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States Need to Get Serious About Pension Reform

It’s clear that the economy is going to be one of the driving issues in the 2016 presidential campaign, but with the entire country riveted to national politics, it’s easy to forget that state issues are at least as important as what the federal government is doing.

Of the 16 Republican candidates, seven have been governors. They understand the importance of state-level reforms, and will be running hard on their records as bold leaders, unafraid to make the hard decisions required of a state’s chief executive. 

As they stand on debate stages trumpeting their accomplishments, they will have to address how the country can deal with its unsustainable obligations on entitlement programs such as Social Security. No less worrisome, however, are the unfunded liabilities faced by state and local pension programs.

A recent report on Houston found that the city owes its municipal employees at least $3.1 billion. That exceeds Houston’s total general fund revenue by $1 billion, and the city is far from alone. California has $1 trillion dollars in pension obligations. Illinois owes $83 billion, only 43 percent of which is funded. Back in 2012, research firm Morningstar found that fully 21 states have pension plans that are fiscally unsound, and the situation has not improved since then.

The question of what can be done is not a particularly easy one to answer. Detroit and the District of Columbia have had some success in restoring fiscal solvency by implementing financial control boards — independent agencies with the power to make difficult cuts without the political consequences faced by a mayor or a governor. The Commonwealth of Puerto Rico, which faces $70 billion in debt, along with rising interest rates and falling credit ratings, is considering a financial control board of its own, looking to these past successes as a model.

Some cities have seen the crisis coming, and have sought to head it off by switching from defined-benefit plans — in which employees are promised a certain payout when they retire — to defined-contribution plans, where that payout is dependent on how much the workers pay into the program. 

Along with cutting overall spending, this has helped prevent a future default and improved fiscal stability. Still, even this has not been easy. Even in these forward-looking cities, it took about a decade of planning just to straighten out local pension plans and ward off problems ahead. If states wait until the crisis is imminent, solutions will prove much more elusive.

One possible model for reform comes from Utah, where state Sen. Dan Liljenquist advanced legislation to rescue the state’s pension system after the housing crisis in 2008. Again, switching from a defined-benefit to a defined-contribution plan was central to the program in order to make costs predictable, but Liljenquist supplemented this idea by giving workers more control over their pensions, providing an incentive to seek out the safest investments with the best rates of return.

There appears to be no silver bullet for pension reform, but one thing is certain: We have to start taking state and local pension crises seriously. 

If states begin to default on their obligations, you can bet that the federal government will waste no time in bailing them out. The alternative of allowing states’ credit ratings to plummet while millions of employees go without their promised benefits is politically impossible; meaning, the rest of us will have to foot the bill.

The consequences of this would be twofold. First, the federal government having to assume states’ obligations would add to our already crippling debt burden and consume ever-greater portions of the federal budget, leaving less money for necessary programs, such as national defense. Second, the signal that Washington, D.C. is willing to bail out the states would remove most of the incentives for governors to practice responsible fiscal management.

Just as the existence of the FDIC incentivizes risky behavior by banks, the federal assumption of pension liabilities would encourage bad practices at the state level. It’s trickle-up debt at its worst.

With all the focus on the presidential election, state pensions may be the biggest problem no one is talking about. If we value our financial future, and the futures of our children, it’s time to change that.

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