Opinion: Let Cooler Heads Prevail — A Potential Deal on Pension Funding

Andrew Sidamon-Eristoff | July 12, 2016 | Opinion
Withdraw the proposed ballot question and instead adopt a law that commits the state to making its annual normal contribution at the beginning of its fiscal year in July

Andrew Sidamon-Eristoff
The battle lines are drawn.

On one side, New Jersey’s public-sector unions, stung by recent defeats in court over the issue of pension funding, are pressing their allies in the state Legislature to approve a ballot referendum for this November. It would amend the state constitution to make the receipt of public-pension benefits an “indefeasible” constitutional right upon vesting and to require that, as of July 2021, the state make a full annual required contribution (ARC) to the pension system. The contribution would be made in quarterly installments to prevent the state from ever again diverting the budgeted pension contribution to cover end-of-year budget shortfalls. All that remains is for a simple majority of State Senate to approve Senate Concurrent Resolution No. 184 (SCR-184).

On the other side, the Christie administration, the legislative minority, business organizations, and most editorialist writers have correctly and appropriately decried SCR-184 as a fiscal disaster in the making that would severely impair the state’s cash flow and fiscal flexibility, threaten the its continuing access to the public finance markets, and inevitably result in drastic budget cuts and/or tax increases. In addition, it is never appropriate to micromanage state budget priorities through the state constitution.

Assuming SCR-184 goes on the ballot, who will win? Although many pundits believe that “no” will ultimately prevail — New Jersey’s sophisticated voters will probably understand that SCR-184 is both bad policy and bad precedent — the unions are said to be prepared to spend tens of millions, potentially overwhelming any business-backed campaign in opposition.

So the only sure thing is that, in what is otherwise an off-year for New Jersey state elections, political consultants, digital media agencies, and advertising sales directors will enjoy a very good year bombarding New Jerseyans with a bitter, divisive, and expensive political war.

What a colossal waste of time and money.

It’s not too late for our leaders to stand back from the precipice and choose a path of imperfect compromise. One possibility would be to withdraw SCR-184 and instead adopt a law that commits the state to making its annual normal contribution at the beginning of the state’s fiscal year in July. This would obviate the most serious objections to SCR-184 yet deliver a substantive and not entirely inappropriate victory to the unions.

What is the “annual normal contribution” and why might it make some sense for the state to commit to paying it early in the fiscal year?

Although many people are familiar with the concept of an annual required contribution for pensions — currently running around $4.65 billion for New Jersey’s public pensions — they may be less aware that the ARC is itself made up of two distinct components: the annual normal contribution and the annual unfunded accrued liability contribution.

The normal contribution is generally the amount that independent actuaries determine is sufficient to fund pension obligations that arose or “accrued” in the most recent valuation year, based upon a wide range of assumptions with respect to benefit levels, headcount, investment earnings, mortality, and so on. In simplistic terms, this is the amount due in relation to active employees’ service. Currently about $700 million a year for New Jersey, this amount is expected to remain fairly stable going forward.

The annual unfunded accrued liability (UAL) contribution is the amount that actuaries determine must be contributed each year to help make up for any deficit with respect to the funds’ ability to pay previously accrued and outstanding pension obligations, again using a raft of financial and actuarial assumptions. In other words, the UAL contribution amount is that portion of the ARC that is intended to pay off or amortize the pension systems’ outstanding debt over time.

If New Jersey had always paid the normal contribution, and the various assumptions had proved accurate over time, the UAL contribution amount would be zero. But undeniably, New Jersey has been inconsistent in making normal pension contributions as well as UAL contributions in recent decades, even as our politicians granted significantly richer benefits and the pension funds suffered significant investment reversals through two deep recessions. The inevitable result: a crushing UAL that now exceeds $43 billion, driving the annual UAL contribution to approximately $3.95 billion. Of course, this amount will increase every year to the extent that the state fails to contribute the full ARC (or investment earnings fall short), with the result that even under the proposed constitutional amendment the ARC could reach a staggering $5.5 billion by 2021.

