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Jumping The Crevice To Reach The Cliff

Across the nation, states and cities struggle to fill budgetary holes that recession-reduced tax revenues and rising costs for health care, particularly Medicaid, have blasted open.

Tax collections, at least, should eventually recover when the economy finally strengthens. That will still leave the problem with Medicaid gaping as an even bigger problem – the retirement of millions of baby boomer government employees – draws ever closer. Local governments will find that they have gotten past a near-term economic crevice only to confront a long-term financial cliff.

Give city officials in Atlanta credit for seeing the problem in front of them and doing something about it. A few weeks ago, the Atlanta City Council unanimously passed a sweeping pension reform, blazing a trail that a lot of other governments are likely to follow in the years ahead. Although even Atlanta’s reform package probably does not go far enough, it puts the city ahead of the curve compared to most of its peers.

The changes are expected to save Atlanta about $25 million annually, which will go toward paying off the $1.5 billion the city had already racked up in unfunded pension liability. “This is a good day because we have stopped the bleeding in Atlanta,” Mayor Kasim Reed said. Fixing the pension system had long been a priority for the mayor, who called the situation he inherited when he took office a “train wreck.”

While some in the city government wanted to eliminate pensions entirely, the final reform package keeps the program in place but shifts more of the burden of paying for it onto employees. City employees will now be required to put an additional 5 percent of their salaries toward the pension fund. To supplement pensions, the reform package also sets up a 401(k)-type plan, to which employees will be required to contribute at least 3.75 percent of their pay. The city will match contributions to the plan of up to 8 percent of salaries. Additionally, the retirement age for new employees will be raised, from 55 to 57 for police officers and firefighters, and from 60 to 62 for others.

Other cities are not too far behind Atlanta on the path to pension overhaul. The Atlanta Journal-Constitution reported that reform efforts are underway in Chicago, Los Angeles and Philadelphia, among other cities. A study released last year by the Pew Center on the States found that states and municipalities set aside around $1 trillion less than they needed to provide the pension and health benefits they had already promised to employees. Each new worker hired under the old system adds to the obligations, and to the gap.

Still, while Atlanta’s actions are a strong start, they probably do not go far enough.

Even the higher retirement ages set out by the reform do not reflect the realities of today’s life expectancies. As of 2007, the last year for which data is available, the average American’s life expectancy was 77.9 years. That means that, with the reform, public employees in Atlanta can still expect to spend about 18 years in retirement. Those who begin their careers after college, at 22, will participate in the workforce for only half their lives. That ratio is unsustainable, which is why younger employees in the private sector already must wait until they are 67 to receive full Social Security benefits – and Social Security’s age is also too low.

More importantly, Atlanta’s hybrid retirement plan, part defined-benefit and part defined-contribution, is not ideal for either workers or the city. The problem is that defined-benefit plans typically assume better investment returns and more generous funding than public employers have been willing or able to provide. This is why the funding gap has widened over the years. Public employees were the ones who pushed to keep a defined -benefit plan in Atlanta, because everyone likes to know that they will receive a government-guaranteed pension that they cannot outlive. They assume that state and local governments, which have been good credit risks for decades, will continue to honor their obligations in the future. It is a dubious bet on the willingness and ability of future taxpayers to cash the checks written today, in the form of overly optimistic assumptions about investment returns and future funding.

In an ideal world, a professionally managed pension plan would provide a higher rate of return for employees than individually managed and possibly mismanaged 401(k) plans. Sometimes things work out that way. But rather than place my own security, or that of my children, in an under-funded government program, I would prefer to have an individually managed 401(k)-type account.

Defined-contribution plans, meanwhile, free states and municipalities from the risk that comes with relying on market movements to meet promises. Originally, pension plans appealed to the public sector because they made it possible to defer the costs of attracting workers. Elected officials could not be certain the money would be on hand when it was needed, but they could be certain that, if the money wasn’t there, it would be someone else’s problem. Now, as the debts are starting to come due, it is too late to withdraw promises that have already been made. But it is not too late to stop making similar promises to another generation of workers.

For now, reasonable retirement ages and a full switch to defined-contribution plans may not be politically feasible. It took Atlanta’s recent reforms to show that even a small increase in retirement ages and a partial shift to defined-contribution plans could be accomplished. Other cities will have to take their own leaps to see what they can achieve.

The only thing cities definitely cannot afford to do is nothing. Just this week, Central Falls, R.I., cited pension costs as it became the fifth U.S. municipality to declare bankruptcy this year; it should serve as an object lesson that ignoring this problem won’t make it go away. The Atlanta City Council recognized that. Soon other cities will have to do so as well.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55. His contributions include Chapter 1, “Looking Ahead When Youth Is Behind Us,” and Chapter 4, “The Family Business.” Larry was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.

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