A Better Solution For Municipalities On The Brink Of Bankruptcy – Pacific Research Institute

A Better Solution For Municipalities On The Brink Of Bankruptcy

Unfunded government pensions are driving municipalities across the country into bankruptcy – from Detroit, Michigan (the largest municipal bankruptcy ever) to Vallejo, California.

Despite the need for states and municipalities to have contributed large annual payments to their pension funds over many years, as a group they failed to do so. When coupled with overly optimistic return assumptions (also designed to reduce annual contribution requirements), it is no surprise that most pension plans are not actuarially solvent.

With the can now kicked, municipalities face unaffordable annual retirement contributions, taking away funds for current services and forcing municipalities like Detroit into bankruptcy. Taxpayers are trapped and public employees are cheated as an ever greater portion of taxes must be funneled into pension programs, or wages and benefits are frozen or cut, and even then, the chances of ever re-stabilizing are slim. Reforms are necessary.

For proof of this, look no further than Detroit, where current workers and retirees, facing massive cuts to promised benefits, had no alternative other than approving a freeze to its current pension plan and replacing it with a hybrid plan where workers bear more of the investment risks.

While Detroit’s hybrid approach recognizes the problem, it still ties government workers to a government run pension system that binds taxpayers to cover any investment shortfalls. And, it is not clear that Detroit’s proposed pension reforms are sufficient to sustainably address the city’s structural pension problems. Consequently, we believe Detroit’s municipal employees (and all municipal employees) deserve a choice.

Under choice 1, workers and current retirees would continue risking their future pension on the wisdom of municipal leaders and hoping that the public pension systems will somehow return to solvency. Under Choice 2, workers and current retirees could cash out.

Under the cash out option, workers and retirees 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.

To enable Choice 2, each worker would be empowered to enter his/her own data into a simple calculator and receive a cash-out figure based upon their specific length of service, employee class, and salary history. Facing this option, some workers would choose to opt out, others would choose to stay.

For every employee or retiree who opted out of the government’s pension system, the unfunded liability and therefore the cities’ annual retirement contribution obligation would be proportionally reduced. The worker could place these funds into low cost Exchange Traded Funds based upon broad market indices, and rules could be established to restrict early withdrawal or investment in high risk assets. Current employees who opted out would be concurrently enrolled in an ongoing defined contribution plan with costs to the worker and city known and comparable to non-public sector employees.

While not a scientific poll, the San Diego County Taxpayers Association has made anecdotal inquiries to a number of public employees. A surprising number expressed a preference for the relative security of funds in their name vs. the uncertainty of the bankruptcy court. In fact, private conversations with some union leaders suggest that such an option may be palatable because of the long term return to stability and predictability for municipal finances and therefore future public employee union member new- hires it would enable.

The San Diego County Taxpayers Association also convinced the authors of San Diego’s Comprehensive Pension Reform initiative (passed by the citizens of the city in June 2012) to include language specifically authorizing such a conversion.

Unfortunately, the freedom to choose conversion – and the opportunity to reduce the need for municipalities across the country to declare bankruptcy is now held hostage by the IRS. The IRS refuses to declare this type of retirement plan conversion to be a tax-free event. Due to this uncertainty, no municipality we are aware of is moving forward with a conversion plan.

With Detroit’s options quite limited, it is time for the IRS to get off their dime and explicitly rule that a conversion from one retirement program to another should not be considered a gain.

Let’s move past rhetoric and talk real numbers and real solutions. Let’s put the power of choice into the hands of public employees and at the same time create a viable solution for municipalities that avoids the costly and uncertain route of bankruptcy.

Nothing contained in this blog is to be construed as necessarily reflecting the views of the Pacific Research Institute or as an attempt to thwart or aid the passage of any legislation.

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