Cities Face a Deepening Fiscal Crisis

The steep fiscal crisis that many states face includes staggering retirement costs for their workers, estimated at some $3 trillion in unfunded future promises. The size of those liabilities has already shaken up some municipal bond investors, and the inadequate, sometimes misleading way that states account for these steep costs has attracted the attention of the Securities and Exchange Commission.

But lurking beneath those obligations is another huge set of liabilities from municipal governments, that is, from cities and counties whose politicians have also made astonishing promises to workers that they will have trouble keeping. Unlike states, which can't declare bankruptcy, a few municipalities have already sought the protection of the courts to try and solve long-term budget problems. More may be heading that way. Bondholders and taxpayers beware.

A recent study of the 77 largest municipal pension systems by finance professors Joshua Rauh of Northwestern University's Kellogg School and Robert Novy-Marx of the University of Rochester estimates that total unfunded liabilities of America's municipal pension systems is well north of half a trillion dollars. On a per capita basis, the professors estimated that each household in the 50 largest cities and counties they studied owes an average of $14,165 for future retiree liabilities. This, of course, is in addition to the other debt these places owe, most especially their municipal debt. New York City taxpayers, for instance, owe about $65 billion of municipal debt on top of what Rauh and Novy-Marx estimate is $122 billion in unfunded pension obligations.

It will surprise few people to discover that these local pension liabilities are especially high in places where state obligations are already stratospheric. Clearly there is a culture in some places that supports handing out big pension promises for political gain, with little prospect that these obligations would be adequately funded by either state or local government. Of course, that means the taxpayers of these cities will have a double pension burden to pay off in coming years.

The city with the highest per household unfunded liability in the nation is Chicago, $41,966 per household, or $45 billion in total obligations. Illinois, meanwhile, is the state with among the most troubled pension systems, with about $285 billion in unfunded liabilities. "Even if all other spending was shut down, the city of Chicago would need to allocate about eight years of dedicated tax revenues to cover pension promises it has already made," the study by Rauh and Novy-Marx estimates. Meanwhile, Illinois' pension obligations amount to seven times annual state tax collections.

California is in particularly bad shape. San Francisco and Los Angeles are among the places with the greatest liabilities among cities, amounting to $34,940 and $18,643 per household, respectively. Their combined pension debt of $33 billion is in addition to some $600 billion in Golden State unfunded liabilities. Also on the watch list from California are a host of other cities and counties, including Contra Costa County, Santa Barbara County and the city of San Jose. Los Angeles County, which runs many municipal functions in addition to those of the city of Los Angeles, has its own woes with a staggering $27 billion in unfunded liabilities.

These obligations have grown so large that I think taxpayers' eyes now glaze over with these numbers. And muni investors in some places seem to think these are bills that somehow will never come due. How else to explain the relatively small risk premium that muni investors still demand of the bonds of a place like New Jersey, which the SEC cited earlier this year for concealing from investors the true nature of its pension woes?

But these obligations are bearing down rapidly on municipalities and states. The Rauh/Novy-Marx study estimates the ‘solvency horizon' of municipal systems, that is, the number of years that current assets could pay for future promises. Philadelphia has enough assets to cover just five years of payments, Boston and Chicago just eight years, New York City just 11 years.

Pension crises have already driven a noteworthy municipality into insolvency. Vallejo, California, a city of some 117,000 people, declared bankruptcy in May of 2008 after the cost of public worker salaries and pensions grew to 80 percent of the city's municipal budget, effectively squeezing out other spending. The court allowed the city to reduce its long-term employee obligations significantly, but the city has engaged in a protracted legal fight against its principal bondholder, defaulting on notes in 2009 and attempting to gain several years of freedom from interest payments through the bankruptcy court.

Even without bankruptcy, the pension burden will weigh down municipal finance and cost taxpayers dearly. The cost of funding retirement benefits for New York City employees, for instance, has increased from $1.5 billion in 2000 to some $7 billion today, out of a city-funded budget of $44 billion. It's similar in other places. The city of Orange, Ca., spends $13 million out of a budget of $88 million on pensions. In Los Angeles, pension costs are expected to double to $2.2 billion in five years. At that point, they will consume a third of the city's budget.

What will make dealing with these obligations so difficult is that municipalities don't have nearly the fiscal tools to rely on that states or the federal government can employ. Most cities depend heavily on just a few taxes for revenues, and many rely on aid from their state capitals. But with states under many of the same pressures, state aid is shrinking. So municipalities have turned to property taxes to buoy their budgets. In 2009, for instance, property tax collections increased three percent in the U.S. even while other tax revenues slumped. Homeowners are likely to be asked to pay a big chunk of future pension liabilities in many municipalities.

Taxpayers have figured out that a huge bill is coming and in places where they have direct access to the ballot, they've voted for reform. In California, voters in places like Bakersfield, Menlo Park and San Jose all passed initiatives on Nov. 2 designed to restrain pension costs. But a high profile reform initiative in San Francisco failed.

"What is clear is that state and local governments in the U.S. have massive public pension liabilities on their hands, and that we are not far from the point where these will impact the ability of state and local governments to operate," Rauh and Novy-Marx observe. If the question of how to solve this crisis isn't resolved soon, the authors conclude, "state and local fiscal crises may translate into losses for municipal bondholders." National recovery or not, the next few years may prove a wild ride for taxpayers, and for muni investors.