Second of a three-part series State public pension systems are in such bad shape that some have called for allowing states to go bankrupt. Aspiring reformers have been reluctant to propose tackling the unfunded liabilities that portend financial catastrophe, yet there is more latitude to restructure retirement benefits than they think.
Legal precedent tells us that contracts are not suicide pacts or straitjackets, and sometimes need to be reworked to serve an important public purpose. The prospect of pension insolvency meets that threshold.
Because government accounting standards are so lax, state retirement systems have been drastically underestimating their liabilities, leaving economists to calculate the true extent of the problem as data become available.
Based on data from 2009, Joshua Rauh of Northwestern University’s Kellogg School of Management found that seven states’ pension systems are on pace to run out of money to pay benefits by the end of the decade.
Twenty states’ unfunded liabilities exceed 20 percent of the size of their economies. After studying the problem for more than a year, Bill Gates recently told the Wall Street Journal, “These budgets are way out of whack. They’ve used accounting gimmicks and a lot of things that are truly extreme.”
Taxing their way out of this hole is a nonstarter. Rauh points out that states only raise revenue of about 5 percent of gross domestic product on average. A tax level high enough to fund these pension deficits is intolerable and most likely impossible.
States are already struggling to raise revenue to close general operating deficits. There is no room left, especially in pension crisis states like California, Illinois, and New Jersey that already have high taxes, to soak top earners more.
On the other side of the coin, states will have to decide if cutting spending by enough to channel billions into their pension systems is conscionable. Because of the revenue downturn from the recession, governors and mayors have been swallowing drastic cuts to essential public services such as Medicaid to keep their finances functioning.
Think Scott Walker’s proposal to slash Wisconsin schools’ funding by $900 million to balance his state’s budget is austere? Imagine that becoming a means of replenishing pension funds.
Fortunately, states under the gun have another way out. Pensions are generally considered contracts between the employer and employee, but that does not mean they are sacrosanct. In 1983 the U.S. Supreme Court ruled in Energy Reserves Group v. Kansas Power & Light that a contract may be impaired if there is a “significant and legitimate public purpose” behind the impairment, “such as the remedying of a broad and general social or economic problem.”
This interpretation and the court’s earlier finding in Blaisdell, enabling state adjustment of contracts during economic emergency, means that states have the ability to restructure contracts like vested pension benefits when conditions meet such a threshold.
Some states including New York, Illinois and Arizona protect pensions from being diminished or impaired in their constitutions. However, the Government Accountability Office noted in 2007 that “these protections can be amended if voters feel the need to rebalance priorities as fiscal pressures increase.”
Arizona lawmakers are considering referring a measure to the ballot that would do this, and states burdened with similar provisions should consider doing the same thing.
Once the affected states use this legal pathway for restructuring retirement liabilities, they can legislate solutions that scale back excessive payouts, extend eligibility requirements, and downsize a system that has gotten out of control based on promises that can no longer be afforded.
States should not force taxpayers and citizens to shoulder a problem that can be fixed from within through reasonable changes.
Rich Danker is project director for economics at American Principles in Action.
