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The Other Pension Crisis
Wall Street Journal, Outlook and Review
August 18, 2006
Former SEC Chairman Arthur Levitt lifted the veil last week on the City of San Diego's pension-fund scandal, and it wasn't pretty. The report -- prepared with Lynn Turner, formerly the SEC's chief accountant, and investigator Troy Dahlberg -- tells of "years of reckless and wrongful mismanagement," "non-transparency, obfuscation, and denial of fiscal reality." In case anyone missed the point, it draws explicit analogies with Enron, HealthSouth and other recent scandals.
San Diego's pension-fund fiasco may be exceptional in that it involves criminal allegations -- five former pension-fund officials were indicted in January and the mayor resigned last year over the issue. But the overall storyline is all too typical among state and local pension plans, which are rife with opportunities for political mischief.
As the Levitt report details, the San Diego government saddled itself with $1.4 billion in unfunded pension liabilities for municipal workers by systematically over-promising on benefits and short-changing the fund on contributions. In July of 1996, the city government was engaged in difficult negotiations with its main municipal unions when, according to Mr. Levitt, someone in the government got a bright idea: The unions could be bought off with more generous retirement packages while the immediate burden on the budget would be alleviated by lowering the amount contributed to the pension fund for the succeeding decade.
Prior to this change, the amount the city was required to contribute was designed to keep the pension fund solvent. The city council, in effect, waved that requirement away. The result was dramatic. By 2005, the city's unfunded pension liability had grown to $1.4 billion from a comparatively modest $96.3 million in 1995.
As the shortfall grew, the city resorted to more financial engineering to cover up the problem, adding additional layers of subterfuge until, three years ago, a city employee blew the whistle on the charade, leading to indictments, SEC investigations and the city's loss of access to the bond market. The Levitt report covers this period in detail, although it notes that the shenanigans began as far back as the 1980s, when the city started fiddling with its benefit formulas to appease city workers and their unions.
The basic problem here is nationwide. Wilshire Consulting, based in Santa Monica, California, has been tracking the funding levels and performance of public pension funds for over a decade. According to this year's study, released in March, state and local pension systems are only 85% funded in the aggregate, down from 103% in 2000.
If a 15% shortfall doesn't sound too alarming, consider that Wilshire reports that over 80% of public pension plans are currently underfunded. The total dollar amount of unfunded liabilities runs to the hundreds of billions; how many hundreds depends on what assumptions you make about future performance and future liabilities. The combined pension plans of the S&P 500, by contrast, are estimated to be underfunded by $81 billion as of 2005. That is not a small number either. But businesses at least have the option of drawing on future revenue streams to pay those benefits.
Public pensions have only one source of money -- the taxpayer. Retirement benefits are also notoriously difficult to take away from unionized public employees, who use the threat of a strike to intimidate local politicians. Last winter's transit strike in New York City was precipitated by an attempt to constrain future retirement liabilities that everyone knows will require big tax increases or fare hikes to finance. But the Transit Workers Union demanded that a short-term budget surplus justified big salary increases and no pension reform. And nine months later the union and MTA still have not been able to agree on a contract.
The Levitt report is heavy on Sarbanes-Oxley-style policing of the pension fund, with external auditors and greater independence for pension-board members. But none of that would deal with the fundamental problem that public pensions are inherently political institutions. A more "independent" board can't stop current politicians from giving away too much in future benefits under union pressure.
The long-term solution is for government to follow the private sector and wean public workers from the defined-benefit pension model to a defined-contribution plan where an individual worker owns and controls his own retirement investments. A handful of states, notably Florida, have already begun to do this. Unions and liberal politicians will resist, precisely because the pension money gives them vast political clout. California Governor Arnold Schwarzenegger found this out the hard way when he tried to introduce only a very modest pension reform last year. But the current public pension system simply isn't sustainable in the long run.
Yesterday, President Bush signed a private pension reform that, for all its warts, will encourage the transition to a retirement-savings system better suited to our 21st-century economy. Now it's time to focus attention on the crisis in public pensions -- unless our politicians want to see San Diego's blow-up repeated elsewhere and often.
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