Chicago's Rahm Emanuel, victorious, now faces $550 million pension shortfall

The fact that Rahm Emanuel faced a runoff is a sign of the concern around how to handle big pension deficits. But old mind-sets about public-employee compensation are giving way to new economic and demographic realities.

Rahm Emanuel won a tough primary runoff on Tuesday, but will soon face another "day of reckoning," as Chicago scrambles to close a $550 million shortfall for police and fire pensions by year's end.

He's not alone. The depth of Chicago’s current crisis is unusual, but the basic challenge is not.

For years, local politicians in the US have been able to grant public-sector workers and labor unions retirement benefits that are generous by private-sector standards. Although there’s debate about whether public-sector workers can be generally called “overpaid,” the problem is this: The benefits haven’t been paid for in a sustainable way.

Now, as an era of baby boomer retirement coincides with the lingering effects of a deep recession, there are signs that old mind-sets about public-employee compensation are giving way to new economic and demographic realities.

Most city and state governments have nothing like the emergency that faces Chicago. But pressures are growing nonetheless in Democratic bastions, like Chicago, as well as less-liberal ones.

• Atlanta has been moving from a defined-benefit style pension to a 401(k)-style model for new hires.
• In Kentucky, reforms in 2013 emphasized steps to ensure against promising new benefits without paying for them.
• In budget-strapped Rhode Island, Democratic Treasurer Gina Raimondo helped to enact something liberals aren’t known for: cuts to public-sector retirement benefits. She went on to win the governorship of the heavily Democratic state last year.
• In California, Gov. Jerry Brown and local politicians have been making similar efforts. In San Jose, soaring pension burdens prompted 2012 reforms by Mayor Chuck Reed, who explained the political equation running through his mind: “If you drain money out of services and pour them into retirements, people suffer.”

This year, it’s Chicago’s turn. Emanuel has already negotiated reforms with the city’s general workers, and now will be bargaining with fire and police employees to reduce future liabilities. (And he’ll have to confront other fiscal troubles in Chicago, beyond worker benefits.)

Los Angeles, Philadelphia, and New York are among the other large cities that also have large pension liabilities that haven’t been adequately funded. The 50 states, meanwhile, had a $915 billion shortfall in their retirement systems as of 2012, according to an analysis by the Pew Charitable Trusts.

In most places, this isn’t an urgent crisis such as Chicago faces. And the politics are tricky, roiling politically powerful unions as cities also scramble to maintain public services and hold taxes down.

“Local government pensions are on average significantly underfunded,” concluded an analysis by researchers Richard Dye and Tracy Gordon for the Brookings Institution in Washington in 2012. “The key reason is that, absent a legal compulsion to do so, many governments have not set aside enough funds each year to cover the extra pension liabilities incurred in that year, much less to amortize unfunded liabilities from earlier years. In effect, they are borrowing to pay for current labor services and shifting the burden to future taxpayers."

In effect, residents of many states and cities will be asked to pay costs (in higher taxes or reduced services) related to the past generation of public employees. Or the costs might be shouldered by current and former public employees, by cutting the benefits. Or a mix of both those approaches.

The question of bailouts could arise, too – either for states to help cities or for federal aid to local governments.

Emanuel would love get help from the Illinois state government.

But Gov. Bruce Rauner is a Republican elected in 2014 on a platform of cleaning up state finances and reviving business activity. He’s promoting pension reforms at the state level, even as Emanuel, a Democrat, seeks funds to cover school-system pensions as well as the police and fire obligations.

By some measures, public-sector employees in the US have generous retirement benefits. The vast majority of them have a defined-benefit pension, as opposed to a 401(k)-style savings plan that doesn’t guarantee any defined level of retirement income. Only one-third of private-sector workers have that. And public employees often have health benefits to bridge the gap between retirement and eligibility for Medicare at age 65.

But although critics snipe at cushy union contracts, it’s a matter of debate whether state and municipal workers are generally overcompensated.

The Center for Retirement Research at Boston College in Chestnut Hill, Mass., for one, has concluded that when you factor wages and benefits together, compensation is pretty similar for public and private-sector workers.

Another analysis, published by the conservative American Enterprise Institute, disagreed, identifying a handful of states (New Jersey, California, Rhode Island, Illinois, New York, Pennsylvania, Connecticut) as offering compensation 20 percent or more above what comparable private-sector workers earn.

In any case, the choices that lie ahead range from tinkering to shifts toward the 401(k) savings model common in the private sector.

The fact that Emanuel failed to win reelection in the first vote, held in February, hints at the political crosscurrents he faces. He’s been labeled “Mayor 1 percent,” with the implication that he’s ignoring the needs of average city residents.

Still, he won Tuesday’s runoff partly because many residents worried that his rival, Democratic challenger from the left Jesus “Chuy” Garcia, didn't have as credible a fiscal vision. 

As Emanuel and other local politicians seek a way forward on the pension front, a twin challenge is to fully fund the programs and also to better estimate how much funding is needed.

The needs are generally calculated based on projected rates of return that the funds will earn from investments. Those assumptions are often too rosy, resulting in so-called “discount rates” that are unrealistic, say critics of the pension-fund math.

“​In almost all cases this discount rate is inappropriately high, and the use of a lower discount could more than double unfunded liabilities,” according to the Brookings Institution analysis.

One worrisome sign that more funding is needed: Some researchers haven’t seen much progress for the health of public pension funds since the recession, despite a strong investment climate.

The Pew analysis found that the funding gap for state plans “continued to grow” between 2010 and 2012. Similarly, unfunded liabilities for pensions in 10 of the nation’ s largest cities grew from 2009 to 2013, despite a strong stock market, Joshua Rauh of Stanford University concluded in a report this year.