There are several reasons why a statutory obligation to make an early normal cost contribution might make sense as a potential basis for compromise.

First, it’s relatively affordable.

Even given the five-year ramp-up period and assuming the most optimistic revenue growth projections, it would be fiscal madness for the constitution to force the state to contribute more than $5 billion a year to the state’s pension system. In addition to a dangerous loss of flexibility in managing the state budget in face of emergencies and increasingly volatile revenues, the sheer size of the commitment would be difficult if not impossible to finance. Since the state receives the bulk of its tax revenues toward the end of the fiscal year, notably the all-important April gross income tax payments, it routinely enters the short-term markets early in the fiscal year to pay salaries and other regular bills. In recent years, the state has borrowed up to $2.6 billion in early July and paid the loan off as of the end of June. Lenders have traditionally regarded these intra-fiscal year loans as a relatively low risk and the state has therefore enjoyed very low interest rates.

That would all change if the state had to borrow an extra $2 billion or $3 billion to make the full ARC quarterly pension payment in quarterly installments. Even if lenders had the financial capacity and were willing to extend that amount of extra credit to the state — which is by no means a certainty, given the dramatic increase in cash-flow risk — the price expressed in interest rates would necessarily be astronomically high on a relative basis. Further, making the full ARC a constitutional obligation would adversely impact the state’s existing bondholders, driving additional credit rating downgrades and higher borrowing costs for the state’s bonded obligations. This scenario would almost certainly require deep budget cuts or tax increases.

That said, despite anticipated grumbling from state treasury officials, the state could probably finance an extra $700 million in the short-term markets to cover a normal cost contribution in July without risking too much collateral damage. Not ideal, but certainly doable.

Second, there is a hint of policy logic to elevating the normal cost contribution to a beginning-of-the-year commitment.

Beyond the obvious difference in amounts, the key distinction between the normal cost contribution and UAL contribution is that the former relates to current employees’ accrual of pension benefits under current laws and employment terms, which can be amended by today’s policymakers, while the latter relates to a debt owed mostly to former employees that arose over a long period of time under terms and conditions that are generally not subject to retroactive amendment. In this light, one could argue that, if we are to impose a significant financial burden on today’s taxpayers, it is “fair” and logical to do so in relation to currently accruing obligations rather than obligations that may predate today’s policymakers and taxpayers.

Moreover, there’s the possibility that the pension system could benefit from an extra year’s investment gains on the $700 million. But remember that any such benefit would accrue to the pension system, not the state directly, and that the state would also incur borrowing costs to cover the contribution.

Third, compromise is demonstrably in everyone’s political interest. New Jersey’s public-sector unions could finally claim an important “win” on pension funding while both sides, not to mention New Jerseyans in general, would be spared a rancorous, expensive, and unnecessary political war.

After years of futile protests against successive budgets’ failure to fund the pension system, and a series of stinging defeats in the courts following the bipartisan reforms of 2010 and 2011, many union members are understandably frustrated, angry, and impatient for action. Their leaders face a choice: “swing for the seats” in support of a very aggressive constitutional amendment that may well face defeat notwithstanding an investment of tens of millions in members’ contributions, or accept the “sure thing” of a less aggressive measure that nonetheless constitutes a real victory.

And make no mistake, this compromise would indeed be a significant substantive victory. While it leaves the UAL contribution subject to the annual budget process, making the normal contribution at the beginning of the fiscal year would, as a practical matter, make it extremely unlikely that future governors and legislatures could ever again zero out the annual pension payment and thus again fall behind in funding the state’s obligations in respect of its active employees.

At the same time, business leaders and other opponents to the current amendment proposal would likely embrace this compromise as a way to avoid the expense of a campaign and to achieve a measure of political stability going into the 2017 gubernatorial election year. Everyone has other fish to fry.

There’s still time. Who will take the first step?