The $366 Billion Outrage All across America, state and city workers are retiring early with unthinkably rich pay packages. Guess who's paying for them? You are.
By Janice Revell REPORTER ASSOCIATES Doris Burke, Joan Levinstein, and Patricia Neering

(FORTUNE Magazine) – Let's just call it what it is: gaming the system. And it's a game that has already resulted in skyrocketing tax increases and the loss of public services across the country--from the shutdown of libraries and community centers to the gutting of many local police and fire departments. It is also a game that is played in the nether regions of public finance, in the fine print of lengthy contracts that hardly anybody sees. As with so many other recent scandals--from Dick Grasso's $140 million pay package to CEOs of bankrupt airlines padding their own retirement accounts to big corporations manufacturing "earnings" that don't really exist--this one has to do with the generally ignored realm of pensions. But here the beneficiaries of the shell game may come as a surprise: school superintendents, librarians, sanitation workers, county clerks, and a host of other public servants. By now you can probably guess who's paying for it. That's right: you.

If you've read the metro section of your local newspaper--or seen recent reports in the Los Angeles Times, the Chicago Tribune, or the New York Times--you may have heard about some state and municipal employees receiving outsized pension payouts, far above what they ever made while working. But chances are you have a sense that the excesses are isolated incidents.

As shocking as it may be, though, the public pension morass is bigger, more wide ranging, and ultimately more costly than anything you've seen in the corporate world. The practices, quietly approved by elected officials, allow workers to dramatically spike their pre-retirement compensation, to retire on more than 100% of their pay, and to draw both their salaries and pensions, with guaranteed market returns, simultaneously.

That's what you'll find in San Diego, for instance, where a city worker qualifying for retirement can instead remain on the job and receive both his salary and an early-activated pension through a so-called deferred retirement option plan, or DROP. That pension, deposited into a special account, earns a guaranteed 8% annual rate of interest, plus a 2% annual cost-of-living adjustment. When the employee actually decides to retire--for real, that is--he can either collect the amount that has accumulated in his special pension account or let it keep compounding at that generous rate of return indefinitely. Add it all up, says Diann Shipione, a trustee of the San Diego City Employees' Retirement System, and the average city worker participating in the plan, earning about $50,000 a year, is eligible to collect a lump sum of about $305,000 at retirement. A fire battalion chief will receive $780,000; a senior librarian will haul in $765,000. But don't be confused: That isn't instead of an annual pension payout; it is on top of it. The post-retirement annual pension payout is equal to 75% of their salary for workers with 30 years' service, a payout that increases 2% a year.

San Diego, you're thinking, must be one heck of a revenue-generating machine. It must be all those tourists who make the pilgrimage to the famed San Diego Zoo. Try again. The city doesn't have nearly enough money set aside to pay for those lush retirement benefits. The pension fund is short by about $1.1 billion and counting. That's because, for almost a decade now, while it has been continually sweetening the pension plan, the city council has also voted to give the pension system far less money than its actuary recommended. But those pension benefits must be paid--they're protected by California law, just as public pensions are constitutionally guaranteed or protected in 40 other states.

As you'll see, the bill is now coming due, and the residents of San Diego are about to pay the price. "I feel like I've been witnessing a crime," says Shipione, who has been an outspoken critic of the city's pension policy. "You look at these numbers, and nobody in their right mind can justify what's being done. Nobody."

Houston Mayor Bill White can't justify what's going on in his city either. In 2001 Houston sweetened the retirement plan for its 12,500 municipal employees so that any worker with 25 years of service who is at least 45 years old could retire and immediately begin to receive an annual pension equal to 90% of his salary, an amount that automatically receives an annual 4% cost-of-living increase. In other words, within three years, he'd be raking in more in retirement than he ever made working.

The generosity of the plan has meant that legions of Houston workers--44% of the city workforce--can quit within the next five years without taking a major financial hit. That, ironically, has spawned a second monster. To prevent an exodus of some 5,000 of its most experienced city employees, Houston has implemented a plan similar to the one in San Diego, in which those who stay on get both their salary and their pension, which will be credited with a minimum annual interest rate of 8.5%. If the stock market has a great year, they'll get even more.

