Who pays the bill?
Pensioners are pushing many cities and states towards financial crisis
Jul 27th 2013 | CHICAGO AND LOS ANGELES | From the print edition

DETROIT may be an extreme case of fiscal incontinence. But its bankruptcy highlights a long-term problem faced by many American cities and states; how to fund generous pension and health-care promises that are no longer affordable.
The problem has been decades in the making. It has always been easier for politicians to promise generous retirement benefits to public servants than to raise their wages. The bill for jam today falls due immediately; the bill for jam tomorrow can be delayed for decades.
The same mindset once caused Detroit’s big three carmakers to strike deals with workers whereby they could retire as young as 48 with gold-plated pension and health-care packages. In the short term, this bought industrial peace. In the long term, it bankrupted GM and Chrysler; in 2009 the government had to rescue them.
Now Detroit, like other cities, faces a choice. It has made promises to creditors and retirees that it cannot meet in full. How should it share the pain?
For Motown, the question will be settled in court. The outcome will send ripples far and wide, affecting the holders of municipal bonds, the insurers that guarantee such bonds, state and municipal public-sector workers and, last but not least, taxpayers around America.
Detroit’s unfunded health-care burden is actually larger than its pension deficit. But the pension problem stands out. First, unlike health care, the city has put aside specific funds to meet very specific pension promises. (A promise of health insurance can be made cheaper in all sorts of ways, but a promise of $30,000 a year can be made cheaper only by breaking it.) And second, courts have made such pension promises legally very hard to break.
The issue also illustrates an emerging divide in American society. Most public-sector workers can expect a pension linked to their final salary. Only 20% of private-sector workers benefit from such a promise. Companies have almost entirely stopped offering such benefits, because they have proved too expensive. In the public sector, however, the full cost of final-salary pensions has been disguised by iffy accounting.
Pension accounting is complicated. What is the cost today of a promise to pay a benefit in 2020 or 2030? The states have been allowed to discount that future liability at an annual rate of 7.5%-8% on the assumption that they can earn such returns on their investment portfolios. The higher the discount rate, the lower the liability appears to be and the less the states have to contribute upfront.
Even when this dubious approach is used, the Centre for Retirement Research (CRR) at Boston College reckons that states’ pensions are 27% underfunded. That adds up to a shortfall of $1 trillion. What is more, they are paying only about four-fifths of their required annual contribution.
On a more realistic discount rate of 5%, the CRR reckons the shortfall may be $2.7 trillion. A similar calculation by Moody’s, a ratings agency, reckons that schemes are 52% underfunded.
The underlying economics of pension funds have deteriorated over the past 40 years. Americans are living longer. A 65-year-old woman can expect to live three years longer than her counterpart could in 1970; a 65-year-old man, four years longer. As the baby-boom generation (those born between 1946 and 1964) retires, fewer workers must support more pensioners. New York City now has more retired policemen than working ones, and spends more on cops’ pensions than cops’ wages.
Worse still, states and cities have used their pension funds as a way of offering supersized payments to senior managers and favoured workers. More than 20,000 former state or local employees in California have retirement incomes of over $100,000; a few enjoy more than $250,000.
Perhaps the best-known ruse is “spiking”. Public employees inflate their