Prediction: Sometime in the foreseeable future, the federal government will step in to address the self-inflicted crisis in state and local government pension and health-benefits funding. The only real question for us in New Jersey is whether it will happen soon enough to save us from ourselves.
How and why? Let’s review where we are:
First, state and local governments in the U.S. face a multi-trillion-dollar shortfall in public sector pension and health benefits funding. This is a genuine and growing financial crisis that clearly threatens our nation’s long-term economic prosperity.
Second, although some Democratic states with powerful public-sector unions like New Jersey and Illinois are comparatively worse off, few if any states can afford to relax and ignore the problem, especially if the analysis considers local government liabilities, rising healthcare costs, and unfunded post-retirement health benefits alongside pension liabilities.
Finally, the existing political environment, in which public employees are by far the most active and powerful constituency in state and local government, means that most blue states and many red states lack the political capacity or will to “solve” their benefits funding crisis on their own.
Unfortunately, New Jersey provides a convenient case study. By some calculations, New Jersey’s unfunded liability for state and local pensions and state health benefits combined tops, among the worst in the nation. Further, 2017 is a gubernatorial election year. The Democratic frontrunner (and thus likely next governor) has secured the support of the state’s public-sector unions in part by rejecting a bipartisan commission’s well-regarded reform recommendations. Those reforms include a proposal to use savings from aligning public employees’ health benefits with Obamacare “Gold” level benefits to help fund the state’s annual pension contribution. Instead, the frontrunner would fully fund pensions along with an ambitious spending agenda by increasing taxes on “millionaires” and closing corporate tax “loopholes.” Trouble is, as even the multimillionaire frontrunner might admit in private, New Jersey’s economy and voters do not have an infinite tolerance for higher taxes, even on corporations and the rich. The likely result will be half measures to keep the ship afloat a while longer and continued deferral of comprehensive reform.
Cue federal intervention. Notwithstanding the 10th Amendment, over the course of history the federal government has repeatedly stepped in when the states’ political systems failed to bring about necessary action. An early example is the Compromise of 1790, whereby the federal government assumed the former colonies’ Revolutionary War debts. A more recent example is federal civil rights legislation made necessary by many states’ demonstrated political incapacity (refusal) to extend the rights of citizenship to all their citizens.
Today, New Jersey and many other states have political systems that are failing to address the escalating benefits-funding crisis. As the crisis begins to restrict and ultimately bar some cities’ and states’ access to the capital markets, exposing the national economy to widespread risk, the federal government will be forced to intervene. Although I cannot predict precisely when or how this will happen, I’ll throw out some ideas to stimulate thinking.
What form will federal relief take? There are many possibilities, but it’s safe to say that rescuing pension systems will be the first priority because rating agencies and current government counting rules place a greater emphasis on unfunded pension liabilities, often protected by state constitutions, than on unfunded retirement health benefit obligations. (Look for that to change soon, but one thing at a time!)
One option would be to extend the federal Pension Benefit Guarantee Corp.’s pension-insurance programs for private employers to public employers. However, the PBGC’s insurance only supports a statutorily defined maximum guaranteed benefit, which in practice results in substantial reductions to middle- and-higher income retirees’ benefits. Moreover, the PBGC is already functionally bankrupt and the model of providing insurance to pay pension benefits on behalf of terminated private employer plans may not be readily transferable, or appropriate, for state and local public employers.
In the absence of a new federal insurance scheme, the most likely option is federal assistance that helps state and local government pension systems refinance their unfunded accrued liability (UAL). For instance, the federal government might lend the states the money on favorable terms, or it could provide a debt-service guarantee in support of state and local pension-refinancing bonds. Either approach would be tantamount to nationalizing state and local pension liabilities, and as such would be controversial. Not impossible, but highly unlikely.
A more limited, and perhaps more politically palatable, approach would be to provide a federal interest subsidy for pension-refinancing bonds. There is precedent. The federal Build America Bond program, part of the 2009 American Recovery and Reinvestment Act, subsidized 35 percent of the interest on state and local bonds issued for capital expenditures.
Once again, let’s use New Jersey as an example for how an interest subsidy might work. As of the end of fiscal 2015, New Jersey reported a total state net pension liability (roughly equivalent to the UAL) of $78.8 billion. This is a long-term obligation or debt like any other, with a cost of funds otherwise known as interest. Unlike a mortgage or business loan, however, there is no stated interest rate. Instead, it is imputed as a function of actuarial assumptions and calculations under government accounting rules. For the sake of clarity, let’s call it X percent.
