Solving the $2 Trillion Problem

The Laura and John Arnold Foundation mixes research and politics to help solve today's public-pension crisis

The Laura and John Arnold Foundation isn’t actually placing personal ads. But it is seeking compatriots willing to engage on one of today’s most pressing public problems. The policy-oriented foundation, seeded with $890 million from the fortune John Arnold earned trading natural gas, is helping a range of cities and states face the reality of their pension promises. Preferably before things end in tears, as is now happening in Detroit.

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“The public-pension challenge is the single gravest economic threat to our country today,” says LJAF president Denis Calabrese.

That’s a strong claim, but some scary numbers give it substance. A joint venture between the Arnold Foundation and the Pew Center on the States has been quantifying the problem across the U.S. They’ve found that the shortfall in funds promised to state employees now totals $757 billion, with another $627 billion gap for promised retiree health benefits. And that’s just the states. According to Pew, 61 of the most populous American cities collectively owe more than $217 billion to current and future retirees for their pensions and health care, suggesting a total public-employee debt nationwide approaching $2 trillion.

“It is a tremendous problem now and it has the potential to become an enormous problem—an absolutely gigantic problem—going forward,” warns Laura Arnold, who left her job as a corporate executive in 2008 to focus on work at the foundation.

LJAF vice president Josh McGee compares underfunded public-sector pensions to an oil spill. Communities need to make serious efforts to clean up the oil that’s been spilled—the money already owed to workers. And they must also stop the leak—the unrealistic promises and faulty systems that created today’s overhang of future debt. That’s the only way to protect workers and taxpayers from future blowups. “If you don’t fix both problems,” McGee said, “you’re just asking for it to happen again.”

Rhode Island gets the message

When the small city of Central Falls, Rhode Island, went broke in 2010, it was facing calamity. It couldn’t pay firefighters, repair roads, buy schoolbooks, or maintain parks. The meltdown awoke not only locals but also residents and politicians across the state to the danger they were in. In Rhode Island, ten cents of every public dollar—on the way to 20 cents in the future—was being sucked up simply to pay for the retirement of public workers. With that much taxpayer money going to old obligations, it became hard to address current needs.

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Dan Liljenquist, Chuck Reed, and Gina Raimondo (Drake Busath, City of San Jose, Office of Gina M. Raimondo)

Rhode Island’s crisis birthed a pension reform trailblazer. State treasurer Gina Raimondo, a Democrat and newcomer to elective office, took the initiative. Her June 2011 report, “Truth in Numbers,” outlined the dire straits of Rhode Island’s public-pension system, and sketched a path toward security. Her message: “It’s not politics. It’s math.”

Raimondo traipsed across the state with graphs and pie charts. She pointed out libraries, bus lines, and homeless shelters that had been closed as unfunded pensions had begun to gobble ever larger portions of the general budget. She emphasized that the pensions themselves would not be secure if the system collapsed in bankruptcy, as in Central Falls.

The Arnolds were impressed by Raimondo. “She certainly has tremendous charisma and is incredibly bright, and we thought that she had a great deal of promise,” says Laura. “And all of that has proven to be true.”

As Raimondo’s initiative gained momentum, the Arnolds sensed an opportunity to help establish a positive precedent that could later be followed by other American cities and states. Outside their foundation, they donated more than $100,000 to support EngageRI, a 501(c)(4) that advocated for repair of the state’s pensions. “Many would have thought this was a third-rail type issue,” says EngageRI spokesman Jon Duffy. But Raimondo “depoliticized it and made it an ‘everybody’ issue.” Motivated by concern that “truly draconian” cuts would have to be made to other parts of the state budget if there was no reform, more than 100 groups joined the coalition, Duffy notes. “The social services agencies were taking it on the chin.”

“Rhode Island came together,” says Raimondo. In the end, the state legislature took 29 hours of public testimony, and legislators were convinced that “the increasing cost to taxpayers would have dramatically impacted the state’s ability to invest in education, transportation, housing, and many other critical issues involving the well-being of all Rhode Islanders,” according to Rhode Island House Speaker Gordon Fox.

