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BENEFITS BEAT
How to Audit and Avoid
Pension ‘Spiking’
Flash the spotlight on OT and sick-leave payoffs. Then redesign the system.
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While traveling across the country last month on speaking engagements in many states, I repeatedly encountered the issue of pension "spiking." The practice attracts more attention to abuses in public employee retirement systems than any other single issue.
For those unfamiliar with this term, pension spiking occurs when employees artificially inflate their final compensation just before retiring in order to game the system. Pension systems typically pay a lifetime annuity based on a percentage of "final average compensation," which is usually calculated using the last three years of pay. So when employees juice their final compensation by cashing out a lifetime of sick leave and conniving with their buddies to pile on the overtime in the final years, they can capture W-2 income with an actuarial value of 10 to 25 times the immediate take-home value. The present value of that cash compensation is a lifetime of pension benefits. If you are a public-safety worker finishing a working career of 20 years, that can mean 45 years of unwarranted pension benefits based on a few years of spiked-up final compensation. In some cases, that overtime work earns as much as $1,000 an hour in present value.
In addition to the "greedy-gimmicky" feeling everybody has about pension spiking, it is unsound from a pension plan financial standpoint. Nationally, over 70 percent of mature pension fund revenues are derived from investment income on employer and employee contributions. When employees play the spiking game, they rob the system of the expected lifetime investment income on their contributions because they have back-loaded their compensation. Spiking is a something-for-nothing abuse of a system.
Conduct a pension-spiking actuarial audit. Elected officials and taxpayer groups should demand public audits of pension fund spiking. This can easily determine the rate by which contributions have already been increased in order to pay the system back for the unfunded liabilities created by past spiking practices, plus expected future payments that will likely occur going forward. If employee unions wish to defend the practice of spiking, then they should accept an increase in employee contributions sufficient to offset the actuarially measurable effect of this employee-driven abuse. Otherwise, they should cooperate to end this blight on the system through an alternative plan as outlined below.
Plan redesign alternatives. There is a simple solution to this problem, although it often requires collaborative labor negotiations if a union is involved. Public employers need to take overtime and sick leave out of the pension formula altogether. It doesn't belong there.
This is not to deny that overtime is a form of compensation. However, it is an irregular form of compensation subject to great fluctuations over a career, especially in work units that favor seniority, which makes it systematically unsuitable to a defined-benefit system.
Fortunately, there is a simple and fair way to give employees a deserved retirement benefit for their extra work: a separate defined contribution (DC) payment in lieu of pensions for overtime pay by the employer equal to the "normal cost contribution" to the pension fund. For example, if a city pays 7 percent of salary into the general employees' pension fund and 10 percent of salary into the police and fire pension fund, then equivalent contributions can be made into a sidecar DC plan for the overtime work.
(Technical note: The DC plan can be either a 401(a) money purchase plan or a 457 supplemental deferred compensation plan; the former often has greater tax advantages for higher-compensated employees; the latter may be preferred by certain public-safety workers eligible to withdraw money in retirement for health care expenses.)
For employees who have already paid into the pension system based on overtime, methods to fairly adjust for this were discussed in my prior column on pension spiking.
Sick leave bank reforms. Likewise, an employer can set up a defined-contribution retirement health savings plan for its employees as part of a redesigned OPEB ("other post-employment benefits") plan for retiree health benefits. Such OPEB-DC plans have the great advantage that the money is free from taxes when withdrawn for qualified retirement medical expenses. Unused "excess" sick leave accumulations can be paid in cash — using whatever formula the employer and employees agree on — into the employee's personal OPEB-DC account. Last year's column on the "Rx for Sick Leave" explained how.
By separating these extraordinary payments from the pension calculation, public officials and pension plan officials can do more to restore credibility to public pension plans than any other action they can take. The media will no longer report cases of retirees getting lavish pensions they never really deserved because of this spiking abuse.
Perhaps as many as half of the state and local governments in America now need to redesign their OPEB (other post-retirement benefit) plans for retiree medical costs anyway. So this is a great time to "kill two birds with a single stone" and simultaneously eliminate the pension-spiking problem at the same time. As I noted last month in my September column on the benefits bargaining battlefield, these will be challenging labor negotiations, but the time for action has never been so obvious.
In multi-employer systems such as CalPERS in California, public employers will also need to work with the pension governance bodies to exclude these compensation items from the pension formula, or at least to permit employers to opt out of a formula they no longer approve.
Pension plans are already facing heightened scrutiny because of investment losses in the recent market meltdown. Some will be attacked for investment underperformance, fairly or not. The increased visibility caused by pension spiking could undermine confidence in otherwise sound and well-run plans. Let's not spoil the fruits of decades of progressive pension plan design and prudent management through spiking abuses that rot the good apples.
Girard Miller, a senior strategist for retirement plans and investments and at the PFM Group, has 30 years of experience in the public, private and nonprofit sectors. He can be reached at millerg@pfm.com.
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