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Five Public Pension Mistakes that Increase Municipal Bankruptcy Risk

Cities and counties across the country are running headlong into the inevitable fact that previously promised pension and retiree health care benefits are insufficiently funded. The Pew Center on the States estimates that the gap between cumulative benefit levels and the funds set aside to pay for them is more than $1 trillion and growing.

Cities like Stockton, Calif., Detroit, Mich., and Central Falls, R.I., among others, are taking extreme measures to cope with inadequate funding levels.

While every municipality is different, the path to public pension trouble revolves around some combination of generous benefits and inadequate funding. Here are five mistakes frequently made by public pension sponsors.

1. Promise Excessive Pension Benefits

The city of Bell, Calif., provides an extreme example of excessive salaries and pensions. The Bell city manager at one time earned a salary of $784,637 with an annual pension package of between $650,000 and $880,000. The California Public Employees Retirement System (CalPERS) later reduced this to $50,000, and has since initiated a systematic review of public pensions and high salaries.

2. Avoid Employee Pension Contributions

As the cost of pensions and health care benefits increases, most plan sponsors are now requiring participants to pay a portion of their benefit costs through payroll deductions. The state of Wisconsin underwent a very public debate on this topic in 2011, and employee deductions were ultimately increased. Stockton, Calif., which is now moving toward bankruptcy, took a different approach by first requiring an employee contribution but then agreeing to pay the worker portion as well as the employer obligation.

3. Inflate Final Pay

“Spiking” is the term used to describe extreme salary increases in the final years prior to an employee’s retirement. The result is a greatly increased pension base. Take the case of a San Francisco-area school superintendent, who was awarded a $61,000 raise in his final year of employment. He then qualified for a $154,600 annual pension, which is more than he was paid in salary most years. This was later cut to $114,600, however, after a review by the California Teacher Fund.

4. Ignore Unfunded Liabilities

Kicking the can down the road is a favorite political expression when it comes to the avoidance of paying for popular entitlement and benefit programs. This is certainly the case with both pensions and retiree health care benefits. State pension plans are only 78% funded, according to the Pew Center on the States. Retiree health care, which is accounted for on a “pay as you go” basis rather than funded in advance, is in dire straits with only a 5% funded level for expected future obligations.

5. Make Risky Bets

Sponsors of under-funded municipal pension plans sometimes see high risk investments as their best chance of accelerating asset growth. Stockton, Calif. is one example. The city borrowed $125 million in 2007 to invest in CalPERS, hoping for big returns. Instead, stock market losses cut the city’s loan principal by 24%-30%. The bet clearly backfired, and now Stockton must pay loan interest costs on top of the underlying pension obligations.

New York state has taken a different approach to dealing with its unfunded public pension liabilities, by allowing plan sponsors to borrow from the state’s $140 billion pension fund as a means of financing their annual contributions. Borrowing this year is estimated to reach $200 million, up from $45 million in 2011.

In Summary

In the current economic environment, new legal precedent is continuing to be set as state and local governments grapple with the debt amassed from their under-funded pension and retiree health care liabilities.

Rhode Island, which is only 59% funded on its $11 billion pension liability, is one state that is leading the way with meaningful pension reform. See for details.

Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.

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