In November 2011, the Rhode Island Retirement Security Act passed the House 57-15 and the Senate 35-2. Raimondo describes it as “the culmination of a long process of study and discussion that engaged all stakeholders.” The law made a raft of adjustments to the system, creating a “hybrid” plan that moves toward guaranteeing pension contributions more than guaranteeing benefits. It also raised the retirement age to match Social Security, suspended cost-of-living increases until the fund is solvent, strengthened accounting standards, and required that the state fulfill its annual contributions from now on. Fox is confident that these measures “will stabilize the state’s pension fund to preserve its solvency for future generations.”

The fight isn’t over yet. Having been beaten in the legislature, public-employee unions filed suit. They “challenged the law on constitutional grounds, essentially saying that the changes for current employees and retirees were a violation of the state contracts clause,” explains LJAF’s McGee. State courts have yet to rule on that.

Meanwhile, the Arnold Foundation and Pew offered research and other help to Rhode Island municipalities with underfunded plans, to help them meet requirements set out in the 2011 reform law, and to guide cities and towns that run their own pensions toward necessary reforms.

As for Raimondo, whose friends and colleagues had all warned her to stay away from public pensions, “her stature as leader was enhanced by pension reform. It wasn’t diminished,” says LJAF’s Calabrese. “That’s good for other leaders to see—that to take this on isn’t dangerous. It’s actually productive.”

Changing politics

Along with Raimondo, Calabrese points to San Jose, California, mayor Chuck Reed (who oversaw a similar pension reform in his fiscally strained city) and Chicago mayor Rahm Emanuel (who is publicly acknowledging the dangers to his city) as good examples of the changing politics of pension reform. “These are all prominent Democrats. Obviously something has changed in the political dialogue around this issue, and that’s very much for the good.”

Public alarm is driving the growing realism. Ballot initiatives to rein in public pensions recently passed with 66 percent support in San Diego and 69 percent in San Jose. Citizens in more and more communities are showing they understand the danger of the issue. “This isn’t now just an insider’s problem,” he says. “The public is willing to step up.” Hard numbers, detailed solutions, and non-partisan problem-solving, though, have been scarce.

Public-employee unions and some activists are resisting pension reform by portraying it as a plot to exploit public workers for “profit.” That antagonism gets directed at anyone involved. One group of opponents called the Arnold Foundation’s pension-research partnership with Pew an “unholy alliance.”

“That’s not really what the debate is about,” says Calabrese. “As we see in Detroit and other cities, the taxpayer may lose all the way down by trying to keep paying in to make up for the shortfall. But when it all collapses, it’s actually the working people who lose the most. And even before that, it starts to compress budgets, so people don’t get raises, replacements are not hired. It hurts all the people in the system.”

“The burden is falling entirely on defenseless people,” agrees David Crane, a California Democrat and political consultant who is an outspoken advocate of pension reform. Once a city goes into bankruptcy proceedings, as Stockton, California, did in 2012, everything is up for grabs. “In one single day, they got rid of retiree health care for employees who had done nothing wrong.”

“Detroit is a high-profile example of a collapse where pensioners are being asked to take 10 cents on the dollar,” says Calabrese. “That’s shocking. People will say, ‘Well, that’s the extreme case,’ but that’s the natural conclusion of not addressing a problem.” He adds that “the taxpayers pay it all the way down and feel pain to the end. And then the pensioners lose their money also. It’s the worst of both possible worlds.”

Ways to nudge public policy

In an effort to head off these lose-lose scenarios, the Arnold Foundation has spent about $11 million on pension reform since 2011. In addition to the work done by its internal research staff, the foundation seeds studies and policy ideas at an array of think tanks and educational organizations across the country. The Arnolds, separate from their foundation, have made parallel donations to advocacy groups that build public campaigns and provide political cover to politicians willing to make a vote for fiscal rectitude.

The foundation also provides assistance to localities assessing their pension shortfalls and identifying possible solutions. In all, the foundation has been involved in more than 25 jurisdictions. Many original, detailed calculations and policy analyses go into each of these interventions. “Each solution is really tailored to the municipality or state, because each locality has a different set of issues and a different set of commitments,” says Laura Arnold.

McGee, an economics Ph.D., heads the foundation’s work on this issue. An expert in pension lore, he has produced a growing library of resources on the causes of the crisis, as well as proposals to address it. “Politicians often don’t understand the riskiness of their plans,” says McGee.

Take the expected rate of return. Public-pension systems are often built on the assumption that their invested funds will earn annual returns of 8 percent or higher. If they miss that target year after year—and actual returns for many funds throughout the last decade have been under 3 percent—then gaping financial shortfalls will open up in the accounts.