White, who took office in January, says Houston can't afford it. The pension fund is now running a deficit of about $1.9 billion. "The fundamental problem here is a compensation system that makes it more profitable to retire than to work in the prime of your life," says White. And the result is a hole that can only be filled, he says, with either steep cuts in city services or property tax increases of at least 15%, or both.

The third option is to cut those lavish benefits. But that's easier said than done. Last September the voters of Texas approved a new state constitutional amendment prohibiting local governments from reducing pension benefits promised to employees. While the state did allow cities a one-time opportunity to opt out of the legislation, it can happen only with voter approval. So White is taking the issue to the polls on May 15. (The word as of presstime was that White stood a good chance of succeeding.)

Still, union leaders representing Houston's municipal workers are crying foul. The city's pension plan, they say, is an eminently fair tradeoff for wages that have long lagged far behind those of the private sector. "The pension is the only form of security that these city employees will ever have," says Kimbal Urrutia of the American Federation of State, County, and Municipal Employees. Mayor White, he contends, is engaging in what amounts to class warfare by attempting to focus the debate on the issue of higher property taxes. "He's targeting the wealthy voters," says Urrutia.

What's happening in Houston and San Diego is just the beginning of a cascading problem. Pension plans covering the nation's 16 million state and local government employees--about 12% of the entire workforce--are gobbling up increasingly large shares of budgets, setting the stage for bitterly fought battles among politicians, unions, and taxpayers. Collectively, the plans owe an incredible $366 billion more in pension benefits to current and future retirees than the money stashed away to pay for them. That's based on the most recently disclosed market value of assets, according to Santa Monica pension consultancy Wilshire Associates. The pension funds of companies in the S&P 500 are about $259 billion short. (Rather than use the current market value of their assets to express how underfunded their pension plans are, most state retirement administrators instead use a three-or five-year average. Using this "smoothing" method the pension hole doesn't look quite as bad--a mere $158 billion, according to Wilshire. But many industry observers criticize the use of averages to measure a pension fund's assets. "If you don't use the market value, you'll never know the truth," says Ron Ryan, president of Ryan Labs, a New York asset management firm that deals with public pension plans. "The retirement systems have a much more severe problem than they indicate.")

Indeed, the cash crunch has already begun: Just about everywhere you look in this country--from state treasuries in Massachusetts, New York, and West Virginia to modest-sized cities like Portland, Ore., and Burlington, Vt.--spiraling pension costs have already led to massive increases in income or property taxes or forced big cutbacks in services such as police and fire departments, libraries, schools, and parks.

How on earth did it get to this point? You may have heard about the "perfect storm"--a lethal combination of a crashing stock market and record-low interest rates--that has hammered the pension plans (and share prices) of many of America's largest corporations. Those same factors have also wreaked havoc on the finances of state and local pension plans.

But when it comes to the government plans, you can add a few more poisonous elements to the mix: elected officials who were more than happy to dole out lush benefits to their heavily unionized employees during--and even after--the stock market bubble; a system that lets politicians push the costs for those increased benefits off on future generations of taxpayers; and a general public that simply wasn't looking. "The public employee, no matter who you compare him to, has become the dominant sector of the labor force that is well pensioned and well benefitted," says Dallas Salisbury, president of the Employee Benefit Research Institute, an organization based in Washington, D.C., financed by employers, unions, and government agencies. "And the real question is, At what point, vis-a-vis tax burden, does the nonpensioned public start to pay attention to that as voters?"

Given that the bill is coming due, we might start to see voters wake up. As with Houston, says Tom Cavanaugh, who heads the government retirement practice for pension consultancy Mellon Human Resources, "there are many public systems where 40%, 50% of employees are now eligible to retire--these are huge numbers." Making the cash crunch even more severe is that in most cities and states, public pension costs are growing more rapidly than the tax base.

Today's problem can actually be traced to a historic advance decades ago for American workers in both the private and public sectors: the widespread adoption of defined-benefit pension plans. These traditional pension plans give employees a guaranteed annual payment upon retirement--$2,500 a month, say, for an employee with 25 years of service and an average salary of $60,000. The employer puts up all or most of the money, and workers gain real retirement security. Unlike defined-contribution plans, such as 401(k)s, the nest eggs accumulated under a defined-benefit plan can't be demolished by a cratering stock market.

