Why We Need Pension Reform

A day after Governor Scott Walker won his recall election, the New York Times wrote, “The biggest political lesson from Wisconsin may be that the overwhelming dominance of money on the Republican side will continue to haunt Democrats.” Democrats have drawn much the same conclusion. “You’ve got a handful of self-interested billionaires who are trying to leverage their money across the country,” said David Axelrod, Barack Obama’s senior campaign strategist. “Does that concern me? Of course that concerns me.”

But then how to explain the landslide victories in San Jose and San Diego of ballot measures meant to cut public-sector retirees’ benefits? What should concern Axelrod far more is that on the central issue of the recall–the costs of public-sector employees–the Democratic Party is wrong on the substance, clinging to its constituents rather than doing the right thing.

Warren Buffett calls the costs of public-sector retirees a “time bomb.” They are the single biggest threat to the U.S.’s fiscal health. If the U.S. is going to face a Greek-style crisis, it will not be at the federal level but rather with state and local governments. The numbers are staggering. In California, total pension liabilities–the money the state is legally required to pay its public-sector retirees–are 30 times its annual budget deficit. Annual pension costs rose by 2,000% from 1999 to 2009. In Illinois, they are already 15% of general revenue and growing. Ohio’s pension liabilities are now 35% of the state’s entire GDP.

The accounting at the heart of government pension plans is fraudulent, so much so that it should be illegal. Here’s how it works. For a plan to be deemed solvent, employees and the government must finance it with regular monthly contributions. The size of those contributions is determined by assumptions about the investment returns of the plan. The better the investment returns, the less the state has to put in. So states everywhere made magical assumptions about investment returns. David Crane, an economic adviser to former California governor Arnold Schwarzenegger, points out that state pension funds have assumed that the stock market will grow 40% faster in the 21st century than it did in the 20th century. In other words, while the market has grown 175 times during the past 100 years, state governments are assuming that it will grow 1,750 times its size over the next hundred years.

Why has this happened? It’s democracy at its worst. Public-sector unions, powerful forces in states and localities, ask for regular pay increases. Governors and mayors can dole out only so much in salary hikes because of requirements for balanced budgets or other constraints. So instead, they hand out generous increases to pension benefits, since those costs will hit the budget many years later, when current officials are themselves comfortably in retirement.

The net effect of these retirement benefits is to starve state and local governments of funds for anything else. Last year, California spent $32 billion on employee pay and benefits, which is up 65% over the past 10 years. In that same period, spending on higher education is down 5%. Three-quarters of San Jose’s discretionary spending goes to its public-safety workers alone–police and firefighters. The city has closed libraries, cut back on park services, laid off many civil servants and asked the rest to take pay cuts. By 2014, San Jose, the 10th largest city in the U.S., will be serviced by 1,600 public workers, one-third the number it had 25 years ago.

The system as it is evolving is highly regressive. Current workers will have their salaries cut, their numbers thinned and their benefits slashed, all to maintain relatively comfortable benefits for retirees, who are on average richer than the people who are being asked to make these sacrifices. Current residents will watch their services dwindle, so that retirees–again, who are richer on average than they are–can have guaranteed generous cost-of-living increases year after year.

Public-sector unions are strong supporters of the Democratic Party, so their clout has drowned out the voices of the poor, the young, students and average citizens. That is why real credit for courage should go to those few Democrats who are taking on these issues, even at the cost of losing support from one of their key constituencies. That includes mayors like Rahm Emanuel and Chuck Reed as well as governors like Andrew Cuomo and Pat Quinn. Sadly, they are too few and too isolated. Democrats should take note: the ideals of liberalism are now being sacrificed for the interest groups of liberals.

TO READ MORE BY FAREED ZAKARIA, GO TO time.com/zakaria