What happens when public pension funds go bust, as so many state and local ones are on pace to do? For those who think the unthinkable cannot occur, an Alabama small town’s horror story is a wakeup call.
Prichard, a city of 27,000 outside of Mobile, stopped making payments to retirees when its pension fund ran out of money in 2009. A recent New York Times story spotlighted the trauma left behind: One retiree filed for bankruptcy, another had to rely on the aid of friends after he could no longer work, and in the most tragic case, the former fire marshal was found dead in abject poverty.
The social upheaval in Prichard is shocking, but the cause behind it was predicted well in advance. The city declared bankruptcy in 1999 and was still going through the process in 2004 when an actuary projected that Prichard’s pension fund would go insolvent in five years.
A bankruptcy court ordered it to start replenishing its pension system, but the cash-strapped city resisted, claiming that doing so would have meant cutting essential services such as police and sanitation. The retirees, all of whom received modest benefits, have sued Prichard and are expected to enter mediation soon.
The choice made in small-town Alabama is a preview of what states and big cities will face if they allow their pension funds to continue on schedule to insolvency: simply run out of money to pay retirees or defund public services in order to come up with it.
As the Times story exhibits, both are disastrous endpoints. Inventing a bankruptcy provision for the states or waiting for effective bankruptcy to arrive, as some have suggested, are not practical or tolerable solutions. Prichard has been through bankruptcy once and is about to at least simulate it again. The experience shows that financial obligations can be discharged but the social consequences cannot. It is far more palatable to resolve the crisis before catastrophe hits.
Various pension reforms have been implemented or proposed in states and large cities across the country, such as increasing employee contributions, raising the retirement age and lowering the cost of living allowance.
Yet these incremental measures do not significantly reduce the approximately $3.5 trillion in unfunded liabilities on the backs of governments. More pointedly, they do not change the fact that insolvency is on the horizon.
Illinois and New Jersey, whose pension systems are scheduled to run dry in 2018, are nearly as close to the breaking point as Prichard was when its actuary delivered the prescient warning in 2004.
Real reform will mean adjusting accrued benefits well in advance of projected insolvency. This is the optimal course of action for the 20 states whose pension systems are less than half funded.
To prevent this crisis from happening again, the pension structure must change from the defined-benefit model to the defined-contribution model, which the federal government and private sector adopted a long time ago because it relieves the employer from mounting future liabilities.
No state or city will fathom shutting down police stations and turning off street lights in order to bail its pension fund out, nor will citizens tolerate massive tax increases to do so.
The public pension system is breaking down, and it is time for comprehensive reform in order to prevent the Prichard scenario from playing out across the country in the near future. As the Times put it, “If nothing changes, the money eventually does run out, and when that happens, misery and turmoil follow.”
Rich Danker is project director for economics at American Principles Project.