Posted May 10, 2007

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Bonus column:
Bring on 401(x)!

Stop Spiking the Pension Punch

It's time to curb overtime, bonus and sick leave abuse

It seems like every week a news report surfaces that tells yet another story of public employees or public managers "spiking" their final compensation with extraordinary pay. It may be overtime pay for extraordinary extracurricular work — at such levels that one wonders when the employee sleeps. Or it could be final-year payments of accrued sick leave and comp time piled up over the years, particularly where the public employer failed to put in place a 'use it or lose it' rule that's commonplace in the private sector. Or there might be a big, fat final bonus. Such "spikes" jack up pension payouts for life since the pension calculation is inflated by including these extra dollars.

It's amazing that so few public employers or pension funds have put an end to these egregious practices. The dysfunction stems from separating the management of pension funds from the management of employee compensation. Department heads and HR directors tend to think in terms of their annual budget and have little incentive to control long-term pension costs on a case-by-case basis. Pension officials view their fiduciary role as protecting the rights of retirees under the formula of their plan. So nobody is in charge of managing the actual long-term costs to taxpayers.

A traditional actuarial approach to the pension-spiking problem is to calculate the lifetime pension using a final average compensation period of more than one year. Many plans use three years — often it's the highest three of the past five or ten years. That reduces the impact of a single-year blip in income to one-third of what would otherwise happen. But this simply dilutes the problem rather than solving it.

If we return to fundamentals, the purpose of a pension is to reward employees for a lifetime of career work — not their contrived earnings in the last one to three years of their careers. The money to pay for their pensions must be carefully accumulated through decades of payroll deductions, taxpayer contributions and investment earnings. So it makes absolutely no sense to pay a lifetime pension for extraordinary compensation earned in the final year or two.

Spiking a public pension payout should be prohibited altogether as a matter of law and certainly best practice. If ever there were an income stream deserving of an IRS excise tax, this would be it.

The solution? Apply the pension formula only to employees' base salaries or normal earnings. Special payments for overtime, sick leave accruals, bonuses and other extraordinary compensation should be excluded from pension calculations. Those earnings can still be rewarded in a retirement plan — through a sidecar 457 deferred compensation or 401(a) defined contribution arrangement.

Using the same payroll percentages as the pension plan, a personal retirement account contribution for non-salary income can be made when the extra pay is earned. It can accumulate and compound as a supplemental retirement account outside the mainstream pension fund. That way, public employees will still receive fair and equivalent employer contributions and tax-advantaged savings for their extra efforts, and they will build a worthwhile extra nest egg for retirement. But it won't result in a bloated, back-end-loaded pension payment with a lifetime actuarial value that exceeds the extra pay itself.

For those employees who have contributed already toward pensions with overtime pay, fairness requires that their prior service and contributions be considered in the pension plan. This can be done by reviewing their overtime and extra pay to date and awarding a supplemental service credit for those hours worked. For example, 1,400 earned hours of overtime, at time-and-a-half, would equate to 2,100 regular hours — or one year of extra service under the pension payment formula. For a 30-year employee, that works out to a mathematically fair 3 percent pension increase — not the 33 to 100 percent of a spiking scam.

Today's automated payroll systems can work the numbers, so public officials and personnel can stop working the system.

Last month:
· OPEB bonds: Look Before You Leap
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Girard Miller, an analyst of benefits and investments with 30 years of experience in the public, private and nonprofit sectors, can be reached at Girardinmalibu@charter.net.
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