Many public pension plans are dragging down their respective state and local governments, and the root of the problem is legislative inflexibility and demographic shifts, stated Chicago resident Jim Bianco, head of Bianco Research.
The Public Pension Straight Jacket
The reality is, the state of Illinois, where Bianco resides, could become the first ever to get hit with a junk status credit rating.
The cause is the unfunded liabilities associated with public pensions in the state. In 1970, the state of Illinois rewrote its constitution, Bianco noted, and added language forbidding changes to any pension or union contracts the state, city, or any entity within the state entered into.
A couple of years ago, the state proposed some rules to make state pensioners pay more into their pension in return for fewer benefits. The state supreme court said these contracts couldn’t be changed, however. The only way was to amend the state constitution, which is unlikely to happen, Bianco noted.
“That kicked off the spiral Illinois is in,” Bianco said. “Illinois’ problem has been that they pay too much in benefits to retirees. There are more people in this state that are getting paid that don’t work for the state anymore in retirement, than do.”
To make up for this, Illinois has been raising taxes of all types. This has led to population flight out of the state, and the tax base is shrinking as a result. The state wants to use more of the same to fix the problem: for example, the recent budget argument in the state included debate about raising taxes.
“There’s a good chance that they probably will raise some taxes … and it will get them through 2017,” Bianco said. “And then more people will leave, and in 2020 or 2021, they’ll be right back where they were before. This is an intractable problem that really the citizens of Illinois have to decide.”
Tax Changes Needed to Prevent Demographic Shift
Illinois needs to reexamine its model, Bianco stated, and consider whether to follow a high-tax model or look to cut taxes. Otherwise, the tax base is likely to continue shrinking. For example, there are 700,000 fewer people in Chicago now than in 1970.
While the tax base shrinks, the state’s liabilities don’t shrink. In 1970, the math worked out. But those in power at the time either didn’t plan out 40 years into the future, or preferred to kick the can.
Other states have problems as well and Illinois is just the start when it comes to America's pension bomb, Bloomberg recently noted. Workers aren’t contributing enough to their own retirement, interest rates are extremely low, and return assumptions are too optimistic. We’re at a tipping point now, Bianco stated.
Population flight is also a contributing factor. For example, in its 2010 census, California picked up no more congressional seats. This is the first time the state hasn’t added seats since the California Gold Rush.
“Illinois is probably further down the line … but they’re all on the same path,” Bianco said. “It’s just that we’re going to find out what the end game looks like with Illinois first.”
To some, the current situation almost appears to be similar to a Ponzi scheme since payouts can only be sustained as long as more people are contributing funds. Ultimately, defined-benefit plans, which is how most public pensions are structured, are doomed to fail, Bianco stated.
“Defined benefit plans don’t work,” Bianco said, “You can never fully estimate your costs and your liabilities into the future, and you always wind up being out of balance. That’s why we went to defined contributions.”