Municipal Pensions: The Problem of the Commons

The problem of the commons (also called the tragedy of the commons) refers to a situation where a shared public resource, for example the “office refrigerator,” can be over-used because each individual user of the field maximizes his or her benefit without fully taking into account the impact on the shared resource to other users. If one user makes a mess or brings pungent food, he or she does not necessarily feel the full impact on other users. Examples of such negative externalities are ubiquitous. For example, driving to work contributes to traffic congestion, over-fishing and other over-uses of environmental resources depletes the environment for other users.

In public finance, there are analogous shared resources problems. In the case of pensions, the resources are shared across time instead of contemporaneously. In the office refrigerator example, instead of many co-workers having to absorb the impact of one person’s pungent lunch, the mess left behind from the pungent food one day is absorbed the next day by future users. Municipal pensions across the United States today are similarly absorbing the underfunding that resulted from decisions often made decades earlier. Pensions represent pooled savings built up over time, and the resource that is shared is the responsibility to sufficiently contribute so that in the future the pension is fully funded. Effective stewardship of a municipal pension depends on meeting this shared responsibility for decades. For example, if decades ago a pension steward assumed a less conservative rate of return on invested contributions, he or she benefited from paying less into the pension fund, but this would have increased risks to future pension stewards from the higher risk to the pension investments.

Today in the United States many municipal governments are contending with this issue. Private sector employers contend with analogous risks by insuring their pensions through the Pension Benefit Guarantee Corporation (PBGC). The PBGC provides pension security to workers if the company they work for declares bankruptcy (though after 1 July 2009, PBGC changed its level of coverage). However, PBGC does not normally guarantee Federal, State or Local employer pensions. Hence, when a municipality enters financial distress, they are put in the difficult position of needing to defund pensions due to the consequences of decades of fiscal mismanagement by prior administrations. The current administration may not have created the municipal crisis, but it is nevertheless responsible of navigating the restructuring while protecting and defending its citizens.

Adding to this problem is that municipal governments must consider the needs of their residents, not just because this is a fundamental responsibility, but the success of the municipality depends on it. Municipalities in distress are vulnerable to a problem that is less often seen in sovereign restructurings and crises: the risk that residents will choose to leave. While there are legal barriers to national emigration, residents can more freely choose to leave a territory or municipality within their country that is not economically viable. There are numerous cases where residents have relocated due to a deterioration during and associated with municipal default (e.g. Detroit). A declining population only exacerbates the municipal government’s problem.

Unfortunately, many municipal pension systems do face financial difficulties due to prior years’ shortfalls in government employers’ pension contributions. There are no easy solutions to underfunded systems. And the reality of underfunded municipal pensions in the United States is acute: numerous municipal governments appear to have persistently understated their pension liabilities and overestimated returns in prior decades using ambitious actuarial assumptions, and the shortfalls accrued to present day pension stewards. There are few appealing options for addressing a pension shortfall. Jurisdictions facing crises have been forced to cut public pensions, for example Detroit.

Whatever mechanisms or entities allegedly exist in the United States to surveil municipal bond markets and municipal pensions, the prima facia evidence of emerging nation-wide pension and municipal finance pressures suggests their work is not on par with the massive efforts that go into surveilling equity and corporate bond markets. Moreover, the reality of pension cuts resulting from municipal financial distress seems to leave municipal workers with the responsibility of carrying out due diligence on their employers’ present and future willingness and ability to appropriately fund their pensions (and possibly avoid bankruptcy altogether). Public opposition to municipal pension benefit reduction is understandable, and reflects the forced reckoning with the fiscal consequences of a pension system suffering from decades of underfunding and more generally the “problem of the commons” of municipal pension funding that continues to be largely ignored by market regulators.

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