The following is a summary of our FS Insider podcast with Lawrence McQuillan (see Day of Reckoning for Public Pensions Underway) which can be accessed on our site here or on iTunes here.

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With several states and local governments across the country facing insurmountable public pension obligations, and a few cities having already declared bankruptcy to cope with the problem, it’s becoming increasingly clear that the current system is unsustainable and will have to change.

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Lawrence McQuillan, a senior fellow at the Independent Institute and author of the book California Dreaming: Lessons on How to Resolve America’s Public Pension Crisis, explains why this is a crisis, how we got to this point, and the reforms that are needed.

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public pension obligations

Is It Safe to Call It a Crisis?

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The short answer is, yes, we’re likely at the beginning of a crisis. From a national perspective, all state and local government pension debt amount to $4.7 trillion, McQuillan stated.

“This is money that should be in the bank today, but isn’t, in order to pay for pension benefits that have already been earned,” he said.

Though contributions have increased in recent years to make up for the shortfall, public pension liabilities are still climbing at a much faster rate and are unlikely to be reversed even under the most rosiest scenarios, notes Bloomberg based on a recent study by Moody's:

The optimistic "best case" of cumulative 25% investment return would reduce net pension liabilities by just 1% through 2019 year-end because of past bad investment returns and weak contributions. Meanwhile, the "base case" scenario of 19% returns would see net pension liabilities rise by 15%.

Because of this problem, politicians around the country are scrambling, said McQuillan.

Some states are worse off than others. Illinois, New York, New Jersey, Ohio, Pennsylvania, Texas are all in poor condition when it comes to unfunded pension liabilities.

However, “the granddaddy of them all is California,” McQuillan said. “We have anywhere up to $750 billion unfunded public pension debt at the state and local government level. … It’s a massive problem here.”

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How Did California Get So Bad?

Though California is home to one of the largest economies on the planet and has many natural resources, public pension obligations are among the highest in the country. This was allowed to occur because of political incompetence and poor signals, McQuillan noted.

“For decades, politicians kept increasing benefits, but they weren’t putting in sufficient amounts of money into the funds to guarantee there would be enough money there in 20, 30, or 40 years,” he said.

This created a perverse incentive structure with politicians using pension benefit increases to buy votes and campaign contributions, but they weren’t held accountable because the costs were deferred.

For example, in 1999—near the height of the tech bubble—the California legislature voted to approve the largest pension increase in the history of the state and not one of the politicians that voted for the increase is still in office now, McQuillan noted.

“There’s no way to hold these people accountable,” he said. “Now that the bill is due, we’re facing this mountain of debt, and now we have this huge crisis that we’re facing.”

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Facts and Figures of Crisis

Ultimately, very generous assumptions on expected investment returns of around 7.5 to 8 percent or more helped enable the crisis.

“The bottom line is that if they use the same pension fund assumptions to calculate the unfunded debt in the private sector that they do in the public sector, the private sector pension fund managers would be in prison because you can’t get away with making the same rosy assumptions in the private sector that you can in the public sector,” McQuillan said. “There are federal laws that prevent that sort of cooking the books.”

The big three public pension funds in California are CalPERS, CalSTRS, and the University of California Retirement Plan.

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These funds work on the assumption that they’re going to generate returns 25 percent higher than Warren Buffet every single year into perpetuity, McQuillan noted. That’s an insanely optimistic rate, but it allows politicians to lowball contributions and use that money for other politically expedient ends.

In proof of the seriousness of the current situation, McQuillan pointed to recent changes to reporting requirements made by the Governmental County Standard Board, which is the oversight entity for state and local government accounting in the United States. These changes mean state and local governments must report on their balance sheet net liabilities of public pension plans.

“Going forward we’re going to have a lot more transparency, but we’re also going to have a lot of sticker shock,” McQuillan said. “I think there’s going to be not only outrage but … a lot more urgency for passing meaningful pension reform.”

Reforms Needed Now

The reality is, it’s likely to take a crisis to get the public to notice and force change.

The problem is so bad in some places that money is being siphoned from police, fire, schools, roads, and other funds to bridge the gap.

In California, at the local government level, pension costs have increased four times the level of tax revenue.

“Pension costs are exploding, and that money has to come from somewhere,” McQuillan said. “Essentially, a very small group of people is devouring a very large, ever-growing percentage of the budget in California.”

There is a ray of hope though because the public appears to be ahead of politicians on this issue, by some measures. For example, a recent survey in California found that 85 percent of likely voters see pension costs as either a problem or a big problem.

“People are seeing what this really means long-term, and I think they’re ready for significant reform,” McQuillan said.

He recommends seven specific actions governments can take to reign in public pension obligations.

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The most important, he stated, is switching all public employees over to a 401(k) system.

“A transition to a 401(k) plan at the state and local level in California and across the country … would yield savings that we can use to pay off the debt that we’ve accumulated,” McQuillan said. “It’s much more financially transparent, it’s sustainable, and there’s never an unfunded liability.”

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