Ivan Osorio

In my previous post, I described the “California rule,” which puts state governments in a legal straitjacket when trying to reform underfunded public pensions. Specifically, it places pensions in a privileged position relative to other types of compensation, like salary or health insurance benefits, by making them more difficult to change. This post highlights a real-world example of the California rule’s dangers.

The place is Pacific Grove, California, a town of 15,000 residents on the Monterey Peninsula’s northern tip, with an annual budget of $11 to $12 million. In 2008, John Moore, a Pacific Grove resident and retired attorney, learned that the City of Pacific Grove had issued $19 million of pension bonds two years earlier, while at the same time it gave the police union a 30% raise.

After making several requests under California’s Public Records Act, Moore uncovered a tale of self-dealing by Pacific Grove and union officials to rip off California taxpayers. The result of Moore’s investigation, “The Fall of Pacific Grove,” was published in The Pine Cone, a Monterey County paper; it’s now available online thanks to the California Public Policy Center.

In 2002, the Pacific Grove city council adopted a 50 percent pension increase for public safety workers, after being told by the city manager that the increased benefit would cost around $51,500 per year. However, the city manager withheld from the council an actuary report that estimated the benefit at over $800, 000 per year. The hidden actuary report was not discovered until 2009. The results have been predictable and dire. Pacific Grove’s pension deficit has ballooned to $45 million, plus $20 million in pension bonds, and is growing at 7.5 percent a year, according to Moore.

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These days, local governments announcing bankruptcy seems like routine in California. Since the onset of the 2008 financial crisis, many state and local governments have seen their pension funds take huge losses. Yet, many of the underlying problems that have made pension shortfalls difficult to address go back many years — more than half a century, in fact.

One major reason public pensions have been so difficult to reform is their having a special legal status above other kinds of employee compensation. A new Federalist Society paper by Emory University law professor (and CEI alumnus) Alexander Volokh explains how this strange situation came to be and offers some ideas for reform.

One of the most important developments in public pension policy occurred in 1955. That’s when the California Supreme Court created what became known as the “California rule” regarding the legal status of public pensions. The case, Allen v. City of Long Beach, concerned a challenge to a 1951 city charter amendment that increased the employee pension contribution and changed the formula for determining payouts.

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broken-piggy-bankIn my previous post, I looked at some basic principles that should guide state policy makers when tackling pension reform. Now, we turn to the politics. And in that regard, Rhode Island’s 2011 pension reform offers a useful example for other states to consider.

In his Brookings study, “Pension Politics: Public Employee Retirement System Reform in Four States,” Drew University political science professor Patrick McGuinn looks at recent reform efforts in four states’ experience in implementing pension reform.

Two of these states—Utah and Rhode Island—enacted significant structural changes to their pension systems while the two others—New Jersey and Illinois—enacted more limited changes that were less innovative.

Drawing lessons from those four states, he then outlines some basic principles for how to implement reform, citing examples.

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Few people would raise their hands when asked that question. But actually putting a state’s financing on sound footing is difficult in practice. That makes Rhode ‘s Island’s pension reform not only unique, but also a good example for other states to consider.  Rhode Island got not only the policy, but also the politics right, according to Drew University political science professor Patrick McGuinn in a new Brookings Institution study.

In other words, how pension reform is accomplished is as important as what the reforms entail. In his study, McGuinn offers some sound principles on the politics — the “how” — of pension reform. Another new study, commissioned by the Society of Actuaries (SOA), offers some basic principles on the policy — the “what”.

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Thus describes an Illinois state Senator the challenge states face in reforming their public employee pension systems. Given that reality, it’s astounding reform would ever succeed. But succeed it has, in states with very large pension shortfalls that threaten to blow up their budgets.

Staring into the financial abyss, it seems, can help politicians overcome their strong temptation to offer generous benefits to their supporters — government employee unions in the case of pensions — and passing off the bill to future generations. Yet, government unions will defend their benefits even in states in extreme financial distress, as the recent Rhode Island pension settlement shows.

On February 14, Rhode Island officials reached an agreement to end six legal challenges to the state’s 2011 pension reform, the most far-reaching in the nation to date. The agreement scales back some of the savings in the 2011 reform bill, but  preserves most of them. Governor Lincoln Chafee and State Treasurer Gina Raimondo invested considerable effort and political capital in crafting and enacting the 2011 pension reform. So why did they agree to scale back any of it?

Because they had to. The state was forced into negotiating by a judge, ruling on a union legal challenge to the pension reform legislation. As Drew University political science professor Patrick McGuinn describes the decision in a new Brookings Institution study, “Pension Politics: Public Employee Retirement System Reform in Four States” (which points to Rhode Island’s reform as a model):

In December 2012, a Superior Court judge ordered the unions and the governor/treasurer’s office into mediation to resolve the dispute—an extremely unusual (and perhaps even unconstitutional) move.

In effect, the judge ordered the Chafee administration to negotiate with the unions to amend a law that had already been passed by the legislature and signed by the governor.

While legally dubious, the February 2014 agreement may be the least bad option in terms of achieving sound policy — which in the case of Rhode Island means preventing a budget meltdown. If a judge is willing to order the state government to renegotiate a law already on the books, who knows what might come next in court?

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Post image for Loss of Economic Freedom Takes a Toll on Small Businesses

The 2014 edition of the Heritage Foundation/Wall Street Journal Index of Economic Freedom is set for release next week, and for America, the news isn’t good.

This year, the United States continued to lose ground to its competitors in the global race to advance economic freedom and prosperity. The U.S. score has declined almost 6 points since 2007, placing the U.S. among those countries considered to be only “mostly free.”

Sounds bad, but what does it really mean? Don’t many new regulations affect mostly large businesses, such as the giant firms bailed out in the wake of the financial crisis? Not necessarily.

In fact, burdensome rules affect businesses all sizes. A stark example of how petty regulators can get is the case of Rhea Lana Riner, an Arkansas small business owner who organizes consignment sales and was recently warned by the U.S. Department of Labor that she may not get help from volunteers. The Washington Examiner‘s Sean Higgins reports:

Rhea Lana, Inc., hosts what are essentially big semiannual yard sales. People who donate clothing or other items get 70 percent of the profits from the sales of their items as well as first crack at the other merchandise.

The donors also often volunteer at the events, doing things like hanging clothes or working the cash register. This helps to ensure that their items get sold. That’s also what got Riner in trouble with the feds.

Forbidding private parties from entering into a mutually beneficial voluntary business arrangement is about as bad a violation of the freedom to contract as you can get.

But sadly, it’s not that surprising, considering the escalating array of labor regulations all employers face. And, as CEI’s Wayne Crews notes in his annual 10,000 Commandments report (page 34), it begins at the very first rung.

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Post image for With Declining Membership, Wisconsin Teachers Unions Consider Merger

The the corporate world, mergers are generally considered a sign of confidence, as companies seek to expand their operations. Within organized labor, by contrast, they’re often a sign of weakness. The latter is certainly the case with two Wisconsin teachers unions currently considering a merger.

The two unions — the Wisconsin Education Association Council (WEAC), affiliated with the National Education Association (NEA), and AFT-Wisconsin, affiliated with the American Federation of Teachers — have experienced steep declines in membership since the enactment of Act 10, the 2011 budget repair bill that brought union militants out in droves to Madison, the state capital, in opposition. The Milwaukee Journal Sentinel reports:

After Act 10, WEAC has lost about a third of its approximately 98,000 members and AFT-Wisconsin is down to about 6,500 members from its peak of approximately 16,000, leaders of both organizations have reported.

This episode illustrates three important points.

One is the extent to which unions rely on compulsory labor market policies to boost their membership numbers.

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Across the nation, state and local governments in dire financial straits face great difficulty in their efforts to bring their budgets under control. Pensions are one of the biggest drivers of deficits, and therein lies the problem. Many states treat pensions not as a form of compensation, but as a contractual obligation to the employee. As a result, states and cities that have tried to bring pension obligations under control have seen roadblock thrown up in court by government employee unions. As the Manhattan Institute’s Steven Malanga explains:

In the private sector, pensions are governed by the federal Employee Retirement Income Security Act. Although a private employer may not cut benefits that a worker has already earned, ERISA allows a business to change the rate at which a worker accrues future benefits.

ERISA, however, doesn’t apply to government employee pensions. Instead, in the states, local laws and court decisions govern how public-worker retirement systems are treated, and in many cases the states depart, sometimes radically, from the standard set by the law.

In many states, that means that pension promises are treated as sacrosanct.

Many legal protections given to public-sector pensions arise from court decisions that treat laws governing public retirement systems as a contract between the state and a worker. That puts pensions under the jurisdiction of the contract clause of the U.S. Constitution, or under state contract law.

In California, a state teetering on the fiscal precipice due in large part to pension liabilities, San Jose Mayor Chuck Reed is leading an effort to amend the Golden State’s constitution to give governments there greater flexibility to make changes to employee retirement benefits. Reed faces a tough fight — Malanga describes his effort as “an uphill campaign” — but he already deserves plaudits for bringing needed attention to this issue.

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The largest longshoremen’s union in the West Coast has decided to leave the AFL-CIO. While this may be an internecine organized labor fight, it illustrates a major problem with U.S. labor law.

In an August 29 letter to AFL-CIO President Richard Trumka, International Longshore and Warehouse Union (ILWU) President Robert McEllrath outlined his reasons for leaving the federation. Areas of contention included health care legislation, immigration reform, and — most importantly — recent conflicts with other AFL-CIO-affiliated unions.

In health care, McEllrath and his union objected to the AFL-CIO’s uncritical support of the Affordable Care Act (Obamacare) — which the ILWU leadership apparently believed did not go far enough in increasing federal involvement in health care — and for “lobb[ying] affiliates to support a bill that taxed our health care plans.”

On immigration, McEllrath criticizes Trumka and the federation for not doing more to promote a path to citizenship for low-skilled immigrants (a fair criticism, in my view, but one that doesn’t consider whether that many immigrants actually want to become citizens, rather than work in the U.S. for a few years, save money, and return to their home countries).

Yet, it McEllrath’s criticism of the role of the AFL-CIO and other unions during some recent disputes with employers that highlights an egregious feature of U.S. labor law that isn’t found in any other area of economic regulation: Unions’ privileged position to act in a cartel-like fashion.

In his letter, McEllrath accuses some other AFL-CIO-affiliated unions of crossing picket lines and of trying “to take over ILWU jobs,” including at one facility “where longshoremen have done this work for generations.” In short, the ILWU’s leadership is upset that non-ILWU workers are trying to take over the work of ILWU workers who walk off the job.

Another word for what McEllrath finds so objectionable is competition. Yet, the cartel-like environment which the ILWU is trying to defend is made possible by unions’ ability to act as monopoly bargaining agents for a given set of workers, under the National Labor Relations Act (NLRA).

Some might cite this as an argument for ending unions’ antitrust exemption, but that would simply pile one bad set of laws on top of another. A better solution would be to repeal the NLRA provisions granting unions monopoly bargaining authority over all workers in a given workplace, including those who do not want union representation.

One of the challenges in addressing the underfunding of public pensions is determining how big the funding gaps are. Estimates vary because of disagreement over accounting methods. State pension actuaries calculate pension plans’ future funding using discount rates based on high rates of expected returns on investments. State officials have an incentive to engage in this kind of fudging because higher expected returns tomorrow mean lower contributions into the pension funds today.

This has resulted in states low-balling their future pension obligations. Now a new State Budget Solutions (SBS) report goes some way toward clarifying the picture. The report, by SBS’ Cory Eucalitto, estimates the nation’s state-level defined benefit pension plans to be underfunded by $4.1 trillion, with a funding ratio of only 39 percent — well below the 73 percent shown through official reporting.

The SBS report arrived at this estimate by focusing not on expected investment returns, but on the fixed nature of the liability itself:

Current public sector practices involve discounting a liability according to the assumed investment returns of plan assets, typically around 8 percent. Yet with discount rates tied to expected investment performance, plan sponsors can easily take on greater risk in order to make liabilities appear smaller. This reduces the resources required today to pay for the promises of tomorrow.

Accurately accounting for a pension system’s liability requires incorporating the nearly certain nature of benefits. That is, once promised, the chances that benefits will not have to be paid are extremely low.

A fair-market valuation does away with optimistic investment return assumptions and instead uses a rate that reflects the risk of the liability itself. One common approach, taken here, is to discount liabilities according to the yield of a 15-year Treasury bond.

The SBS report calculates plan liabilities using a discount rate based on a Treasury bond yield as of August 21, 2013 – 3.225 percent.

Thus, it is not enough for state pension reforms to cut a couple of percentage points off their discount rates; they need to slash expected rates of return by half or more.

But even then, reforms to how pension liabilities are calculated may not stick, as politicians will always have an incentive to divert funds away from future retirees to the present-day constituencies that lend them support, such as public sector  unions. A more lasting solution would be to move away from defined benefit pensions toward defined contribution plans, such as 401(k) accounts.