The defined-benefit pension bomb is starting to explode. Detroit, Rhode Island, San Bernardino, California – are all cities where pensioners have lost or are likely to lose significantly. Chicago appears to be next. And the crisis is on its way to Pennsylvania. The so-called "defined-benefit" pension is turning out to be anything but.
The fact is that states and local governments across the country simply cannot and will not fulfill their future pension liabilities. If you are a state or local government worker, you should be preparing yourself for a much lower payout than you were promised.
The heart of the problem is politics and mismatched incentives.
Laying blame for America’s municipal pension mess is like figuring out who the murderer is on the Orient Express. Everybody did it. Officeholders concerned about immediate re-election made promises they knew they wouldn’t have to keep. Union leaders bargained for every last dollar, regardless whether cities could actually pay up. Bond buyers took an extra slice of interest while whistling past the graveyard. And voters weren’t paying attention at all. It boils down to decision-makers with the short-term incentive to make outlandish promises were able to ignore long-term costs.
Compounding the problem, when faced with rising costs, elected officials could either cut services or raise taxes. Instead, they chose the third option: cook the books. If a city needs $100 million in 20 years it will have to set aside just over $2.5 million per year with a conservative 6% rate of return. But, if a city assumes an 8.5% rate of return, it can cut that payment by over $600,000 or 25%. Of course assuming 8.5% is simply absurd, but financial chicanery beats out tax hikes and spending cuts any day of the week.
Today the political calculus has changed. With pension funds going broke, present-day officeholders have nothing but bad choices. They can raise taxes, cut services to the bone, or walk out on the pension obligations. Since pensioners and municipal workers are a small voting bloc than taxpayers, they are going to lose out. Making that decision easier is that today’s officeholders didn’t make the pension promises in the first place. That makes it easier politically for them to walk away.
While pensions are not going to zero, they will fall. The defined-benefit guarantee is going to founder on the rocks of political reality. Relying on the promises of politicians is a risky game, but relying on future politicians to keep the unrealistic promises of past politicians is a losing game.
The mistake that municipal workers and their unions are making today is failing to learn from this debacle. As great as the defined-benefit pension sounds, the fact is that those so-called defined-benefits are only as secure as the finances and political will of the future. There is no evidence that the politicians of today or tomorrow will act more responsibly than the politicians of the past. Labor unions and their members who are relying on state constitutional guarantees are just fooling themselves. When the political pain becomes intolerable, the government will just change the rules.
The smart strategy would be for workers to shift to defined-contribution plans. Given the poor track record of individual investors, the pension plans could be designed to automatically invest subject to a specific set of rules. The pension contributions by the local government would be defined and due each year, leaving politicians and union leaders of the present and future unable to cheat the fund with accounting tricks and unrealistic assumptions. Even if a city goes bankrupt in the future, the workers will have something in their accounts.
The fact is there is no such thing as a defined-benefit pension. The defined-benefit is contingent on the fiscal health of government in the future. The benefits municipal workers have been counting on are turning out to be a mirage. The best thing for them is to walk away from the defined-benefit fantasy and take co