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Puerto Rico, Illinois And California: Public Pension Dominoes

This article is more than 7 years old.

The U.S. Commonwealth Puerto Rico is making a lot of news these days, but for the wrong reasons—it’s economy, overburdened by government, can’t generate enough income to cover payments on its $70 billion debt. Measured on a per capita basis, each of the island’s 3.5 million residents owe $20,000, a debt they can avoid by simply moving. Compared to its economy, Puerto Rico’s debt-to-GDP ratio is about 68%.

Congress recently moved to rescue Puerto Rico from its debt crisis. Ironically, this is the same U.S. Congress that has presided over the accumulation of a $19.3 trillion U.S. federal government debt for a U.S. debt-to-GDP ratio of 106%. Throw in the unfunded liabilities for Social Security, Social Security Disability Insurance, Medicare and other obligations, and the debt balloons to about $127 trillion, give or take.

Paying debt service is easier when you can print money and run deficits at will. Local and state governments, in contrast to the federal government, are obligated to balance their books. It’s this level of government where a looming debt crisis is gathering, the likes of which make Puerto Rico seem a minor prelude.

Illinois offers a textbook case of the coming pension fund meltdown with its years-long slow motion fiscal train wreck where on Monday, the Illinois House overrode Gov. Bruce Rauner’s veto of the Chicago police and fire pension bill at the urging of Chicago Mayor Rahm Emanuel. With the Senate’s override vote earlier, the bill becomes law. Without the bill, Mayor Emanuel warned of a “Rauner Tax”—a $300 million property tax hike made necessary by the fiscally-strapped city being unable to borrow $843 million from its pension fund at 7.75% to meet current obligations.

Gov. Rauner said the veto override would put “… an additional $18.6 billion on the backs of taxpayers” warning about “…governments (that) fail to promptly fund pension obligations” and kick the can down the road instead of enacting reforms to “grow our economy, create jobs and enable us live up to the promises we’ve made to police and firefighters.”

Gov. Rauner has a strong point. In three separate tranches starting in 2003 under Gov. Rod Blagojevich and ending in 2011 under Gov. Pat Quinn, Illinois borrowed $17.2 billion to cover its pension obligations. This year’s payments on the debt total about $1.4 billion, according to a report from the Illinois Policy Institute.

Unfortunately, Illinois is far from alone in this fiscal quagmire. Top honors for unfunded public pension debt belongs to The Last Frontier State, Alaska, with per capita pension debt, assuming market rate returns, of $38,251, according to the Stanford Institute for Economic Policy Research at Stanford University. Illinois comes in at second, with $28,880 in unfunded pension liabilities per person. Connecticut, California, Massachusetts and New Jersey round out the top six, each having more debt per capita owed to just their pension systems than Puerto Rico owes on its bond debt.

That unfunded state and local government pension liabilities have been allowed to grow beyond the ability of governments to pay for them without raising taxes is due to a number of reasons.

In good times, lawmakers at the state and local level are more than happy to give raises to government employees along with generous benefit increases. The future costs for higher retirement benefits are assumed to be covered by the booming stock market investments held by pension funds.

This happened in California in 1999 after government union-backed candidates won both the governor’s mansion as well as the state treasurer’s race and then pushed through a massive increase to pension benefits on the financial strength of what turned out to be the ephemeral froth of the '90s tech boom. After the promises were made and the market returned to more reasonable valuations, the state’s public pension contribution obligations jumped five-fold from $611 million in 2001 to $3.5 billion in 2010. California’s unfunded pension liability totals $25,325 per capita, the fourth-highest in the nation, when assuming a market rate of return.

In lean times, lawmakers who appropriate money for the government’s share of pension fund contributions often pare back those expenses, promising to make up for the deferred payments at some point in the future. This is rarely done.

At the local level, many public employee pension boards are run by the employees themselves, with the board composition typically made up of one-third current employees, one-third retirees who are receiving benefits and one-third politicians who owe their positions largely to the first two groups. Other than being left with the bill, taxpayers are left out of this equation.

Studying Stanford’s extensive pension database for patterns in the debt turn up a few obvious links to public policy and demographics, with states that spend more at the state and local level as well as regulate more and restrict property rights generally having higher per capita debt, as adjusted for a state’s cost of living. But, one factor out of more than 40 tested in a series of multivariate regression analyses stands out as being most predictive for unfunded pension liabilities: the degree of urbanization in a state.

Take Alaska, for example. Most people in the Lower 48 would assume that Alaska’s population is mostly rural—they would be wrong in making that assumption as 66% of Alaskans live in cities.

Why might urbanization be a driver of higher pension obligations? Cities tend to have their own police and fire departments as well as other employee groups, many of whom are unionized or represented by professional associations. For instance, three unions represent workers in the City of Wasilla, Alaska: The International Union of Operating Engineers, Local 302; Laborers’ Local 341; and Teamsters Union Local 959, the latter which, surprisingly enough, represents the rank and file police.

These unions and, in right-to-work states, associations that are functionally similar, hold enormous sway in local elections—elections that are often held in odd years or in months before the general election when voter turnout is far lower and where the unions have far higher odds of electing allies to office. Once elected, these politicians are highly incentivized to keep their union “stakeholders” happy, exchanging promises of higher benefits today for debt and the promise of higher taxes on future taxpayers.

This is what is known as “moral hazard” in which politicians and public employee unions pass a crushing debt burden onto future voters, many of whom have yet to be born.

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