In the midst of the nation’s financial meltdown, the bandwagon was overloaded with soothsayers vying for the spotlight in their apocalyptic vision of state and local government finances. The collective wisdom predicted that a massive number of muni issuers would sink under a crushing load of financial woes led by a cascading burden of pension obligations.
Though it garnered a lot of attention at the time, that narrative today may be undergoing a re-write.
Last month, in a 2:1 landslide, voters in two California cities backed unprecedented proposals to cut retirement benefits for current and future municipal employees.
Measure B in San Jose requires existing employees either to increase their contributions from 8% to 16% of pensionable pay and retain existing benefits, or to accept a modified plan with lower annual service credits, higher retirement ages and reduced inflation protection. New employees will be offered a less generous hybrid defined benefit/defined contribution plan, and future changes to retirement benefits will be subject to voter approval.
In San Diego, Proposition B freezes base pension pay at 2011 levels for six years and offers new employees only a defined contribution plan similar to a 401(k).
That the measures in both cities were overwhelmingly approved by voters of all political stripes was not terribly surprising.
Change was inevitable
Many public pension plans are so underfunded that investment gains alone cannot make up the shortfall, especially while investment returns remain anemic by historical standards. If municipalities do not curb future benefits, pension expense and catch-up contributions will absorb an ever-increasing proportion of municipal budgets.
For example, San Jose saw pension costs soar from $107 million in 2009-2010 to $245 million in 2011-2012; the city projects a further rise to $319 million in 2014-2015, about 24% of the city’s anticipated general fund revenues. The numbers in San Diego are almost as bad: pension costs absorbed 20% of the 2011-2012 general fund budget.
Something has to give, and in troubled economic times, when voters are reluctant to approve tax increases, municipalities must either cut services or benefits – or both. San Jose had already trimmed services in recent years, axing 22% of police officers, 13% of firemen, 26% of librarians and 35% of parks and recreation staff. Firehouses were closed, and four new library buildings never opened because of a lack of funding to operate them.
Shift in thinking
Now that the future has arrived, the electoral calculus has changed. The recent votes in California—along with the recall vote in Wisconsin that failed to replace Gov. Scott Walker, a strong proponent of taking retirement benefits off the collective bargaining table—served notice that change is afoot.
Assuming the measures survive legal attacks—unions opposed to the ballot measures have taken their fight to court—it is an encouraging development for municipal bondholders.
Municipalities that act now will see pension expenses grow for a few more years—like supertankers, pension liabilities don’t turn on a dime—but then taper off before the cost threatens their solvency. Investors will reward issuers that take control of future pension costs with a lower yield for their bonds, while issuers who do nothing, or kick the can down the road, will pay a penalty.