Since New Jersey hasn’t contributed enough to its pension systems each year to amortize its net pension liability (the actuarially required contribution amount or ARC), and investment returns have not made up the shortfall, both the liability and the ARC keep spiraling upward. However, if the state used proceeds from bonds to make a full pension contribution, both the liability and the ARC would stabilize. Although the state would have to pay debt service on the pension bonds, it would come out ahead if the interest rate net of the federal subsidy is less than X percent. This could be assured by keying the interest subsidy to the pension system’s cost of funds. Moreover, the state would derive annual cash-flow savings if the pension bonds had a longer maturity than the pension system’s amortization period.
As a practical matter, of course, the financial markets do not have the capacity to lend $80 billion to New Jersey all at once. Happily, that wouldn’t be necessary. Rather, the program might be structured so that the state could only use pension bonds to make up the shortfall between the ARC and the amount it actually contributes in any one year. Provided the program includes a strict requirement that the state build up to a full ARC over a period of a few years, this transitional approach would stop the accretion of new unfunded liabilities through continued annual underfunding, in effect staunching the bleeding. (By the way, a direct federal loan program could be structured on a similar basis.)
If the idea of pension bonds is both vaguely familiar and negative, it’s because New Jersey had an unhappy experience with its issuance of $2.7 billion in pension bonds back in 1997 under former Gov. Christine Whitman. At the time, the expectation was that investment returns on the bond proceeds would exceed the bonds’ interest cost. It didn’t work out that way, giving pension bonds a very bad name. But we’re talking apples and oranges. Whereas Whitman’s pension bonds gambled that investment returns would exceed the cost of money, federally subsidized pension bonds could be structured to avoid imposing any additional arbitrage risk on state or local governments.
Will a federal subsidy for pension bonds be expensive? Yes, but probably a lot less expensive and disruptive than widespread state and local pension defaults. Further, the federal government will probably borrow the money it uses for the subsidies, and its cost of funds is the lowest in the land. Finally, as noted, this particular Rome would not have to be built in a day, so the cost could be spread over many decades.
What about the politics? Why would members of Congress from comparatively well-off, fiscally disciplined states support federal legislation that appears to “bail out” worse off and arguably less disciplined states?
There are several answers. First, almost every state will benefit. Even if some states have comparatively well-funded pension systems, most are facing serious financial pressures with respect to public employee health benefits. Second, this is not a simple red state versus blue state issue; not all blue states are in trouble and not all red states are in the clear. In the sausage factory that is Washington, this could lead to strange and unexpected alliances.
When the political dust settles, federal relief for state and local government pensions will come at a very steep price, payable in the form of stiff conditions that will force dramatic cuts in public-employee pensions and health benefits while requiring increased pension contributions and higher employee premium shares for health insurance.
Despite a focus on rescuing pension systems, federal legislation will likely treat pensions and health benefits as components of a single integrated benefits system. Why? First, the two issues are inextricably linked administratively, financially, and politically. Second, the fact that every state and local employer is facing a significant health-benefits funding challenge portends a broad political coalition for reform. Third, as the New Jersey reform commission pointed out, savings from health-benefits reform represent the largest and most logical available resource for addressing pension shortfalls. Accordingly, federal legislation would likely insist that all savings from paring back health benefits be used in the first instance to address pension shortfalls.
By imposing conditions, the federal government will essentially take over and standardize “plan design” for state- and local-employee benefits. For pensions, this will include setting key parameters such as benefit accrual rates, employee contributions, and retirement ages. For health benefits, this will include important features such as premium shares, co-pays, deductibles, out-of-pocket maximums, and out-of-network reimbursement rates.
What would this mean in practice? With respect to pensions, federal legislation will likely push most state and local public employees into either lower-cost defined contribution plans or hybrid plans that include both defined contribution and defined benefit components. Existing benefits for federal employees might be an appropriate reference point. Currently, the Federal Employees Retirement System (FERS) includes both a traditional defined benefit (Basic Benefit Plan) and a defined contribution savings plan (Thrift Savings Plan). This may be a moving target, as there is talk in the Republican Congress of reforming (i.e., reducing) federal benefits to align more closely with prevailing private-sector benefits.
As for health benefits, federal legislation would likely insist that the value of state- or local-employee health benefits not exceed the value of equivalent benefits for federal employees. This would save a lot of money and is a political no-brainer. It would be difficult to argue that the federal government should subsidize richer health benefits for New Jersey teachers than those under the Federal Employee Health Benefit Program. Another possible reference point might be Obamacare “Gold” level benefits.
Even in the best of scenarios, federal intervention will be painful and far from a panacea. We and our children will be living with the benefits funding crisis for decades to come. But whether you look to the future with confidence or dread, make no mistake: federalization of the state and local benefits-funding crisis is coming. New Jerseyans can only hope that it happens sooner rather than later.