But traditional pension plans are also a risky financial proposition for employers. If a plan's assets don't generate enough income on an annual basis to pay for those retirement benefits, the employer must make up the shortfall. For corporations that means either diverting cash flow from shareholders or, as has been the case increasingly, slashing employee benefits. In the case of government employers, it typically means increasing taxes or cutting back on services. As we'll see, cutting employee benefits is almost never an option.

There's another crucial difference between the public and private sector plans: A corporation, under federal law, typically must start pumping money into its pension plan once the value of the plan's assets sinks below 80% of its liabilities. But there is no such law governing state and local plans--the decision to pump additional money into a pension plan lies with the individual discretion of state and local governments.

Thanks to this discretionary funding system, shortsighted politicians can simultaneously dole out rich pensions to their heavily unionized workforces (thereby presumably currying favor with a powerful group of voters and avoiding nasty strikes) and keep the rest of their constituents at bay by shoving the liability for those increased benefits onto future taxpayers. "The next generation of taxpayers is not sitting at the table," says Jeremy Gold, a New York--based pension consultant. "In fact, the money is going from our children's pockets to today's municipal employees."

There is another big trend at play here: the ever-widening divergence between the proportion of public and private sector workers who participate in a traditional pension plan. For private sector workers, the number has progressively slipped, from almost 40% at the beginning of 1980 to about 17% now. "Companies have been burned over the past few years by bad pension plan performance, and they're trying to insulate their shareholders from that risk," says Kevin Wagner, director of the retirement practice at benefits consulting firm Watson Wyatt. "We will clearly see more corporate employers moving away from the promises of defined-benefit plans." In February, for instance, retail giant Sears announced that it was phasing out its defined-benefit plan, claiming that the move was necessary to compete with Wal-Mart, which does not offer its employees a traditional pension plan.

The story is very different in the public sector, where traditional pension plans have continued to flourish: Ninety percent of all state and local government workers are currently covered by a defined-benefit plan, unchanged from a decade ago. "It all comes down to strikes and votes," says Salisbury.

The statistics certainly appear to back up that statement: Only 9% of all private sector workers are now represented by a union, less than half the percentage of two decades ago. Meanwhile, the proportion of state and local workers with union representation has held steady over the same time, at about 43%, a percentage that union leaders say will rise in coming years. "We're in a growth industry," says Richard Ferlauto, a director with the American Federation of State, County, and Municipal Employees, which represents more than 1.4 million state and local government employees across the country.

It also helps to explain why government plans are generally much richer than those offered by corporations. The average public sector employee now collects an annual pension benefit of 60% after 30 years on the job, or 75% if he is one of the one-fifth or so of workers who are not eligible to collect Social Security benefits. Of the corporate employers that still offer traditional pensions, the average benefit is equal to 45% of salary after 30 years.

Just as important, about 80% of government retirees receive pensions that are increased each year to keep pace with the cost of living, a feature which protects pensions against the effects of inflation and that can increase the value of a typical pension by hundreds of thousands of dollars over a person's retirement. But such inflation protection is nonexistent in corporate plans. "Private sector employers figured out a long time ago that one of the most expensive things you can ever do is put on cost-of-living adjustments," says Wagner.

And then there are the plans, like those in Houston and San Diego, that allow workers to draw both their salaries and pensions simultaneously. Unheard-of in the private sector, the plans are burgeoning in the public sector, as government employers in municipalities ranging from Baton Rouge to Dallas to Philadelphia attempt to hold on to the legions of baby-boomers who are now qualified to retire.

Union officials say those greater benefits are part of a long-honored compact between governments and their workers. "Historically people deferred wages and traded them for retirement benefits," says Ferlauto. "That's been the public service quid pro quo." But whether they are actually trading off wages anymore is anything but certain. "I have not seen any recent studies that say yea or nay on that," says Mellon's Cavanaugh. According to the federal Bureau of Labor Statistics, state and local government employees averaged $23.56 an hour in 2003, compared with $16.49 for private sector employees. But that average is skewed by the fact that there is a much higher proportion of minimum-wage jobs in the private sector. When similar jobs are compared, the results are mixed: The BLS has found that private sector pay is better for many executive and managerial jobs, while the public sector pays better for many service and technical positions. And the results can vary significantly by locality.

