October 22, 2013

Pensions Crushing Growth of Local Government Revenue

Report by Manhattan Institute explains why taxpayers will see no benefit from revenue surge

Some see signs of hope in a revival in state and local government spending, which after years of being dragged down by poor revenue collections, is showing some life. Indeed, an analysis by Lord, Abbett & Co. released Monday makes this case, arguing that a boost in spending and hiring should aid the economy.

While the analysis by economist Milton Ezrati shows that sources of revenue, including even property taxes, have finally reached the pace that historical trends would have put it at were it not for the housing and financial crises, it states an important caveat:

“Of course, some of these new monies will be directed away from new hiring and spending toward pension trust funds, where many states, towns and cities face huge funding gaps.”

That caveat is the subject of another (and totally separate) report by the Manhattan Institute for Public Policy Research, which, while acknowledging that the economy is growing and spending is rising, asserts that the increased revenues will necessarily be absorbed in the black hole of pension and health care costs of retired public employees.

In other words, taxpayers should expect to see no benefits in terms of improved government services from the current upswing in revenues, barring significant reforms.

Titled “Quantifying Crowd-Out,” the report by the libertarian think tank's senior fellow Stephen Eide shows through tables and charts how local government expenditures on current employees and services have declined as the share reserved for the benefits of former employees has grown.

So while local government revenues have grown 1.7% from 2008 to 2011, pension contributions have grown 8.9% during the same period. What is referred to as OPEB (“other post-employment benefits”) in budget parlance now accounts for 12% of the typical city’s budget.

But that figure actually understates the problem since it reflects what governments are spending on OPEB rather than what they should be spending. Large pension systems have been found to make just 80% of annual required pension contributions.

And even those that fully fund their pensions often make unrealistic investment return assumptions (such that in reality they remain underfunded). Another problem is that local governments may fund, even fully fund, their pensions with pension obligation bonds that become another budget line item for annual debt service.

Eide looks at the crowd-out phenomenon in five different cities, drawing some lessons from their experiences.

In Los Angeles, in the difficult years between the fiscal 2007 and 2014 budgets, overall spending increased 2% while health and retiree spending increased by 10 times that amount. In that time, the city has lost 5,000 employees — 1,000 of them in public works. The message is that budget math necessitates a reduction in current services.

Eide describes energy-rich Houston as the biggest boomtown in America over the past several years. While the metro area has added 300,000 jobs since the recession bottomed out, its city personnel numbers look much like they did two decades ago, while the city borrows from credit markets to pay for OPEB obligations that it is underfunding. This difficulty is a legacy from the big benefit increases Houston extended to city employees in the go-go '90s.

Boston is cited as a positive role model of a city that has successfully wrestled its heath-care costs down via co-pays and deductibles. As a result, health benefits percent of city revenue has actually been declining in each of the past three budget years.

Baltimore’s current trends don’t look good yet the city has undertaken a farsighted 10-year financial forecast. The report therefore describes the city as at an inflection point similar to where Boston and Detroit were in 1980, before the former got and the latter lost its grip on its finances.

The fifth city examined, Detroit, illustrates the thin line between crowd-out and insolvency. When emergency manager Kevyn Orr issued his restructuring proposal, he projected that the city was less than five years away from the point where two-thirds of its budget would be devoted to legacy costs. The report shows that Detroit would not be bankrupt but for its pension and retiree health care debt. For cities at this stage, the untenable choice is between police or promised benefits to former city workers.

While the problems of fixed contractual costs may seem beyond the control of city managers, Eide says there is a way out in managing crowd-out, and that is to reduce the principal rather than interest, so to speak.

Cities should resist taking on new hires; follow the example of governments that have exempted some portions of compensation from collective bargaining; shift more health care costs to copayments and deductibles as is standard in the private sector; adopt 401(k)-style retirement plans whose costs can be expensed precisely up front, as is done in the private sector, rather than defined benefit plans whose whose funding is costlier and less predictable; shift compensation more toward salaries rather than benefits.

More controversially, governments can shift employees onto Obamacare exchanges, as Detroit and Chicago have pledged to do.

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Check out Using Deferred Annuities to Build Pension Plans for the Next Generation by Robert Bloink and William Byrnes on ThinkAdvisor.

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