Now that Treasurer Gina Raimondo has released her much-anticipated report on Rhode Island’s pension system, all eyes are turning to the General Assembly as lawmakers decide what action to take in response. The Center on Budget and Policy Priorities’ Elizabeth McNichol offered her thoughts here on Thursday.
Josh Barro is the Walter B. Wriston Fellow at the Manhattan Institute for Policy Research in New York City and author of many articles on state and local finances, including “Dodging the Pension Disaster.” He discussed Rhode Island’s situation with me in a phone interview earlier this week.
Our State Retirement Board just approved new investment return and longevity assumptions that reduced the pension system’s funded ratio to about 48%, with an unfunded liability of about $7 billion, giving it among the biggest shortfalls in the country. How do those numbers strike you?
Well, 48% is quite bad. It’s worse than most states. It’s not the worst in the country; I don’t know if the Illinois funds have released all the updated figures, but the estimate I’d seen recently is that Illinois is at 38% funded. So you can do even worse than 48%, but it’s definitely significantly worse than average.
So if you were a state official in Rhode Island, what are the first steps you’d take to address this?
There are two things you have to do when you have a big unfunded pension liability like this. First is come up with a plan to deal with closing the gap, and usually that mostly just involves putting a lot of money into the pension system over time. And then the second thing you have to do is make sure that further gaps don’t form in the future, because this is really unaffordable for the state.
In my view, that should involve fundamental pension reform, particularly moving away from this defined-benefit structure, which allows funding gaps like this to form – putting employees on plans that look more like 401(k) plans, where the government contributes its money up front. Then there’s no risk of an unfunded liability forming the future because investments underperform.
And I’d note that you don’t just have to make changes for new employees. There are no national-level restrictions that prevent you from making changes that apply to benefits that current employees will accrue in future years. Private companies do this all the time – they say that you get to keep the pension benefits that you’ve earned to date, but going forward we’re going to offer you a different deal that’s more affordable and better matches our business objectives. So similarly, a state should be able to say to employees, going forward we can’t afford to let you accrue the same pension benefits that you’ve accrued in the past. And that will free up some savings to put toward closing the unfunded liability you already have.
There are a bunch of things there I want to ask you more about, but let’s start with what you said about putting a lot of money into the pension system. I know you’re not an expert on Rhode Island, but we have a troubled economy and a structural budget deficit – is it politically and financially feasible for states like Rhode Island and Illinois to find enough money to cover the pension gap?
Well, it obviously depends on the specific financial situation of the state. I’m not specifically an expert on Rhode Island, although I do know about the pressures you face being surrounded by Massachusetts and Connecticut, which have higher average family incomes, so you’re trying to keep up with government spending in states that have a significantly deeper tax base to finance their spending.
Essentially, these unfunded liabilities are like debt. They’re promises made to government employees for work that they already did, and so you can’t take lightly the idea of defaulting on those promises. The sorts of situations in which states should think, “Well, gee, maybe we can’t even afford to pay the pension benefits employees already earned or that retirees who are already done working earned” – I think the situation in which you’d think about defaulting on those is the sort of situation where you’d think about defaulting on your bonds, which is to say a very dire situation that is akin to a bankruptcy in the private sector.
Even though states can’t technically go bankrupt legally, they could default on various obligations. But it’s not something that generally they should be doing. It’s always an option if things get really, really bad, but I don’t really think you’re there yet. I don’t even think Illinois is there yet. You do have a long time to pay off these obligations – they represent payments that are due over periods of years and decades, so even though the numbers are very large, you do have a long time to cope with them.
So I would say that it is theoretically possible for a state to have built up a pension liability that is literally unaffordable, but you should think very hard before you think about defaulting on it.
That’s interesting to hear, because a lot of folks around here seem to want current retirees who are getting pension benefits to have those reduced.
When the state makes promises, sometimes those promises might be unwise, but still you have to tread very carefully before you break them. I wrote a piece about the two kinds of pension promises. Basically, I think we need to draw a distinction between when you promise someone something and they did work for you in the past based on that promise – say, a retiree who worked 30 years as a cop because he expected to get this specific kind of a pension – as compared to when you’ve hired someone and they’ve worked for you for a couple of years, and they think they have some sort of promise that they will get to participate in this pension system while they’re working for the next several decades.
The second one is not the same kind of promise. We can say, well, we’re not going to offer you that kind of promise anymore, and if they don’t like that they can leave their job and go work somewhere else.
Certainly there are some states that have defaulted at least a little bit on vested pension benefits, particularly by changing cost-of-living formulas -
Yeah, that’s something we’ve done already, and it’s being litigated.
First of all, that may not even survive litigation – they may have some federal claims that it violates the contracts clause of the U.S. Constitution. I’m not a lawyer – I don’t know how that stuff’s going to stand up, but in a lot of states I think it’s likely that those reforms will not stand up.
Then also, generally, I think the state needs to honor the promises it makes. Clawing back somebody’s vested pension benefits is not that different from reaching into their bank account and taking back money that you paid them in a previous year. So in general, no, I would say that states should not be defaulting on pension benefits that vested in the past.
