Many union and retired city workers protest in front of the US Courthouse where Detroit’s bankruptcy eligibility trial began 

Once an economic powerhouse of American industry, the city of Detroit is today little more than a hulking shell of its former self. This is a city that, in its heyday, was America’s fifth-largest, home to 1.8 million citizens and the birthplace of the American auto industry. Six decades on, however, one in five residents were without a job. The once prosperous auto industry – fresh from a 2009 bailout – was struggling for a solid footing, and an estimated 78,000 buildings stood unoccupied.

Having accumulated $18.5bn of debt over 60 years of steady decline, the city’s mayor, at the mid-point of 2013, said that without reverting to extreme measures, spiralling bills would claim 65 cents of every dollar earned. And so, on July 18, 2013, Detroit filed for chapter nine bankruptcy, becoming the largest urban administrative division to do so in US history, and another name on the long list of states and cities to have fallen foul of insurmountable pensions liabilities (see Fig. 1).

The circumstances have brought to light the consequences that pension funding gaps can bring if left unchecked, and have called into question America’s ability – or lack thereof – to protect state pensions in the event of a collapse. “It is a scandal in government management that should be addressed,” says John Turner, Director of the Pension Policy Centre. “However, I am sceptical that it will be, at least within the next year.”

Broken promises
According to data published this year by the Pew Charitable Trusts, American state and local government pension obligations – as of fiscal year 2012 – surpassed $1trn. Beginning in 2008 at a humble $452bn, unfunded state liabilities grew to $757bn by 2010, and bulged by another $158bn over the next couple of years, despite a string of strong investment returns. As a consequence, almost every state in America has fallen short of its predictions, and, as of 2012, only 17 states managed to better the 80 percent fulfilment quota. Jagadeesh Gokhale, Senior Fellow at the Cato Institute, is critical of a long-standing failure to address the crisis, and believes the principal reasons for the state’s runaway finances to be twofold.

“The first has to do with what’s permissible under the Government Accountability Standards Board (GASB) accounting rules,” he says. “Those rules allow valuing pension liabilities by discounting future pension payments at the rate of return expected on fund assets – at least, until existing funds are not depleted.”

Leslie Papke, Professor and Director of Graduate Studies at Michigan State University, echoes Gokhale’s concerns, and questions the integrity of those promising lofty payouts, irrespective of the costs. “This is misguided from an economic perspective,” she says. “The size of the pension liability should be valued independently of how assets are invested. The pension liability should be discounted at a rate that reflects its risk – in this case, risk comes from any uncertainty that the payments will actually be paid. Generally a risk-free rate would be around three or maybe higher at four percent, if we think there is some likelihood, as in Detroit’s case, that the entire promised benefit won’t be paid.”

The funding gap that exists for many US states and cities is due largely to irresponsible politicians in years past who have chosen not to fulfil their pension promises, but to pass the buck on to later incumbents. By assuming that investments will yield sky-high returns in the future, states and cities have been allowed to effectively write off any shortfalls for the immediate term, and avert disaster at the expense of future generations. Fast-forward to today and yesteryear’s overly rosy assumptions have landed some states with gaping holes in their public finances.

“The other major contributing factor is political,” says Gokhale. “Reducing the discount rate to correctly reflect the certainty and high protections accorded to benefits would increase unfunded liabilities and increase pressure to make annual pension fund contributions. Politicians want rather to spend on their constituents’ wishes for public services rather than salt funds away for future pension payments. So fund rates are set high by investing in riskier assets. These incentives ensure that liabilities are ‘safe’ but investments are risky – a perfect recipe for [the unfolding] disaster!”

Whereas the worst of the financial crisis subsided some time ago, the funding gap that opened in the immediate aftermath has continued to rise – albeit by a lesser degree – since. “State and city pension funds have invested a higher percentage of their portfolios in the stock market than have private sector funds. This appears to be fine when the stock market is going up, but many people think they have taken on excessive risk,” says Turner. “Furthermore, they have used unrealistic assumptions for determining the value of their liabilities, causing a considerable understatement.”

Buoyed by a stint of better-than-expected returns, some states were too eager to anticipate similarly impressive returns in the years to come. Once the crisis awoke, however, many proceeded to skirt their responsibilities and allowed the gap to widen, sometimes to unmanageable degrees.