For instance, the average Houston municipal worker is paid a salary of $32,000 a year, about 19% less than the $38,000 average earned by private sector workers in similar jobs, according to a compensation study supplied to FORTUNE by the city's human resources department. But factor in the value of the city's pension plan, and the city workers come out way ahead, says Joe Esuchanko, president of Actuarial Service Co., a consultancy hired by the city to evaluate its plan. To accumulate the same pension received by a city employee, the average private sector worker participating in a 401(k) pension plan would have to receive a salary that's at least 25% higher during each year of his 30-year career, save every dime of that difference, and generate an annual 8.5% return on his savings. "For most people, that's not likely to happen," says Esuchanko.

Back in the late '90s, nobody really cared about those old-fashioned defined-benefit pension plans. As the stock market boomed, workers with 401(k) plans were the ones getting rich. Meanwhile, public pension plans, which typically invest about two-thirds of their assets in equities, were suddenly overflowing with surplus money. Politicians responded by handing out heavily sweetened pensions as if they were party favors. With their pension coffers overflowing, state and local legislators were told that the changes wouldn't cost taxpayers anything.

The stock market did, of course, collapse, leaving public sector pension plans without nearly enough money to pay for promised benefit increases. Even more troubling is that many governments continued to sweeten pension plans long after the stock market bubble burst in 2000. The benefit enhancements that drove the costs of the Houston and San Diego plans over the edge were implemented in 2001 and 2002, respectively. Illinois offered a generous early-retirement package to state workers in 2002 that enabled 50-year-olds to retire with generous, unreduced benefits, a deal that cost the state $222,000 for each of the 11,000 or so employees who jumped on it (a scary $2.4 billion in total). In 2001 alone, pension benefits were increased in at least 17 state plans, including those in Delaware, Missouri, Nevada, and New Jersey.

All this was happening at precisely the same time that those puffed-up 401(k) accounts were shriveling, leaving millions of private sector employees watching helplessly as their retirement security crumbled. But the benefits promised to state and local employees remained rock-solid, thanks to those constitutional and legal guarantees. In other words, when it comes to state and local pension plans, the bubble never actually burst.

It certainly didn't burst for Henry Bangser, the superintendent of New Trier High School in Winnetka, Ill. In 2002, Bangser, who was then earning an annual salary of $190,000, informed the school board that he intended to retire in 2006. The board responded by cutting him a new five-year contract that will catapult his final salary to $346,000; on top of that, he's eligible for another $20,000 a year in bonus payments. Since Bangser's pension is based on his highest annual average earnings, he'll be raking in a minimum pension of $221,000 a year when he retires at age 57, increased annually by a 3% cost-of-living factor after he turns 61. "I'm very appreciative and proud that the board felt I merited retirement compensation that would be at or near the top when I finished," he says. But Bangser was hardly surprised. In fact, he expected it.

The ramping-up of final salaries--a practice known as "spiking"--to produce outsized superintendent pensions is standard practice among Illinois school boards. "This is pretty typical for how these contracts work around here," says Onnie Scheyer, the New Trier school board president. And it's not hard to understand why. While superintendents' salaries are paid out of local school board budgets, pensions are not--they are paid out of a retirement system that is funded by Illinois taxpayers. So when the local boards engineer those big pensions, they're basically playing with free money.

Career-end salary spikes are also commonplace for teachers. According to the Illinois Family Taxpayers Network, the 100 top paid teachers in the state raked in salaries ranging from $131,000 to $196,000 in 2003. For example, the salary of one Leyden High School trigonometry teacher has vaulted from $93,000 to $173,000 over the past four years. But that's hardly the norm, says Steve Preckwinckle, political director for the Illinois Federation of Teachers. He points out that in 2003 the average Illinois teacher retired with an annual pension of $42,000, increased annually by a 3% cost-of-living factor. "Nobody's going to get rich off that," he says. While he admits that abuses of the spiking system do occur, he says the system is nonetheless necessary to "make the pensions more livable" for teachers in general.

