US city budgets stable - but decisions loom

New York City is on a roll.

Its coffers are so full of unexpected revenues that Mayor Michael Bloomberg is cutting taxes, building parks, extending a subway line, and putting money away in a rainy-day fund.

"In many ways, we're back to the same momentum we had before the recession and the terrorist attacks," says Ronnie Lowenstein, director of the Independent Budget Office, the city's official budget watchdog agency.

But like every other city in the country, New York has a huge cloud looming on its budget horizon: the cost of soon-to-be-retiring municipal employees, who are part of the baby-boom generation. Accountants have their own names for it: pension liabilities and "other post-employment benefits" (OPEB), which is another way of saying promised healthcare.

While few cities are experiencing the kind of economic boom New York is, most have also recovered from the recession and impacts of 9/11. And because of some changes in accounting rules, which for the first time require cities to include those future costs in their current fiscal assesments, they're encountering some tough decisions about current and future budgets.

"Most cities have returned to a level that we call stability. They're not seeing lots of growth like New York, but they're not seeing dips in their revenues either as they were in 2002 and 2003," says Chris Hoene, research manager of the National League of Cities in Washington. "But the pension and healthcare liabilities are a pretty similar story across the country."

During the boom years between the mid-1990s and the recession of 2001, revenues in most cities went up consistently and often created surpluses. That ended up masking underfunded liabilities, because cities covered the costs with their surpluses.

At the same time, many city governments increased benefits to their employees as a way to keep them from leaving for better-paying work in the overheated job market. But when the recession hit, the surpluses disappeared, and many cities saw huge structural deficits looming in the future as a result of all the promised benefits.

One of the most extreme cases was in San Diego, where city officials discovered their pension system was so mismanaged that it was underfunded by $1.5 billion. That eventually led to several criminal investigations as well as a settlement with the Securities and Exchange Commission. Last week, as a result of the settlement, San Diego created a special audit board that is charged with ensuring the city accurately represents its current and future liabilities in all its financial reporting.

Houston and Milwaukee also found themselves with problems.

"Those [three cities] tended to be unique scenarios because the economic and cyclical issues were combined with questionable policy decisions that were made by the leadership," says Mr. Hoene. "But what is common [among most cities] is that as the baby-boom generation starts to hit retirement and those numbers go up, those pension and healthcare liabilities are really climbing fast."

Two reports issued recently by Moody's Investors Service found that the costs of providing pension and retiree healthcare benefits are growing at "notably higher" rates than general inflation – in some cases as much as 10 to 15 percent. Because of the new accounting rules that require cities to calculate total costs, most cities are only now coming to terms with how to cope with these future costs, says Douglas Benton, a senior credit officer at Moody's in Dallas.

"Because this hasn't been looked at before, there's a lot of additional analysis that has to be done," he says.

Over the next few years, cities will be grappling with such questions as whether to cut back on benefits they offer employees, or whether to raise taxes now to ensure future obligations are funded.

"If a city looks at its liabilities square in the eye with good realistic assumptions, that's the first right step to take," says Dwight Burns, a vice president and senior analyst at Moody's Investors Service.

New York is in better shape than many other jurisdictions because its pensions are fully funded, but its healthcare costs for retirees are not. Those total future obligations are as high as $50 billion, according to Laura Porter, a director of the Public Finance Group of Fitch Ratings in New York.

"Some cities have posted some pretty big numbers, and as people continue to retire, those numbers are going to continue to increase," says Joseph O'Keefe, a senior director with Fitch's Public Finance Group. "They have to do something more actively to control these costs – either through better healthcare management, scaling back benefits, scaling back eligibilities. Potentially, it could be disruptive for some governments as they accommodate these costs. They may have to scale back services to deal with those costs."