Connecticut’s financial situation is perilously unstable

Like a profligate spender with maxed out credit cards and limited income, Connecticut finds itself stumbling towards financial ruin.

Relying on an addict to convey the true depth of his problem is, in general, ill-advised. This instance is no different. Hiding behind accounting gimmicks impermissible in the private sector, Connecticut politicians in the state’s Comprehensive Annual Financial Report (“CAFR”) measured a substantial $70 billion hole at the end of 2014: $22 billion of bonded debt, $26 billion of unfunded pension liabilities and $22 billion of unfunded retiree healthcare liabilities. Large as these numbers are, they understate the scale of the problem.

Politicians have long manipulated pension assumptions to mask long term problems. Prior to 2017, the state mandated unrealistic 8 percent and 8.5 percent discount rates to determine the current value of future pension liabilities in its two main plans. In February, politicians were forced to lower these rates to 6.9 percent in conjunction with yet another “kick the can down the road” deferral. Many financial experts and academic critics, however, suggest rates of 3 percent to 4 percent are more realistic. The table below illustrates the effects that discount rates have on pension liabilities (using the actuarial rule of thumb whereby a 1 percent discount rate decrease corresponds to a 12 percent  liability increase).

With total debt somewhere north of $80 billion and growing and tax revenue of $16 billion in a good year, Connecticut’s fiscal situation is perilously unstable. There are four ways to address the imbalance: i) raise taxes, ii) accelerate economic growth, iii) cut spending and services and reallocate savings to pay down debt, and iv) restructure or default on these obligations.

Raising taxes from today’s levels would further damage a floundering economy. Absent significant reform to alleviate already heavy tax and regulatory burdens, it is not unreasonable to expect the economy and tax base to deteriorate over time as families and businesses continue to emigrate.

Recognizing their inability to i) raise additional taxes or ii) accelerate economic growth, politicians have been forced to allocate a growing portion of the state’s annual budget to meet retiree obligations. As this continues, public employees and retirees will find themselves in an increasingly adversarial position vis-à-vis other beneficiaries of the state’s limited resources: should Connecticut pay a retiree’s six figure pension, foster care for an orphaned toddler, or health services for a low-income septuagenarian on Medicaid?

February’s “kick the can down the road” deferment lowered large, imminent and required pension payments by financing them at usurious interest rates. While politically expedient, this was but an expensive Band-aid. The question of how the state can afford both necessary services and retiree obligations remains. The path out of this mess requires hitting problems head on.

A good medic would stop the bleeding first. Similarly, Connecticut should limit the damage by freezing pensions plans immediately. Only in a worst-case scenario should the state wait until 2022 for the expiration of the current collective bargaining agreement to do so.

Next, the state should move its employees to 401k-style defined contribution plans. Retirees and employees would remain entitled to pension payments at their frozen levels while active employees would have the added benefit of regularly funded 401ks. Reforming the retirement system keeps a lid on fiscal problems and moves the state away from a pension retirement structure rife with abuse.

Public sector unions will certainly balk at changes that reduce their political leverage. The state’s political apparatus has long been tilted in their favor. The fact that the new speaker of Connecticut’s House of Representatives is also an active public union administrator only makes overt what had been practically true for a long time.

Decades of public union victories may ultimately prove Pyrrhic, though, as the state finds itself incapable of footing the bill. Fixed costs, such as pension and healthcare payments, are expected to account for 53 percent of the budget in 2018, up from 37 percent in 2006. Even after freezing pension plans, pension and healthcare liabilities will likely remain intractable.

If forced to choose between necessary services and retiree obligations, politicians should expeditiously restructure pension and healthcare liabilities through bankruptcy, assuming successful passage of federal legislation authorizing this option. While never an optimal outcome, bankruptcy would halt an increasingly painful downward spiral affecting all Connecticut residents, including those in private sector unions. As is the case with an individual after personal bankruptcy, restructuring unaffordable obligations would ultimately prove therapeutic for Connecticut.

In addition to fiscal stabilization, Connecticut must reform its political system to realign politicians and residents. Connecticut should, at a minimum, pass common sense proposed legislation requiring general assembly approval for collective bargaining agreements and arbitration awards.

Going a step further, legislators should repeal binding arbitration and implement the spending cap promised in conjunction with passage of the income tax 25 years ago. These reforms, among others, will moderate political misbehavior and increase the likelihood that the state finds its way back to long term sustainability.

By effectively addressing its fiscal crisis and political misalignment, Connecticut will create an environment in which businesses and families will again find opportunity and a promising future.

Erik Cafarella is an investment management professional who lives in Glastonbury.