What's become less and less livable, though, is that the pension plans covering the 630,000 state workers and retirees of Illinois are now collectively underfunded by $35 billion, the worst deficit of any state system in the country. The salary-spiking incidents certainly haven't helped, nor did the costly 2002 early-retirement package. But the major cause of today's problem dates back to the early 1980s, when Illinois legislators began to skimp on pension contributions in order to balance their tight budgets. By the mid-1990s, when the assets in the state's pension plans had plummeted to a dangerously low 55% of liabilities, the government finally passed a law mandating huge cash infusions into the plans every year through 2045. The required contribution for fiscal 2005 alone: $2 billion.

Illinois Governor Rod Blagojevich, who inherited the pension mess plus a $5 billion budget deficit when he took office in January 2003, wooed voters with a promise of "no new taxes" during his 2002 campaign. So, with a tax increase effectively eliminated as an option, Blagojevich has turned to borrowing. Last year Illinois issued $10 billion in so-called pension obligation bonds, with the proceeds earmarked for the state's five pension systems. But while borrowing may have helped Blagojevich skirt his way around a short-term budget squeeze, it doesn't make the longer-term pension problem go away--it simply postpones it.

It's not only tax hikes that the lawmakers in Illinois are sidestepping. Absent from any of the proposed fixes to the massive pension shortfall is an attempt to cut back pension benefits for unionized workers. Earlier this year Illinois House speaker Michael Madigan sponsored legislation that would sharply curtail the career-ending salary hikes for both superintendents and teachers. But since then the proposed legislation has been amended to exclude the teachers entirely--only the superintendents, who are not unionized, would see the salary spiking come to an end. "I'll let you figure that one out," says superintendent Bangser.

The truth is, even if they wanted to change the benefits of existing employees, the Illinois legislators would probably run into a brick wall. Thanks to the widespread constitutional and legal guarantees, politicians even attempting to reduce benefits can almost surely expect protracted court challenges, like the one now being fought by the state employees of Oregon. The state's pension plan is one of the most generous in the country: A recent study by the Oregonian newspaper found that more than a quarter of employees with 30 years of service who retired in 2003 received a pension annuity greater than their salary when working. Faced with a gargantuan $16 billion pension deficit, Oregon passed legislation (which gained strong bipartisan support) in 2003 that would reduce future pension benefits for current workers.

The unions are now suing, claiming that benefit changes for existing workers are unconstitutional. The Oregon supreme court will hear the case in July, but state attorney general Hardy Myers has already indicated in a written opinion that he believes the key elements of the legislation will be thrown out for being an "unconstitutional impairment of contract rights."

Dave Wood certainly believes that his constitutional rights were violated. But the issue for the 67-year-old Wood, who retired in 1994 after working 31 years for the city of San Diego, isn't the dollar amount of his pension. His main worry is that the retirement system is going to run out of money.

Wood's concerns date to the mid-1990s when, under intense budget pressures, San Diego began a policy of deliberately contributing less to the employee pension plan than the amount recommended by the system's actuary. (Sound familiar?) In 2002, with the plan's finances severely weakened by a combination of the funding policy and a collapsing stock market, the city council voted once again to continue underfunding the plan.

That was bad enough, says Wood. But what really threw him over the edge was the fact that, at the same time, the city also handed out significant pension increases after negotiations with the unions. The changes meant that a 30-year worker could now retire and receive a benefit equal to 75% of his salary, increased annually by a 2% cost-of-living adjustment, up dramatically from the 53% of salary Wood received when he retired a decade ago. "That's unaffordably generous," says Wood. "I think what I got was fair." By June 2003 the plan had racked up an unfunded liability of $1.1 billion.

Wood, along with a group of his fellow retirees, decided to sue the city and the retirement system, claiming in essence that both had deliberately placed the pension fund's long-term finances at risk in order to gain favor from the unionized current workforce. What Wood and his fellow plaintiffs were seeking was a big-time infusion of city cash into the pension plan to return it to a healthy funding ratio. "They've been underfunding and jeopardizing my retirement--I find it egregious," says Wood.

