A tale of four cities: pension reform in and out of bankruptcy

by Gregory A. Stein and Wayne Winegarden

Filing for bankruptcy is not, by itself, a solution.  Bankruptcy just creates time and breathing room to renegotiate obligations and enact reforms.  It is this process of rearranging municipal balance sheets that, ultimately, restores solvency.  But, if political interests such as the California pension system (CalPERS) or public employee union leaders browbeat a municipality into leaving pension reform off the renegotiating table, then bankruptcy becomes a feckless exercise.

Vallejo exemplifies this problem.  After declaring bankruptcy in 2008, Vallejo reduced payments to bondholders; cut health-care benefits; laid off public-safety workers; and cut spending on public services – including cancelling and deferring investments in its degrading downtown area.  Illustrating how deep its spending cuts were, Vallejo warned residents to be judicious with their use of the 911 system as a means of saving money, despite the fact that crime rates were higher than other comparable cities in California.

Then Vallejo hit a wall.  CalPERS threatened extended litigation if Vallejo tried to address their unfunded pension system.  Vallejo complied with CalPERS’ wishes.  As a result, despite emerging from bankruptcy, Vallejo remains fiscally insolvent.  Vallejo’s budget projects that, while revenues will grow 1.7 percent a year through the FY2019-20 budget, pension expenditures will grow 8.5 percent a year.  Based on the city’s own projections, pension costs will grow to 21.3 percent of the total budget in FY2019-20 compared to 13.6 percent of the budget in FY2012-13.

Bankruptcy didn’t make Vallejo solvent, but it did impose major costs such a lower credit rating and more expensive borrowing.  Vallejo’s population continues to decline, the tax base is still eroding, and it boasts an underperforming economy. Vallejo is caught in a self-reinforcing negative spiral of higher costs and lower revenues forcing leadership to turn to either further cuts, wage freezes, tax increases or another round of Chapter 9.

Stockton and San Bernardino filed for bankruptcy protection in 2012.  At this stage, their experiences confirm the lessons from Vallejo.  For instance, both Stockton and San Bernardino have been facing the same economic costs as Vallejo in terms of lower growth and out-migration following each municipality’s bankruptcy filing.

In late October, Stockton’s bankruptcy exit plan was approved by the courts.  Even though Stockton chose not to address its problem of a severely under-funded pension system as part of its bankruptcy plan, it did reduce other debts by more than $2 billion.

Stockton made this choice to hold off on pension cuts despite Judge Christopher Klein’s ruling which stated that pension obligations aren’t entitled to “extraordinary protection” under bankruptcy laws.  Opportunity squandered, Stockton retreated in the face of the pressure from CalPERS and emerged from the process no better off in the long run than when they entered.

San Bernardino’s bankruptcy is still underway.  Initially, San Bernardino indicated it might address the problem of unfunded pensions as part of its bankruptcy process.  Alas, in a court filing in early November, San Bernardino indicated that, it too, will take a pass on addressing unfunded pension obligations

The unwillingness to address pensions indicates that both Stockton and San Bernardino will likely find themselves in the same situation as Vallejo in a couple of years – teetering back toward fiscal insolvency.  Like Vallejo, the costs each city incurred for declaring bankruptcy will be for naught

But the pension situation may not hopeless-more promising models do exist, such as San Diego. San Diego addressed the dangers posed by an unfunded pension system through Proposition B, which capped the city’s pension liabilities by switching all employees hired after July 20, 2012 into a defined contribution program (police were exempted).

Prop B also implemented sensible adjustments to the defined benefit pension system of current employees.  These adjustments will help ensure that pensions remain affordable to taxpayers while ensuring an appropriate level of benefit for current employees.

Thanks to these reforms, the City’s independent budget auditor estimates that San Diego’s pension costs will be reduced by $950 million over the next 30 years.

Perhaps most importantly, Proposition B authorized the pension system to offer employees a cash out option. Though currently blocked in practice due to a recalcitrant IRS refusing to rule this “roll over” a tax free event, should the IRS get out of the way, San Diego pensioners still eligible for the defined benefit pension will have the same choice familiar to anyone who has ever won (or wanted to win) a lottery. When an employee retires, he or she can receive their pension over time as it is currently defined, or he or she can choose to receive a financially equivalent lump-sum payment upon retirement.

Under the cash out option, workers and retirees (if they so choose) would receive their share of the currently funded portion of their pension obligation in a personal 401k-type account.  The payout would eliminate all future obligations of the pension fund – both the asset and liability are zeroed out at the current funding level.

To get a sense of the process, take a public safety worker in Vallejo as an example.  According to Calpensions.com, “for safety workers retired under five years, the average Vallejo pension was $101,867.”  Based on the minimum age for retirement (50 years) and the current life expectancy of a male reaching 65 (a bit over 84 years), this public safety pensioner can expect to receive $101,867 a year for 35 years.  Based on the interest rates for the current 30-year Treasury bond (3.06%), the present value of this pension is $2.3 million.

If Vallejo’s public safety pension was fully funded, it could give the average safety worker about to retire a lump sum payment of $2.3 million in lieu of the promised payment stream.  However, the system is not fully funded – it is severely underfunded.  Depending upon how the assets are valued, the assets of Vallejo’s pensions are currently 60.9 percent to 73.0 percent of the estimated liabilities.

Under the cash-out option, a public safety worker about to retire would be offered a choice.  Either stay in the system (hoping the city will be able to meet its future obligations) or receive a lump-sum payout of between $1.4 million and $1.7 million – 60.9 percent to 73.0 percent of the net present value of the workers promised pension.  For those public safety workers not about to retire, the present value would be scaled to their years of service.

For comparison, according to the Daily Finance, the average 45 to 54 year old has $219 thousand dollars saved for retirement (the median was only $101 thousand).  While most of these workers will also receive Social Security benefits, the average Social Security benefit is $1,320 a month.  The net present value of the Social Security benefits adds an additional $196 thousand to these workers retirement nest-egg.  Therefore, the average 45 to 54 year old has a net present value of around $400,000 in retirement savings and Social Security benefits.

Creating a workable cash-out option is an important pension reform worth considering because it has the potential to dramatically reduce the cycle-time required before a defined benefit plan can be permanently closed out.  As the Vallejo experience illustrates, ignoring the unfunded pension liabilities is not a viable option.  Alternatively, the cash-out option offers both workers and taxpayers an opportunity to provide government workers with a reasonable pension while establishing some certainty with respect to current municipal pension obligations.

Gregory A. Stein is the Chairman of the Board of the San Diego County Taxpayers Association. Wayne Winegarden is a Sr. Fellow in Business and Economics at the Pacific Research Institute and a Partner in the consulting firm Capitol Economic Advisors.

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