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States Need to Make Public Disclosures of Their Unfunded Pension Liabilities

CNBC Guest Blog

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Washington, Jul 15, 2011 | Jonathan S. Henes | comments
For far too long, states and municipalities spent above their means, creating massive structural budget deficits.

To pay for programs and other services, states and municipalities relied on the municipal bond market and, more importantly, the federal government. For instance, in 2010, local governments received more than $650 billion in federal funds. In 2011, federal funds to states has dropped precipitously and, based on the fiscal position of the federal government, an increase in federal funds to states should not be expected. In addition to borrowing and receiving federal funds, states “borrowed” from their public pension plans. Through this “borrowing”, which was effectuated by failing to make pension plan contributions, states and municipalities created today’s massively underfunded pension plans.

The unfunded pension plans put states’ fiscal health at risk over the long term and need to be addressed immediately. If the issues are not addressed appropriately, the pension payments relied on by retired police officers and fire fighters will not be made. The broken promises will have real world and potentially devastating effects.

The recent fiscal crisis has exposed the states’ and municipalities’ severe structural budget issues and, in particular, the significant unfunded pension and other retirement liabilities that have stealthily accrued off their balance sheets over the past several decades. It is important that states and municipalities come clean about their fiscal issues, especially the size of their unfunded pension obligations, so the public is aware of the issues and the governments can restructure these programs. Congressman Devin Nunes of California has proposed the Public Employee Pension Transparency Act (“PEPTA”). The proposed legislation, currently pending before the House, would require states to publicly disclose their pension liabilities under uniform guidelines with non-compliant states losing their ability to issue federally tax-exempt bonds. PEPTA is important legislation as it will unveil the true fiscal situation of states and, in doing so, highlight the need for states to act now to start addressing their unfunded debt problem.

What do we know?
Promises by states and municipalities to pay pension benefits have been made to 27 million public employees and retirees. These employees and retirees are our police officers, fire fighters and teachers. These promises were and are relied upon by them but states and municipalities did not fully fund them - not even close. Needing to fund spending initiatives, states and municipalities held off funding pension plans to fund other programs, leaving the funding for another day. Unfortunately, that day is here, but the funds are not. Estimates of the amount of unfunded pension obligations range between $1 trillion to more than $3 trillion. To cover the unfunded liabilities, economists estimate that each American household would need to contribute $1,398 per year for the next 30 years. In Rhode Island, the City of Central Falls will run out of pension funds this Fall and of the remaining 36 pension funds in Rhode Island, 23 are at risk. An additional ten states will run out of pension funds by 2020 (Rhode Island may run out of funds by 2023) and that is under the optimistic assumption that assets in the relevant funds grow at 8 percent per year.

Why is this important?
It is clear that the states and municipalities face an “unfunded” debt problem. States and municipalities need to get this unfunded debt problem under control. Part of the problem is that public pensions are defined benefit programs, meaning the states have promised retirees and public employees that upon retirement they will received a defined payment. This is supposed to mean there is no risk to the retiree. But the risks of non-payment are real and, as certain municipalities like Grand Falls, Rhode Island are demonstrating, the risks to retirees are growing each day. Corporations have already recognized the issues with defined benefit programs and have steadily shifted over to defined contribution plans (where employees invest a defined percentage of salary each month into a retirement fund, such as a 401k plan). Indeed, since 1980, the number of private sector defined benefit plans has fallen from 148,096 to 48,892. This is because defined contribution plans do not create unfunded obligations. In contrast, defined benefit plans - especially when states and municipalities skip making contributions - can create massive unfunded liabilities, which put retirees, as well as states and municipalities, at risk.

Why is the PEPTA important?
Disclosure is important. In the corporate setting, public companies are required to make financial disclosures on a quarterly basis to allow shareholders to understand the fiscal health of companies. In the bankruptcy setting, a corporate debtor is required to make disclosures to creditors so that they can make an informed decision on a proposed plan of reorganization. States and municipalities, however, do not make public disclosures on a regular basis and, when they do, it is not always complete or easy to understand. PEPTA addresses this clear deficiency in transparency by requiring states to disclose information about their unfunded pension obligations under uniform standards and at appropriate estimated rates of returns. This will provide the proper motivation to states to make honest disclosures about the true state of their pension obligations and, by extension, their fiscal health. This is important for three main reasons. First, states will finally acknowledge the true extent of the holes they have created. Second, by acknowledging this, states will almost be forced to address the real economic issues and clean up their fiscal houses. Third, the public will more fully understand the magnitude of the states' problems and, hopefully, will understand the need of states to reform their pension systems.

The Time is Now
PEPTA should become law. While PEPTA may need to be followed by other legislation to give states a greater array of tools to use in their negotiations with public unions on meaningful public pension reform, it is an important and necessary first step to forcing states to face their long-term problems and begin to work them out.

Jon Henes is a partner in the restructuring group at Kirkland & Ellis LLP where he has led some of the most complex restructurings in the United States and abroad across a variety of industries, including media, chemicals, energy, manufacturing, real estate, retail and telecommunications. Jon has also frequently appeared on CNBC's "Worldwide Exchange" as a guest expert on various financial and economic topics, federal, state and local fiscal issues.
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