Passing the buck
At the end of 2013, Illinois had the highest unfunded pensions liabilities in America at $100bn. Due to unrealistic expectations and years of legislative inactivity; the state has been landed with the lowest credit rating in all of America, pushing borrowing costs to unprecedented heights. As a result, and to the dismay of the public sector, at the tail end of 2013 Illinois proposed a number of radical reforms to overturn the state’s runaway fiscal problems.

By cutting retirement benefits for state workers and forcing the state to make good on its pension promises, Illinois authorities estimated that it would save approximately $160bn over the next three decades. While the proposed cuts would trim Illinois’ unfunded liabilities by 21 percent to $79bn, many believed that by passing the bill on to state employees, the financial implications were grossly unfair for public employees.

Whereas most business groups backed the legislation, public workers were less than enthusiastic about the proposal. “This is no victory for Illinois, but a dark day for its citizens and public servants,” wrote one coalition of union workers acting under the name of We Are One Illinois. “Teachers, caregivers, police, and others stand to lose huge portions of their life savings because politicians chose to threaten their retirement security.”

As such, the plans to stabilise the state’s pension system have come undone after unions challenged the constitutionality of the proposed legislation.

The central fact still remains, however, that taking the necessary funds from any one party will come up against stiff opposition. Illinois’ proposed reform package highlights one of the more important considerations when tackling state pension-funding gaps; that is, who will foot the bill? Opinions differ dependent on the individual questioned, but the vast majority believes the gap will be plugged by a combination of tax increases and broken pension promises.

“The bill for the funding gap will be borne in part at least by workers and retirees through reduced benefits and reduced wages,” says Turner. “Taxpayers may be affected through higher taxes, or more likely by reduced services. Bond ratings will be affected, which increases the cost of borrowing, which is borne by taxpayers.”

One report by the Centre for State and Local Government Excellence entitled State and Local Government Workforce: 2014 Trends reveals the extent by which retirement plans have changed over the past year. The report found that 27 percent of respondents had increased employee contributions, 18 percent had decreased pension benefits, 16 percent increased eligibility requirements and eight percent had reduced or eliminated cost of living adjustments.

What’s arguably more important for the debate moving forwards, however, is whether or not state pensions will enjoy the same protection rights they historically have done. Detroit, therefore, is an especially important case in that anything less than a guarantee could have huge ramifications for the way in which state pension promises are managed. “It could go either way as the crisis unfolds,” says Gokhale. “Shortfalls may lead to stripping existing protections in some cases. But, given recent experience with poor pension fund management and plan conversions in so many places, public pension beneficiaries may begin lobbying for even stronger protections in the future.”

The worst affected states have so far chosen to focus on making adjustments to existing retirement plans as opposed to changing state legal protections, and some believe that the central problem is not necessarily the guarantee, but the fact that obligations were allowed to go on unpaid for so long. “The real lesson is a need for greater transparency,” says Dean Baker, Co-Director of the Centre for Economic and Policy Research. “If politicians had made required contributions year by year, then no pension would be in any trouble. The problem was that it became a sport to skip these contributions in places like Chicago and New Jersey.

Cause for optimism
Although the funding gap in certain instances has strained public finances close to breaking point, many are in agreement that the worst of the crisis is now over. Provided that taxpayers and employees accept the resulting concessions, most states and cities should see their funding gap steadily decrease over time. “If pension plans meet their investment return targets and government sponsors make recommended contributions to their retirement systems, states can expect to see funding levels start to rise in future years,” reads a Pew Charitable Trusts report.

“There will be little or no funding gap to pick up in the vast majority of cases,” says Baker. “Most of the gap came about because the market plunged in 2008 to 2009. Because of averaging, the 2009 valuations still appear in most state and local pension funds’ measure of assets. Assuming there is no collapse in the market this year, funds will look considerably better when we have next year’s valuations [2014 valuations replace 2009 valuations]. Instances of serious shortfalls have come about almost entirely because states have gone years without paying required contributions. If the parties approach this problem in good faith, in most cases the gap will be manageable.”

In New Mexico, for example, state legislators and unions agreed on a plan to plug one of the country’s largest funding gaps, which in fiscal year 2012 came to $12.5bn. However, beginning last year, certain plan members are required to make larger contributions, and the minimum retirement age for young workers and new hires has been raised. Together, the reforms have offset the vast majority of the state’s projected funding gap, and significantly reduced the strain on public finances.

“If other states follow this sort of model, it is likely that the gaps can be filled in even seriously troubled systems without too much pain. However if you have politicians who want to score political points by inflicting pain of public sector workers then we see serious problems,” says Baker.