The lawsuit worked. In March the city agreed to a tentative settlement that would require it to increase its annual payments to the pension plan dramatically, starting with $130 million in 2005 (a 40% increase over the prior year) and gradually rising in subsequent years. To put that amount in context, San Diego's total general revenue fund for 2004 is $742 million. No matter what, San Diego residents are now facing some drastic cutbacks in city services or unwanted tax hikes. As for the latest round of pension increases, they can't be reduced because--you guessed it--they're protected by law.

San Diego's mayor, Dick Murphy, and the city manager declined interviews with FORTUNE. Union officials likewise turned down repeated requests for interviews. But Frederick Pierce, president of the retirement system's board, contends that the funding arrangement was not illegal. And while he notes that the retirement board does not get directly involved in collective bargaining between the city and its unions, he says that there are "huge political pressures associated" with the entire negotiating process.

But fellow retirement board member Shipione says that's no excuse. "The whole thing was cooked," she says. "The deal was that the city would only agree to increase benefits if they didn't have to pay for it now."

So what's the answer to the pension morass? While changing benefits for existing employees is difficult, if not legally impossible, a handful of politicians have recently been attempting to at least reduce the amount of cash the plans siphon out of government budgets in the future. In California, for instance, Governor Arnold Schwarzenegger is proposing to create a new tier of pension benefits for newly hired state employees that would produce retirement benefits similar to those that employees received before Gray Davis sweetened the plan in 1999. Union groups have already voiced opposition to the proposal.

In New York City, Mayor Michael Bloomberg recently backed off a proposal to create a separate tier of benefits for new hires that he says would have saved the city nearly $10 billion over the next two decades and decreased benefits to "reasonable levels, competitive with the private sector, where most city taxpayers work."

A recent attempt by Massachusetts Governor Mitt Romney to force newly hired workers into a 401(k)-style defined-contribution plan was met with overwhelming union resistance and has been postponed indefinitely. If anything, the pendulum seems to be swinging the other way: In Nebraska, one of a handful of states that requires at least some employees to participate exclusively in a defined-contribution plan, employees were recently switched back into a more secure defined-benefit plan. The reason? The defined-contribution plan was providing employees with retirement income equal to only 25% to 30% of their pre-retirement salaries, compared with the 60% to 70% income replacement rate enjoyed by those workers enrolled in the state's traditional pension plan.

Governments will probably continue to offset rising pension costs by slashing services and, in the process, laying off workers--not a pleasant alternative for either the workers or the citizens of the community. This phenomenon has led some observers to accuse older union members of "eating their young" in order to preserve their own retirement benefits. In Houston union leader Urrutia says that city workers are aware of the fact that layoffs could be looming if their generous pension plan remains intact. But he says that city employees are prepared to take that chance. "This was their option from day one," he says. "They'd rather keep their pension."

Another alternative is for employees to contribute more to their pension plans. About 80% of all state and local plans require employees to make at least some contribution to their defined-benefit plan; the average payroll deduction is 5% of salary (that amount is deducted on a pretax basis, so the average reduction in take-home pay is about 4%). But increasing that amount is a tough sell: In California, Schwarzenegger is proposing that employee contributions increase from 5% to 6% of salary; union leaders vigorously oppose the plan.

Don't count on a booming stock market to come to the rescue. For most heavily underfunded state and local plans, the market would have to return to the irrational exuberance of the late 1990s to erase the damage that's been inflicted by the combination of the bear market and the increases in benefits. In New York, for instance, the assets of the state pension plan would have to grow by 22% per year over the next three years to avoid a continuation of double-digit property tax increases or dramatic cuts in services, according to state comptroller Alan Hevesi. The actual annual growth rate has averaged 8% over the past ten years.

No, it's looking as if the main responsibility for the public pension mess is going to rest squarely with taxpayers for the foreseeable future. Preckwinckle, of the Illinois Federation of Teachers, acknowledges that the situation might be creating some anger among workers in the private sector. "As more people are concentrated in positions that have no pension system at all, they look at some of these things with resentment," he says. "Hopefully some day they'll all join unions, and they can negotiate better benefits for themselves."