Detroit has become the largest U.S. city to crumble under the weight of huge, unfunded public employee benefits such as pensions and retirement health care. It is unlikely to be the last: Recent bond-rating downgrades in Chicago and Cincinnati indicate that more municipalities could be forced to seek bankruptcy protection.
While it is too late to save Detroit, it may still be possible to prevent similar disasters from unfolding elsewhere by ending our long-standing practice of putting state and local governments in charge of pensions.
Public-sector plans are in peril because pensions are essentially mere promises that are paid for years or even decades after they are made. A politician can woo votes by promising benefits today, knowing very well that after he or she has left office, someone else has to figure out how to pay the bill. This opens the door to plan mismanagement, flawed accounting assumptions and disingenuous politics.
The Secure Annuities for Employees Retirement Act of 2013 - a proposal by Sen. Orrin Hatch, R-Utah - would address this fundamental flaw: It would give state and local governments the option of getting out of the pension business while letting employees keep the benefits they earned.
Instead of governments managing defined-benefit plans and investing assets, the plan would let municipal or state employers purchase a portable annuity from an insurance company that would manage and invest the funds and deliver retirees' monthly checks.
One of the biggest advantages for both public employees and taxpayers is that there would be no more accounting shell games or unrealistic assumptions about the future performance of the economy. Governments would have to face the bill and fund employee benefits fully by paying the insurance company upfront. Public employees would own the annuity as they earn it and wouldn't have to bank on the promises of politicians or budgetary vagaries. And taxpayers would no longer have to fear a sudden pension crisis that requires raising taxes or cutting services.
Detroit is no anomaly. State and local pension plans are repeating the same mistakes across the United States. Consider these examples: Since the late 1990s, New Jersey has periodically granted itself a "pension holiday," skipping or reducing contributions as a form of "budgetary relief." Today, the state has an unfunded liability of $173 billion. Pennsylvania also took a pension holiday in 2003 until state lawmakers finally decided to do something about rising plan costs. They gave themselves a "fresh start" and reamortized the liability. The government's approach to pension stewardship has followed the political maxim that if you don't like the bill, just change it.
Accounting smoke and mirrors have made this fast-and-loose contribution policy more dangerous. Even when governments make the full contribution, they rely on flawed Governmental Accounting Standards Board guidance that assumes a rate of return on assets with a great deal of risk. Governments then apply that assumed rate to valuing a plan's liability.
Mixing assets and liabilities for valuation purposes is a huge error, akin to revaluing your mortgage based on the expected performance of your 401(k). What's left off the books is the enormous cost of guaranteeing these assumed returns on asset investments. This oversight means taxpayers, and elected officials, are routinely caught off-guard by gaping holes in public pension plans. Governments operate both sides of the cash register, calculating the bill and paying for it. If the bill is too small, few complain until a crisis jeopardizes retirement benefits. The result is that even when they pay the full actuarial contribution, governments are setting aside too little to fund benefits.
With accurate, market-based prices on plan annuities, state and local governments could no longer hide behind accounting subterfuges to make these inflated promises look affordable. The price of these annuities would be publicly disclosed, made clear in a competitive market, and transform pension-funding policies from a pass-the-buck nightmare to a single bill paid by employers when services are rendered.
It may be that the best candidates for this change are governments that have relatively well-funded plans that won't be in critical mode in the short term. In the end, the economics will catch up to all public-sector plans. The goal for policy makers should be to avoid making the same accounting and political mistakes that undercut the safe retirements of public- sector workers.
Get governments out of the pension business, and give employees the certainty that they will receive the benefits they earned.
Eileen Norcross is a senior research fellow with the Mercatus Center at George Mason University. Roman Hardgrave is the director of online strategies at the Mercatus Center. They are co-authors of the Mercatus working paper, "Accounting for the Cost of a Public Sector Worker in New Jersey."