Public Employee Benefits: The Numbers Behind the Debate

Setting aside the politically sensitive aspects of the ongoing national debate over public workers' benefits, we can learn a lot from a fundamental economic analysis of one city's pension and health care costs.

Before we get to that specific analysis, more broadly, growth in the overall economy as measured by GDP is the basis for higher incomes and higher taxes. If GDP is flat, then household incomes are also flat. If the government increases taxes by more than the growth rate of the GDP, it's virtually certain to crimp household disposable income.

Below is a graph of U.S GDP growth since 2000. Adjusted for inflation, the U.S. economy grew smartly between 2001 and 2007 -- 35% -- and then went flat. In constant dollars, U.S. GDP in 2010 was almost precisely the same as it was in 2007: $13.363 trillion in 2007 and $13.382 trillion in 2010.

But household income hasn't even been treading water -- it has declined. According to the Census Bureau, real median household income in 2009 was $49,777, a 5% decline from its 1999 peak of $52,388 (adjusted for inflation).

To keep the U.S. economy afloat, the federal government has borrowed and spent extraordinary sums of money. As I recently reported on DailyFinance, federal spending has leaped by about $1 trillion since 2007. The national deficits of the past three years and the estimated shortfalls for fiscal years 2011 and 2012 exceed $6 trillion.

2008: $458 billion
$1.4 trillion
2010: $1.3 trillion
2011: $1.5 trillion (CBO est.)
2012: $1.6 trillion (est.)

But without this infusion of federal spending, U.S. GDP would have declined, as indicated by the red line on the chart.

Clearly, the macroeconomic backdrop hasn't been conducive to higher wages or increased tax revenues.

States and Local Government Face Structural Shortfalls

Combine a flat economy and declining household incomes with state and local government costs that keep rising, and the result is a structural disconnect between revenues and expenses. The nonpartisan Little Hoover Commission closely examined the finances and governance of public pensions in California, and it recently issued a 100-page report on this long-term structural disconnect between expected pension revenues and state revenues, and pension expenses.

So, let's take a closer look at Berkeley, Calif., home of the University of California at Berkeley, as a typical representative of other "town-gown" college cities in the U.S. (For context: Berkeley's population is about 102,000, while Madison, Wis., has about 235,000 residents.)

While these numbers may be higher than your local city, county and state figures, they track national trends in public pension and health care costs.

In Berkeley, pensions for retired city workers will cost about $32.7 million in fiscal year 2013 and rise to $41 million by 2016. Those figures are up from about $2 million in 2000.

Clearly, pension costs are rising significantly faster than GDP. Even if we assume the $2 million pension costs in 2000 were significantly under what should have been contributed and push that starting point up to $10 million (the light-blue line), the trend doesn't really change: Pension costs are still rising steeply while GDP is either flat (including unprecedented federal borrowing and spending) or declining (if we factor out the massive federal spending).

Public employee health care costs have been rising an average of 11% per year in the decade since 2000.

Here's what happens to $1 in health care spending when costs increase 11% per year:

$1 (2001)
2.08 (2008)
$3.15 (2012)
$4.78 (2016)

At this rate of growth, costs triple by 2012 and almost quintuple by 2016, which illustrates the fundamental problem: Revenues are flat due to a slow economy, while costs are rising at a rate far exceeding that of the general economy.

Willie Brown, a staunch union supporter and former California legislative leader and San Francisco mayor, recently wrote in the San Francisco Chronicle:

People constantly ask how we wound up in this mess. The answer is, we are all to blame. There was no way we [political leaders] should have agreed to guaranteed fixed-amount pensions and health care packages without takebacks that would have triggered if the economy went bad. And the public also needs to shoulder some of the blame for voting repeatedly to expand retirement benefits, especially health benefits for government workers and their families, which are turning out to be an even more expensive problem than pensions.

The other backdrop to today's benefit crisis relates to the relative performances of the stock market during two key periods. In the later half of the 1990s, the markets outperformed, and many pension and benefit plans modified their contribution regimens based on projected annual stock market growth rates of 8% -- forever. But the market has underperformed since the 2000 peak, and after a decade of those weak returns, it's no surprise that pension funds are facing shortfalls.

Adjusted for inflation, stock returns since 2000 have been negative, even counting dividends. The S&P 500 index has declined from over 1,500 in 2000 to around 1,300 in 2011 -- a 13% decline that must be added to a reduction in purchasing power (inflation) of another 28%. Not counting dividends of around 2% a year, that's a decline of 41%. Just to stay even with inflation, the S&P 500 would have to be above 1,900 now.

A 2% annual dividend yield compounded since 2000 turns $100 into $124.34. So buy-and-hold pension funds have experienced a 24% gain based on dividends since 2000, but a 41% loss in equity value, resulting in a net 17% loss. A 2% (inflation-adjusted) growth rate in the real economy compounds to a 24% increase over 11 years -- but that 11% annual increase in employee health care costs discussed earlier compounds into a 315% increase.

And there, where those two macroeconomic forces collide, lies the heart of the debate over public workers' benefits: Not in "greedy" unions or "heartless" union-busters, but in the stock market's underperformance (plus some absurdly optimistic planning assumptions) and the rapid growth of health care costs.

If we as a nation can't trim the growth rate of health care costs to match the growth rate of the economy, we'll face a structural financial problem that won't go away.