The major issue facing states and municipalities is the unsustainability of their defined benefit public pension plans. States and local governments made promises to public employees that upon retirement they would receive defined payments for the rest of their lives.
Unfortunately, this was a promise that could never be kept over the long term and today, states and municipalities are facing trillions of dollars of unfunded public pension obligations. There needs to be a restructuring of these obligations, but doing so will not be easy and will take sound economic, as well as political decisions.
During the past decade, corporations have been shedding their defined benefit programs for defined contribution programs. This was and is being done because corporations realized they could not meet the obligations of guaranteed retirement payments forever.
At some point, it becomes a ponzi scheme. Defined benefits risked the very existence of certain corporations and, as a result, much of corporate America achieved pension reform. States and municipalities need to do the same.
If you're not convinced, look no further than Rhode Island. Today, the New York Times reported on the fiscal crisis facing Central Falls, Rhode Island and Rhode Island itself. The article demonstrates the dangers of unfunded pension obligations and the need for states and municipalities to restructure their unfunded debt.
If this does not occur, states and municipalities will not only fail financially, they will fail their citizens, which is already occurring as public school class size increases, property taxes rise and courts, libraries, parks and social services are shut down. States and municipalities need to review their balance sheets and services, prepare a long-term and comprehensive restructuring plan and execute on that plan.
Here's what's happening in Central Falls, Rhode Island. Its median income is $33,520, and the average home price is $130,000. However, 214 retired police officers and firefighters are owed $80 million in pension obligations. That equals more than $373,000 per retiree.
More than likely these amounts will not be paid in full as Central Falls' pension fund will run out of money in October. So, what happens and who pays?
This question can be asked all around Rhode Island (and the rest of the country). Rhode Island has 39 cities and 25 percent of those cities are characterized as distressed. Of the 36 pension funds in Rhode Island, 23—or more than 60 percent of the pension funds—are at risk.
Providence, Rhode Island's capital, may run out of money in the fall and owes more than $60 million in pension obligations. Rhode Island's cities are dying on the vine.
Rhode Island is in no position to save these cities. It doesn't have the money for a bailout and the state pension funds cannot assume the pension obligations of the cities. So, what does Rhode Island do?
It is attempting to make the State and its cities more attractive to the municipal bond market. Currently, a bill is sitting on the Governor's desk, which would give general obligation bonds priority over all other obligations, including pension obligations.
To make this law even more attractive to municipal bond investors, the State would be required to raise property taxes to generate the revenue necessary to pay the general obligation bonds. This shows the desperation of Rhode Island.
Borrowing to make pension payments simply trades one obligation for another and potentially at a higher cost. In addition, if Rhode Island cannot make a bond payment, it will raise taxes on its citizens. It is a dangerous shell game and, potentially, an oppressive burden. It's also a bad formula—borrow to pay pensions and raise taxes to pay bonds.
At the end of the day, it means that today's workers are paying the State's obligations to current retirees and the State's obligations are not being reduced because they continue to borrow. There is only so long such a plan can or will last.
States and municipalities cannot continue to exchange one liability (pension payments) for another (bond debt) and the taxpayer cannot be continually asked to cover unsustainable promises while suffering from reduced services.
Indeed, borrowing, tax increases and spending cuts lead to slow growth, which causes a downward economic spiral. States and municipalities need to begin addressing this major problem now, which, if done correctly, will lead to economic growth and fair compromises.
Jon Henes is a partner in the restructuring group at Kirkland & Ellis LLP where he has led some of the most complex restructurings in the United States and abroad across a variety of industries, including media, chemicals, energy, manufacturing, real estate, retail and telecommunications. Jon has also frequently appeared on CNBC's "Worldwide Exchange" as a guest expert on various financial and economic topics, federal, state and local fiscal issues.