Unfortunately, I think states are somewhat pushed to that because they have other avenues that are closed off to them. I think it should generally be pretty easy for states to modify pension benefits that people will earn in the future, but in practice they tend to face tremendous political and sometimes legal barriers to doing that. So I think lawmakers are feeling a little bit desperate and are sort of looking for any way they can find to reduce their pension liabilities and their pension costs, and if more of the options that should be on the table actually were, then I think they wouldn’t have to resort to these undesirable options.
Another policy option being discussed here by Governor Chafee and others is “re-amortization,” which would stretch out our unfunded liability payments over a longer period. What do you think of that idea?
In general, I think re-amortizations are a bad idea. They’re effectively a way of borrowing money. You’re putting less money into the pension system but you’re not accruing fewer liabilities in the pension system. So in fact you’re really hiding the cost of the pensions that you have – you’re pushing more of it off to tomorrow and making the system look more affordable than it really is.
That said, if you coupled the re-amortization with reforms that really did produce long-term cost savings – particularly if you coupled it with reforms that applied to future benefits for current workers, and not just for new workers – I think it would be fine to have a re-amortization as part of that deal. Essentially, if the state took its medicine by reforming the pension system in a way that would produce real savings then it would be OK with me if they did a re-amortization to provide a little bit of a short-term fiscal boost.
But in practice, when states do those re-amortizations it usually is a way of putting a Band-Aid on a problem and avoiding finding a real solution.
That’s actually the approach our treasurer, Gina Raimondo, put forward in her study this week - allowing a re-amoritzation so long as other steps are taken. Another suggestion made this week was that the pension fund could take over our big slot parlor, Twin River, or the state Lottery. What about that?
That sounds like a gimmick. You can move money around on the state’s balance sheet – one thing a lot of states has done is issue bonds and then use the money from those bond proceeds to put in the pension fund.
Illinois has done a lot of that, right?
Right, and it hasn’t worked very well for Illinois. It’s basically a way of trading one kind of debt for another. So if the state owns a valuable asset, like the stream of future income off the Lottery, and it sticks that in the pension fund, the state hasn’t become more fiscally sound – it’s just moved stuff around on its balance sheet. I mean, currently that lottery revenue gets used for other stuff, right?
Yeah, gaming money is about 11% of our general revenue now I believe.
OK, so now your pension fund is more solvent but then you have this big hole that’s formed in the rest of your budget.
You’re a proponent of transitioning state retirement programs from defined-benefit to defined-contribution plans, but I’ve heard people express concerns that the transition costs of switching would be overly high. What do you say to that?
The transition costs I would say are an illusion that’s created by the manner in which pension accounting is done.
First of all, people often conflate this with the discussion about Social Security privatization, which would in fact entail huge transition costs. The difference here is that unlike Social Security, defined-benefit pensions are supposed to be fully funded. So if you do the transition, you have to come up with all the money to close the funding gap by the time all the retirees and active workers are dead essentially. But theoretically you’re supposed to be doing that anyway – you’re supposed to be shoring up the funds to 100% funding by making all those same payments.
Now the way the accounting rules work, they can change the schedule on which you’re supposed to make those payments and effectively encourage you to move to a faster amortization schedule, and I’d say two things about that. One is that that’s not really a new cost – it just means more payments up front and shallower payments in the future, the present value of which should be the same. The other is that the government can simply ignore the GASB rules that tell them to speed up the amortization. I mean, governments all over the country are already ignoring so many GASB directives on pensions that they can feel free to amortize on any schedule they want.
Politically, I think that’s a tough sell. I can sit down in a room with some pension administrators and we could structure a way to do that such that the schedule of payments is not changed at all by the fact you had a transition – politically, it would be difficult to sell people on that, especially because it would probably involve a pension bond issuance.
That’s been a real stumbling block, and I think that’s unfortunate because I don’t think there’s a real transiton cost issue even if there is an imagined one.
Any other bottom-line thoughts you’d like to offer Rhode Islanders as this debate on pensions moves ahead?
When you take a step back, there’s a reason that Rhode Island and so many other states are in the trouble that they’re in right now, which is that defined-benefit pensions are basically a structure with which state lawmakers cannot be trusted. They involve making promises over periods of decades. They involve state lawmakers now making decisions for political benefit, and being able to send the bill to people who will be in office far in the future.
It was very common around the country about a decade ago to give out a pension “sweetener” – around 1999 or 2000, the stock market was doing very well, pension balances looked very strong, and there was this idea that, oh, it’s free money we can give away. Now of course that wasn’t true, first of all because there was the risk the stock market would decline – and then some states used accounting tricks to artificially inflate the funding situation for their pension funds.
But basically, behavior like that is inevitable because pension funds are so complicated. People are paying attention to them right now because there’s been so much trouble, but five years ago no one was watching except the public employee unions, which obviously had very good reason to be very well informed about these issues. And so policy gets made without lawmakers necessarily even understanding it, and not necessarily for the benefit of taxpayers. So part of the benefit of a simpler compensation system is simply that it is simpler, and therefore it’s easier for the public to hold lawmakers accountable for the decisions they make about it.
(photo: Manhattan Institute)