One problem is that when the investments have a good year, politicians often redirect the surpluses for popular causes. Then when below-average years come along, the entire system falls behind. Politicians love to “shave off the top of the good markets” with benefit giveaways and pension holidays—breaks from making contributions—notes McGee.

“We have a structural problem,” he says. “The structure of the system allows politicians to promise one level of benefits and not pay for it.”

The system, says Laura Arnold, incentivizes politicians to please employees today and “kick the can down the road for payments tomorrow, when those politicians would not be in office.” Whether you blame insufficient contributions, gold-plated benefits, the financial crisis, or some other reason, what matters is that “you’ve got this gap between what you have and what you owe. You can have lots of conversations about the reason. Regardless, the shortfall is still there.”

One of McGee’s solution papers, “Creating a New Public Pension System,” notes that a favorite style of public pension is the “defined-benefit” model, in which civil servants are promised a specific level of retirement payments until death—no matter what investment returns are like, no matter how much elected officials have set aside to pay them. “My argument is this is just a bad system for what we want to accomplish, and that we can provide the protections for workers that we want in a simpler, better system,” he summarizes.

The alternative form used by most private-sector employers is the “defined-contribution” plan. Employers pay a promised amount every year into an account controlled by the employee. Often the employee makes supplementary payments of his own. This is similar to the 401(k)-type plans that are ubiquitous at corporations, nonprofits, many universities, and increasingly some states. For many of the most egregiously underfunded public pension systems, the proposed solutions involve some form of migration from defined-benefit toward defined-contribution plans. Rhode Island now provides a small defined-benefit plan as the baseline, with defined-contribution accounts for each individual worker on top.

Bolstering good ideas with bold action

Careful, customized research on problems and solutions is just the starting point. “In order to have lasting impact and achieve the change in policy that is needed, you have to turn innovative ideas into law at some point,” says Laura Arnold. “That’s where our (c)(4) comes in.”

The Action Now Initiative, the Arnolds’ 501(c)(4) organization, has spent more than $1 million on pension reform efforts. Like every other (c)(4), one of the main things that makes it different from the 501(c)(3) foundation is that it can engage in direct advocacy. ANI has, for instance, contributed to campaigns in support of pension-reform ballot initiatives in a number of states as well as San Jose and San Diego—generally with six-figure investments. “All of this work is local,” Laura Arnold emphasizes, noting that every jurisdiction has its own advocacy needs.

“Generations from us forward will be dealing with this problem if it’s not addressed now,” says Alison Ferguson, the executive director of the Action Now Initiative. “One of the motivations is to make sure that it’s a sustainable pension program, that when a person does retire, there’s something there, and the promise is kept.”

Former Utah state senator Dan Liljenquist, who led his state’s successful 2010 pension reform, is a consultant for the Action Now Initiative. Like most public pension funds, Utah’s relied on investment growth to defray the cost of paying for benefits. The financial crisis intervened. As the freshman senator dug into the accounts, he found that market losses had reduced Utah’s funding level so severely that the state would have to spend 10 percent of its general budget for the next 25 years just to make up the shortfall.

This is in Utah, he notes, a scrupulously well-managed state that avoided the bad practice of skimping on its annual contributions to pension funds that so many other states have been guilty of. “We always pay our bills,” says Liljenquist, but even Utah’s good behavior didn’t spare it from the crash. Tallying up the damage nationwide, he concluded, “we’re in a full-on tragedy as a country.”

As he grappled with alternate ways of covering his state’s pension hole—a 16 percent budget cut across the board, a gaping $500 million shortfall, leaving 8,000 teaching positions unfilled—he came to the conclusion that Utah urgently needed fundamental pension reform. What he didn’t calculate was the animosity he would stir up by facing the problem.

One weekend, out with his kids in the family van, he turned a corner into a crowd of 4,500 protesters chanting his name. He received thousands of outraged missives from public employees. He told them he respected their work, and explained that his priorities were to ensure that the state would be able to meet its obligations to them, while also protecting taxpayers, and setting up a sounder system for new public hires that would provide them with a secure retirement in the future.

