on the knuckles to Philadelphia, Boston, Chicago and other major cities.

Their warning: Better fix your pension problems fast.

An analysis by Robert Novy-Marx of the University of Rochester and Joshua Rauh of the Kellogg School of Management finds that public pension plans for America's 50 biggest cities and counties are underfunded by $382 billion--or $14,000 for every household in those same cities. Some of the biggest plans may run out of money to pay promised benefits in as little as five to eight years.

Click here for a table of 50 municipalities with the biggest underfunded pensions. The table is at the end of the report.

Michael Zuccht, general manager of the San Diego Municipal Employees Association says the problem has been building for decades.

Year after year, municipalities have put off fully funding their pension obligations, just kicking the can down the road. Now, though, with the Baby Boom retiring, that road is running out.

"For 30 years elected officials have failed to meet these 'boring' obligations," says Zuccht, referring to his city's and others' pension plans. "They preferred to spend their money on 'exciting' things like parks and libraries and recreation. Guess what? It's come due now. It's hit the fan."

Cities claim their liability is less--only $190 billion, or $7,000 per household. But Rauh and Novy-Marx say this lower figure is the result of government accounting that assumes too rosy a return on assets and underestimates the cost of pension promises. The professors use private sector accounting standards, then calculate how long the assets in each fund (as of June 2009) could keep paying out the benefits promised, as of that same date.

Philly, by their reckoning, has just five years until it can't pay. Boston, Chicago and New York, have eight.

Of the 50 cities in the study, 20 won't be able to pay their promised benefits after 2025.

Philadelphia Finance Director Rob Dubow takes issue with the study. "It's an academic model that looks at what would happen if we didn't put any more money in during the next five years. Yes, then we would run out. But that's not going to happen. Our contributions over the next five years will be well over $2 billion."

The city's plan, he says, calls for the pension fund to be paid-up in full over the next 29 years. If you're a Philadelphia employee today, how should you feel? "You should feel you're going to get your pension," says Dubow.

The Pension Bill Comes Due

The danger Philly faces, he admits, is real. Pension costs have risen from just under $200 million a year to $400 now. In five years, he says, they'll be $600 million.

Cities have few options. To shore up pension funds, they can raise taxes or re-direct spending: they can pave fewer potholes, close libraries or cut back on other services like schools, fire and police. The problem, of course, is that disgruntled citizens can always move elsewhere, depleting the local tax base.

To cut costs, some cities are experimenting with alternatives to the traditional defined-benefit plans. San Diego, for example, wants to give new hires a savings vehicle similar to a 401(k). Philadelphia offers them a 'blended' plan that combines features of a traditional pension and a 401(k).

How about reducing benefits to workers whose pensions have already vested?

Merely to ask this question is to draw a gasp from lawyers, union leaders and city managers alike.

Courts have declared public pensions--as distinct from private ones--to be absolutely sacrosanct, inviolate. In California, government's obligation to pay is written into the state constitution.

Says San Diego's Zucchet, "Cities can't just say, 'Whoops, I got in over my head.' They have to find a way to fulfill their promises."

In the private sector, of course, vested pensions get re-jiggered all the time, through bankruptcy. "Look at the airline industry, autos, steel," says John Schotz, co-founder and chief investment officer of Saybrook Capital in Los Angeles.

"In all those industries, benefits paid retirees were adjusted down because of bankruptcy. It's why you've got somebody retired from United Airlines whose pension went from $180,000 a year to $42,000."

What happens when a city declares bankruptcy?

Would-be pension busters and worried unions are watching with interest what happens in Vallejo, California. The town, badly battered by the closing of a naval base on which its economy depended, sought relief from its creditors in May 2008 under Chapter 9 of U.S. bankruptcy law. Its creditors include city unions, some of whose pensions are generous.

In a groundbreaking decision, the judge in the case, Michael McManus, ruled that the city's labor contracts can be overturned in bankruptcy.

Says Schotz, "Most people felt the only reason Vallejo filed for bankruptcy was to pop the unions."

Will Vallejo, through bankruptcy, be able to pay pensioners less than 100 percent of their promised benefits?

Marc Levinson, the lawyer representing Vallejo, is quick to emphasize that no such request has been made yet by the city: "Vallejo has not asked the judge to modify pension benefits." Some lawyers, though, "have contended that the bankruptcy code permits pensions to be modified. I would be very surprised if someone in the future did not try to do so."

The pension debacle, he notes, is huge, nationwide, and only getting worse. That doesn't even count state pension shortfalls -- the Pew Center on the States reckons that there's a $1 trillion shortfall at the state level.

How will it end? Levinson doesn't know, but he thinks any resolution, when it comes, will be grisly. There is, though, one bright spot:

"I'm 62. Happily, I'll be dead by then."