by Arnold Bock with Lorimer Wilson

Public sector employees, the workforce 'elite' led by state and municipal workers, are now storming legislative chambers to preserve their special status. Wisconsin is the current case study in what happens when the government, a monopoly service provider, confronts the fact that the taxpayer is tapped out and can't take it anymore - when there simply isn't enough money. Those realities are going to result in major adjustments in worker incomes, future pensionsand benefits and their overall standard of living. Let me explain.

Why State and Municipal Governments are in Financial Trouble

As odd as it may seem, state and local governments, are in even worse financial shape than the federal government with its parabolic deficits and accumulated debt. The reasons are that:

a) States and municipalities don't have the franchise to create money through entering digits on a computer screen or running the printing press. 'Quantitative Easing' is the exclusive prerogative of the federal government. States and municipalities must, by law, balance their operating budgets although capital expenditures can be financed through the sale of bonds, assuming buyers can be found to accept the interest rates offered and the inherent risks of owning such securities.

The crisis in state and municipal debt is real with insolvency and financial collapse near for many. According to Northwestern University's Kellogg School of Management, pension underfunding of municipalities currently totals $574 Billion. States are much worse off in terms of their underfunded employee pensions to the tune of $3.3 Trillion.

b) States and municipalities are suffering from unrestrained spending on salaries and wages, health care benefits and pensions of their employees. The single largest component of budgets is the salaries and benefits of the employees. As a case in point, it costs the City of Milwaukee 74.2 cents extra for every single dollar of wages it pays its public school teachers and other employees as compared to the additional 24.3 cents that similar private sector employees receive... a whopping 205.3% more! With income disparity like that is it any wonder that the 'workforce elites' in America today are public sector employees?

Precious few coddled private sector workers remain who share the special status enjoyed by public sector workers. General Motors and Chrysler are recent examples of what happens to private sector workers whose total compensation package becomes bloated beyond reason. Predictably, they ultimately faced the realities and judgement of a marketplace where competitors with better products, services, price and choice prevail. While the federal government bailed out both the companies and their UAW employees, the magnitude of state and municipal debt is much more overwhelming.

Not all municipalities and states are the same and they are certainly different from their private sector counterparts. One obvious difference, for example, is that 36.8 percent of all government employees in the U.S. are unionized, while only 6.9 percent of private sector workers carry union credentials.

How Public Sector Salaries and Benefits Got So Over-the-Top

Government employees can credit their special status on:

• their monopoly position as service providers,
• their union muscle,
• the fact that their employer also had the deep pocketed taxpayer in its corner until now,
• the current electoral process, and
• the manner in which "fair and equitable" contract settlements have been negotiated.

Public sector unions have increasingly developed alliances with candidates and political parties. Vast quantities of campaign cash, as well as paid and volunteer help from public sector workers, have cemented mutually productive relationships with many of their elected employers. President Obama's election and recent intervention in the Wisconsin conflict pretty much explains which party has been the primary beneficiary this electoral grease. Hence the quid pro quo when wages and benefits are on the negotiating table.

Because of the multiplicity of state and municipal jurisdictions, all performing similar functions, it is only normal for salary and benefits to be compared. Pattern-setting settlements of salaries and benefits achieved by strong unions, among compliant employers, are regularly cited as the benchmark for 'fair and equitable' settlements in many other jurisdictions. Frequently, the pattern-setting leaders are those states and municipalities with histories of strong unions and 'established partnerships' with their elected decision makers.

Often a much more subtle set of circumstances prevail. Designated executives and managers excluded from the bargaining unit are usually in charge of 'negotiations' with representatives of the broader workforce. Since it would not be considered fair for the salary and benefit increases of the non-union and executive employees to be less, in percentage terms, than those awarded workers more junior in the pecking order, there is a built-in bias to higher wage and benefit settlements for the broader group of employees. Hard-nosed confrontational bargaining definitely isn't the norm. Yes, there is plenty of public posturing, but out of sight, the relationship is much more collegial - for mutual benefit.

Passively allowing union negotiators to 'win' at the bargaining table provides an automatic 'push' for the subsequent executive and management compensation package. Even more effective is designing and/or exploiting a process by which labour tribunals are used and 'acceptable' arbitrators are appointed to award favourable judgements to the employees. When decisions run counter to reason, common sense and are beyond the financial capacity of the state or municipality, politicians and executives in charge of the process throw their hands up in feigned dismay and frustration claiming that there was nothing that could be done to alter the outcome. The consequence is a 'sweetheart deal' to the benefit of everyone - except the taxpayer.

