Unsustainable and Unaffordable Public Pensions Cannot be Solved by Raising Taxes or the Passage of Time, but There are Some Practical Solutions
W. Gordon Hamlin, Jr.; Mary Pat Campbell; Andrew M. Silton; and James E. Spiotto
To date, no American state or local government has adopted a realistic solution to the public pension crisis. To date, they’ve failed to follow New Brunswick’s path-breaking shared risk public pension system. To date, no local government has proposed a prepackaged Chapter 9 bankruptcy. To date, public employees and retirees have insisted that increased taxes are the only pathway to achieving full funded status, even if that is thirty or more years away. To date, constitutional provisions prohibiting legislatures from impairing contracts have forced legislatures to target only future employees. To date, many legislatures have focused on switching as many employees and retirees as possible to the 401(k) world, which has left an entire generation of Americans unprepared for retirement and the problem unsolved.
It’s time to solve this policy dilemma, which is straining state and local budgets and crowding out vital investments in education, healthcare, and infrastructure. It’s time to stop believing that anything less than 100% funding is realistic and that future legislatures and taxpayers will fund any shortfall. It is time to account properly for future liabilities by adopting a risk-adjusted rate of return and budget with realistic contributions.
Real reform needs to begin with a task force of affected stakeholders (employees, teachers, retirees, school districts and local governments) who work with an independent actuary and an independent facilitator/mediator to design a new pension plan along the lines of the New Brunswick shared risk model. Second, the legislature has to adopt that model through enabling legislation and then require school districts and local governments to contribute on a one-time basis an amount sufficient to bring the relevant plan up to 120% funded status (calculated with a discount rate of less than 5%), an amount that none of those entities could afford.
Having created a framework for reform, the Chapter 9 bankruptcy process can provide the vehicle for transitioning to a shared risk model. Having satisfied the “insolvency” criteria of the Bankruptcy Act, the local entities would inform bondholders and other creditors that the upcoming Chapter 9 bankruptcy will not impair them and will only address pension liabilities. The local entities would begin the process of disclosure and voting with the three classes of unsecured creditors (current employees, inactive employees, and retirees) to try to reach agreement on a new shared risk model. Once these negotiations and voting by the impaired classes are complete, the Chapter 9 petition, the prepackaged Plan of Debt Adjustment, can be filed, indicating that a majority by number and two-thirds (2/3) by amount of the claims voted (of at least one of the classes of impaired creditors) have voted in favor of the plan. The Bankruptcy Court then approves the reform plan transitioning all the local employees and retirees into the shared risk plan. Direct state employees and retirees would transition voluntarily, perhaps with the incentive that COLAs would only be available within the shared risk plan. Assets would then be transferred to the new shared risk plan.
The task force we described earlier would be charged with producing a legislative blueprint along the following lines:
- Base the pension benefit calculation solely on base salary (thereby eliminating pension spiking as a common practice);
- Incorporating a cap on earnings for pension calculation purposes (much like the cap on maximum taxable earnings in social security);
- Achieving a 75-80% replacement of the five highest years of substantial earnings over at least a full 35-year working career, subject to the cap on earnings and considering the likely range of social security benefits for the employee (thereby using the social security administration’s 35-year formula for calculating benefits);
- Moving away from end of career formulas, such as high-three, for purposes of calculating the pension benefit, thereby at least partially encouraging the expansion of partial employment options toward the end of one’s career;
- Extending working careers for non-public safety employees so that the normal retirement age coincides with the social security retirement ages, possibly indexed to future longevity trends;
- Studying the best available evidence on physical decline and longevity after retirement for public safety employees, including any epidemiology and actuarial experience studies, for purposes of determining whether the normal age of retirement for such workers should be increased to, say, age 60;
- Moving toward a proportional sharing of the contribution costs between employers and employees, thereby making employees more conscious of the cost of unfunded benefits;
- Utilizes a discount rate much closer to high quality corporate bond rates to compute the unfunded liabilities;
- Incorporating some form of stress testing, or stochastic modeling, to manage the portfolio and identify risky or underperforming assets or asset categories that should be eliminated in favor of more sustainable income streams;
- Evaluating the best pension practices, especially those in world leaders, such as the Canadian or European plans;
- Using much shorter amortization schedules (thereby moving toward correcting the current intergenerational equity imbalance); and
- Seeking to achieve a funded status of 120% of liabilities within a reasonable period (thereby providing a cushion for inevitable economic downturns).
Essentially, this is the shared risk model pioneered by the Province of New Brunswick, which has been praised by, among others, the American Academy of Actuaries and Alicia Munnell of the Boston College Center for Retirement Research.
There is no reason to follow the “free-fall” Chapter 9 example of Detroit, which spent $170 million on professional fees. Municipalities instead can follow the lead of corporations, which in the 1980’s and 1990’s developed prepackaged bankruptcies to avoid these unwelcome aspects of bankruptcy. Section 1126(b) of the Bankruptcy Code is applicable to Chapter 11’s as well as Chapter 9’s, and provides an expedited process by which a debtor may propose and confirm a Chapter 9 plan. Under this provision, a prospective municipal debtor may solicit consents for a proposed plan from its creditor constituencies and thereafter file a petition under Chapter 9.
The case law now permits municipalities to alter their pension obligations in Chapter 9 proceedings, even if statutes or constitutional provisions prohibit impairment of contracts. Some 24 states currently permit Chapter 9 filings, with some requiring approval by a state official. States which have not granted such approval, like Illinois, could do so with an enabling statute.
America’s public pension plans have nearly $4 trillion in unfunded liabilities, according to Stanford’s Josh Rauh. Severely underfunded pension plans simply cannot tax their way to full funded status. Bankruptcy has provided a “fresh start” since the Kings of Mesopotamia declared debt jubilees, and our Constitution has continued that tradition. States under stress can utilize the process we have outlined to start afresh and preserve the desirable risk-pooling and insurance aspects of defined benefit pensions. Better funded public plans can reach 120% funded status relatively quickly and have some cushion against future market downturns. In addition to achieving financial stability for state and local governments, we believe our proposal preserves meaningful pension benefits for employees and retirees. In the absence of real reform, employees and retirees risk losing all their retirement benefits.
No solution is perfect, but this proposal seems more fair, secure, and sustainable than any other solution we have seen.
* W. Gordon Hamlin, Jr. is a retired lawyer now residing in Tuscumbia, AL. Mr. Hamlin is a 1978 graduate of Harvard Law School, practiced with a large Atlanta law firm for over 32 years, and was a 2016 Fellow in Harvard’s Advanced Leadership Initiative. He is the President of Pro Bono Public Pensions, a non-profit which seeks to create fair, secure, and sustainable public pension solutions. As principal author, comments or inquiries can be directed to him at gordonhamlin@comcast.net.
Mary Pat Campbell, FSA, MAAA, is a life-annuity actuary with a long-standing interest in public pensions working in Hartford, CT and residing in New York.
Andrew M. Silton is a retired lawyer and investment manager in Chapel Hill, NC. During his career, he served for several years as the Chief Investment Advisor to the North Carolina Treasurer, the sole Trustee of that State’s public pensions. He managed over $68 billion in assets in that capacity.
James E. Spiotto is a retired lawyer, now Managing Director of Chapman Strategic Advisors LLC in Chicago. He is the author of Municipalities in Distress? and Primer on Municipal Debt Adjustment, both published by Chapman and Cutler LLP. Municipalities in Distress? is available on Amazon and can be purchased by clicking on the link below: