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Detroit is only the beginning

Conor Durkin | Sunday, September 8, 2013

Even if you don’t really follow much financial or public policy news, there’s a good chance that you heard about one of the biggest public finance events of the summer: Detroit’s bankruptcy.
Following Detroit’s declaration of financial emergency last March, the city filed for chapter nine bankruptcy on July 18. This became the largest municipal bankruptcy filing in U.S. history, with somewhere around $18 billion in existing debts and liabilities.
As groundbreaking as the Detroit bankruptcy was, it should not have come as a great surprise. Indeed, the writing has been on the wall for quite some time. The city has seen a tremendous population decline since the mid-20th century; at 700,000 current residents, its population is less than half of its 1950 peak of 1.8 million people. As its residents fled and its economy worsened, the city’s tax base collapsed, and without any sort of revenue, the city was unable to provide quality public services, creating a negative feedback loop that only worsened the city’s situation.
While other cities and states across the country may not be experiencing the same level of urban decay that Detroit has undergone, there is one area of public finance where they share much in common, and it’s one that should leave us very troubled about the future of our local governments: pension liabilities.
For quite some time, we’ve heard about the perilous position our federal government is in with respect to the national debt and how federal expenditures on Medicare and Social Security are likely to cause our future debts to skyrocket in the coming decades. What we haven’t heard, however, is about the future debts that states and cities have been taking on.
One of the best kept secrets in public finance is how bad state and local pension underfunding really is. Over the years, politicians have often responded to demands from public sector unions for higher pay by agreeing to increase their pension payments. It’s a clever way for them to boost pay while kicking the can down the road, since these pensions won’t be paid out until many years later. In the meantime, all they need to do is allocate a much smaller amount of money into their pension plan investment funds and use the magic of compounded interest to make that money grow into the amounts they need.
There’s just one catch: They haven’t put away nearly enough money.
Instead, they’ve either neglected to allocate funds or used accounting tricks such as assuming high rates of return and smoothing out losses to make the funds seem in better shape than they otherwise are.
According to the Pew Center on the States, as of 2012, state pension plans across the country were short around $757 billion compared to what they need to be holding in order to pay out future retirees, and are short another $627 billion in the funds for retiree healthcare benefits that they’ve promised. Moreover, as large as these numbers are, many scholars make the case that even these numbers understate the scope of the problem by assuming that the funds will earn a higher rate of return than one should actually predict. According to economists Robert Novy-Marx and Joshua Rauh, across the country, states are actually short a whopping $2.5 trillion dollars, and the American Enterprise Institute’s Andrew Biggs estimates the problem to be $4.6 trillion dollars, with the average pension plan a mere 41 percent funded.
Some states are worse than others. Illinois, for instance, has a pension shortfall of over $150 billion in pension and other retiree-related debts (for comparison’s sake, the state brought in just over $30 billion in tax revenue in 2012), leaving the state’s five retiree funds 57 percent unfunded. Moreover, research from the Illinois Policy Institute suggests that using a more reasonable rate of return, the problem becomes much larger, with over $200 billion in pension-related debts. These sorts of problems exist at the local level as well. According to Kevin Orr, Detroit’s emergency manager, the city’s pension funds are underfunded by $3.5 billion, making up almost one-fifth of their total existing debt, and in Chicago the unfunded pension liability was reported as $19 billion at the end of 2012.
It might sound far-fetched to imagine a state like Illinois going bankrupt, but a hole that size won’t go away on its own. If politicians continue to refuse to take action on pension reform, bankruptcy could be a real possibility.
We need to understand what’s at stake if that happens. In Detroit, retired workers like teachers and policemen are being forced to fight in court for the benefits that they have counted on to get them through retirement. They deserve better. The pension underfunding problem is one that can be solved, as some places like the cities of San Diego or San Jose, or the state of Rhode Island have shown, and it is one that must be solved. Otherwise, governments in cities and states across the nation could soon be facing a future similar to that in Detroit.

Conor Durkin is a senior studying economics and political science. He can be contacted at [email protected]
The views expressed in this column are those of the author and not necessarily those of The Observer.