Why Many Public Sector Pension Plans are Under-funded

As the workforce ages, pensions and health care benefits have come to the fore, especially seriously underfunded and unfunded liabilities of pension plans. In the past, excessively favourable pension provisions and underfunding were seldom discussed. They were considered to be problems for the distant future to be dealt with on someone else's watch. But the future is now. No longer can decision makers extend and pretend. Delaying and praying won't help either. What is real is that many, maybe a majority, of public sector pensions are underfunded. Why?

a) Unwarranted Assumptions: The actuaries hired by fund managers and politicians made unwarranted and exceptionally optimistic assumptions about rates of inflation, investment returns, interest rates, salary levels and other relevant facts, which provided the answers the law demanded and the persons signing the consulting contract wanted to hear. This process is reminiscent of the prevailing practice of bond evaluators who placed AAA investment grade ratings on rancid Wall Street financial derivatives. The pension plans in the states of New Jersey and Illinois, among others, were regular beneficiaries of these deceptions.

b) Back-end Loading of Incomes: Another example of unprincipled self-dealing on the public sector pension front is the practice of 'spiking' one's income during the last year, or years, of employment. The intent is to build the base upon which the retirement pension is calculated. Obtaining generous overtime assignments and receiving payment for accumulated, but unused, sick pay has a similar and most salutary effect on the pension. Since many employees leave with a full pension after thirty years of employment and a minimum of fifty years of age, they can be expected to draw their pension for thirty years after which their spouse can draw approximately half of the pension for their remaining years.

c) Inflation Adjustments: There is another significant perk which most non-government employees, and those without defined benefit pensions, are unfamiliar. It is called 'inflation adjustment' or COLA (Cost Of Living Adjustment). It means that the public sector defined benefit pension is adjusted upwards each year to reflect increases in the Consumer Price Index. Aside from protection against price inflation, this provision allows much psychic certainty for the duration of the retirement period leading to considerable peace of mind for the lucky public sector pensioner.

d) Subsidized Contributions: Many, but definitely not all, government employee defined benefit pension provisions come almost free of charge - to the employee. During the years of employment many employee plans do not require the employee to pay for any or only part of their benefits, although others do. Many defined benefit pension plans use a matching formula where the employer and the employee make equal contributions.

e) Free Health Insurance Premiums: These are frequently treated in a similar manner as pensions whereby the employer pays the entire cost, or the contributions are matched equally between both employer and employee. After retiring, the benefits continue but without further contributions by the retiree. The period between a retirement age in the low 50's and the retiree's eligibility for Medicare at age 65 represents a very expensive period for the public sector employer.

What Under-funded Pensions Mean for the Future

Where does this discussion lead? What are the conclusions? What does it mean to state and local governments? What effect does it have on the taxpaying public?

Certain states and municipalities have demonstrated responsible long term financial planning, especially as it relates to funding pensions and benefits for their employees. They have funded their future obligations based on honest formulas and assumptions. The employee was an equal partner in contributing to the costs. Pension and benefit provisions - and enhancements - were not implemented without appreciating the essential role of the taxpayer in the period ahead. However, such prudent planning and management was not carried out across the board by many municipalities and states. As mentioned above, a massive financial brick wall of underfunded pensions lies directly ahead to the tune of $574 billion and $3.3 trillion respectively.

The fact of the matter is that the current weak economy, coupled with high unemployment, an annual federal deficit of $1.6 Trillion (three times what it was as recently as two years ago) and a balance sheet debt in excess of $14 Trillion, means that there is no federal money to bail out states and municipalities. In addition, unfunded federal obligations for Social Security and Medicare are somewhere north of $50 and up to $100 Trillion. The country is insolvent...as in broke! The economy can't grow enough and the government can't tax enough to make the deficit and debt crises disappear - or even become manageable.

Conclusion

The 'tough love' we are beginning to see in New Jersey, New York, Wisconsin and other states and municipalities is merely the tip of the proverbial iceberg. Externally imposed constraint by bondholders and especially the taxpaying and voting public will become the norm. Public sector workers everywhere will need to accept the reality of:

• lower incomes,
• lower pensions,
• lower benefits and
• lower living standards.

These new realities are coming our way in the near future. They cannot be circumvented. Public demonstrations by the aggrieved public sector elite will not alter the abovementioned financial and economic facts. Rather, they portray the end of gold-plated defined benefit pension plans which have no regard for the taxpayers who foot the bill. It is either that or a major revolution instigated by taxpayers.