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A Republican, Liljenquist encourages philanthropists and others hoping to encourage pension reform to keep in mind that public workers generally “did not cause this problem.” He and the experts from the Arnold Foundation have stressed that civil servants have just taken advantage of what politicians offered them. “It is not productive to blame them for it. My recommendation is to keep it a reality issue.” In the end, Liljenquist led Utah to a plan that gives public workers a choice—between a generous defined-contribution plan in which the state contributes 10 percent of pay, or a traditional defined-benefit pension with a capped employer contribution.

Although pension debt is one of the biggest economic issues we face as a nation, says Liljenquist, “it’s also the most solvable of our issues.” To help precipitate solutions in as many states and cities as possible, the Arnolds’ Action Now Initiative has joined forces with Liljenquist to send him around the country. He travels to advise pension-repair efforts underway in Pennsylvania, Oklahoma, and other places, talking to legislators about their options. However useful the intellectual ammunition supplied by the Arnold Foundation may be, legislators are especially comforted by Liljenquist, says ANI’s Ferguson. “Let me talk to the guy who did it,” she recalls them saying. “He’s walked through the fire and passed pension reform in Utah.”

A foundation-led compromise in Kentucky

In 2012, the Arnold-Pew pension team played perhaps its most active role in catalyzing a major pension reform. Legislators in Kentucky knew they had a big problem. But while the Republican-controlled Senate wanted to go all the way to 401(k)-type plans, the Democratic House wanted to stay with traditional pensions. As a compromise, legislators created a bipartisan task force. The group received extensive advice and support from the Arnold-Pew team of experts, who advised adopting a hybrid “cash balance” approach.

State Senate majority floor leader Damon Thayer, who co-chaired the task force, credits the foundations for breaking the stalemate. “I would give them the highest recommendation,” he says. “I’m not sure we would have been successful without them.”

Bryan Sunderland of the Kentucky Chamber of Commerce says the Arnold-Pew experts were able to “help provide an unbiased, nonpolitical approach.” The Chamber got involved because the pension system “was drawing needed resources away. We were seeing less money invested in colleges and universities,” and schools had to delay purchasing text books.

As elsewhere, the (c)(3) research and education assistance from the Arnold Foundation was undergirded with (c)(4) investment in political advocacy from the Action Now Initiative. ANI, for instance, paid for a media campaign run by the Chamber of Commerce and the Kentucky League of Cities, which cost more than $100,000.

Kentucky’s reform bill passed in its House 70-28 and in the Senate by 32-6. It was signed into law in April 2013. Its three main components are an agreement that retirees get increases only when there is money to pay for them, an increase in contributions to the fund amounting to about $100 million a year, and a new hybrid cash-balance system for all future enrollees. Employees now have a much more certain future. And “taxpayers will save $10 billion over the next 20 years,” according to Thayer.

Stand and deliver

This string of successes has not been achieved without some bruising. Implementation of the reforms in Rhode Island, San Jose, and some other places remains bogged down by lawsuits. And John and Laura Arnold have endured some personal excoriation from representatives of public-employee unions. They answered critics in an August 2013 op-ed after Detroit declared bankruptcy.

“Local elected officials have knowingly and irresponsibly made unsustainable promises of large future benefits, often in order to avoid wage increases that would impact short-term budgets. They have done so with full knowledge that not they, but future elected officials and taxpayers, would be held accountable for delivering on these promises. Meanwhile, unions shortsightedly exert enormous pressure on politicians to make these deals,” the couple wrote.

By the time pension funds run out, “the politicians who promised the undeliverable, and the union leaders who encouraged those promises, will be long gone. Our public employees deserve more than false promises. They deserve to be part of a system that is fiscally sound, responsibly managed, and that ensures that their retirement benefits will be paid when due.”

With the help of the Arnold Foundation and its sister advocacy organization, more than two dozen states and cities have taken measures to put themselves on a more secure path. “It is a joy to be able to actually fix a problem,” says Calabrese. “We don’t get to do that often enough in the foundation world.” With pension reform, “we are permanently solving real systemic challenges in society.”

“The hope is that we’ll create sufficient momentum where this will become the norm,” adds Laura Arnold. “People will now ask, ‘Why is it that our town has this pension shortfall? Why is it that we’re not addressing it?’ Human nature is such that you often don’t act until it’s an emergency, a fire drill. The challenge for us is to inspire people to act before the situation is on the brink of disaster.”  

Zachary Janowski is an investigative reporter for the Yankee Institute for Public Policy.