The Pension Time Bomb, Part II

How can governments escape the ?scal black hole some already have entered and others are on the verge of falling into? Unfortunately, there is no...
by | November 1, 2009

How can governments escape the ?scal black hole some already have entered and others are on the verge of falling into? Unfortunately, there is no silver bullet for fixing the pension problem--no single strategy that ?ts all situations. Several options exist, and states and localities must choose approaches that best ?t their ?scal situation and policy goals.

In general, fixes fall into four categories:

· Restructure employee benefits

· Enhance investment returns

· Reduce administrative costs

· Find alternative funding sources

These techniques also fall into two general categories - those that can produce immediate, short-term saving, and reforms with benefits in the medium- and long-term. Because of the immediacy of the current crisis, this article will focus on the short-term fixes and then briefly discuss more fundamental changes that are needed to create a sustainable system.

Six Short Term Fixes

For states and localities facing large unfunded pension obligations, it is vital to stop--or at least slow--the ?nancial bleeding. This means ?rst making sure that current contributions at least cover current liabilities.

Pension bene?ts are dif?cult to modify for exist­ing public employees and nearly impossible for retirees. Therefore, more fundamental reforms often can be applied only to new employees entering the public workforce, so the impact of these changes may not be felt for many years.

The six cost-cutting and revenue-boosting options listed here generally can be applied to current public workers, however, depending upon spe­ci?c contract and legal provisions of the pension plan. These strategies are designed to deliver relatively quick improvements for underfunded public pension systems.

Quick Fix #1 - Close Loopholes

There are generally three big areas of loopholes that can be tightened: large pay increases in the years immediately preceding retirement; overly generous sick leave policies; and tightening eligibility for the enriched retirement of public safety personnel.

The state of Illinois sought to close these loopholes through legislation de­signed to limit the impact of end-of-career raises on state pension plans. The act targets the common practice by local school districts of granting large pay raises to school employees a year or two before they retire. The school district pays the higher salary brie?y until the employee retires, but the state absorbs the long-term expense of fatter pension bene?ts triggered by the salary increase. Massachusetts has likewise tried to clamp down on this practice.

Numerous states also have begun to target growth of special public-safety pension bene?ts by limiting the categories of eligible workers.

Quick Fix #2 - Adjust Benefit Formulas

Some pension plans offer special bene?t formu­las that increase plan costs. For example, the State University Retirement System in Illinois had a basic bene?t formula and a special money purchase formula. University employees automatically got the most lucrative of the two bene?t calculations. The Illinois pension reform law eliminated the money purchase formula for Illinois state university employees hired after June 30, 2005, and changed the way interest rates are set for current employees who remain eligible for the money purchase formula calculation. Previously, those rates were set by the retirement system. Now the state controller sets them. Although the changes don't reduce bene?t accruals already earned by university employ­ees, they do limit interest rates (and costs) going forward.

Quick Fix #3 - Raise Employee Contribution

States and localities can consider raising the amount that employees contribute to public retirement plans. As noted earlier, employee pension contributions generally have held steady as plan costs have increased. Instead, contribution amounts could be tied to actual plan costs. So, for example, if total pension plan costs increase by 10 percent, employee contributions would increase by the same percentage or at least by some amount.

These adjustments are common for employee health plans. But institut­ing similar practices for pension contributions would depend on potentially dif?cult negotiations with public employee unions and consideration of state constitutional provisions.

Quick Fix #4 - Find New Revenue Sources

State and local governments may have un­tapped revenue sources that could be used to fund pension obligations. Finding these dollars will require innovative thinking, however. Illinois, for example, is exploring selling or leasing its state tollway system. Proceeds from the sale would be funneled into the state pension system. Public infra­structure also represents an increasingly popular investment alternative for pension funds. Other revenue sources might include sales of unused public properties with the proceeds dedicated to pension funding.

Another tactic used to pump more revenue into retirement plans is pen­sion obligation bonds. This is a very risky approach, however, and should be researched in depth before being considered seriously.

Quick Fix #5 - Review and Refine Investment Policies

Risky, potentially high-yield investment policies may be imprudent, but overly cautious investment strategies needlessly re­duce income potential. They also often do not offer the ?exibility that is needed to manage the portfolio and manage risk. For example, conservative investment policies often place a ceiling on equities and don't allow hedging or alternative investments. Yet limiting the types of investments and invest­ment mix can actually create greater risks under certain market conditions.

Quick Fix #6 - Cut Administrative Costs

Reducing administrative expenses won't solve the pension crisis--not by a long shot. Nevertheless, cutting plan overhead should be a component of any comprehensive solution. The biggest opportunity lies with consolidating multiple pension plans. There are more than 2,600 public employee retirement systems nationwide, according to the U.S. Census Bureau. In Texas, for example, dozens of state and local public retirement plans cover government workers, teachers, po­lice and ?re?ghters. Similarly, the state of Illinois has ?ve separate retire­ment boards, each with its own workforce and infrastructure.

Medium to Long Term Fixes

Fundamental changes to the public retirement system are politically difficult, and their effects won't be felt for many years.

Because of the dif?culty of reducing bene?ts for current employees, the most practical option for cutting overall costs is to scale back retirement pack­ages for newly hired workers. Such two-tier retirement programs, extremely common nowadays in the private sector, reduce retirement and health bene­?ts for employees hired after a speci?c date, while maintaining agreed-upon bene?t packages for existing workers. Although such programs don't affect current employ­ees, employee groups have opposed these ideas in the past.

Clearly, public leaders risk voter backlash as runaway pension costs hit taxpayers in the pocketbook and cripple economic competitiveness. As tax increases or service cuts become more commonplace to address this issue, citizens will demand that public policy-makers implement reforms to con­trol the price of public employee pension programs. What's more, without corrective action, the pension crisis is likely to worsen as Baby Boomers start reaching retirement age in the near future.

This article is adapted from "States of Transition: Tackling Government's Toughest Policy and Management Challenges," published by Deloitte, edited by William D. Eggers and Robert N. Campbell, Chapter 4" Fixing the Pension Crisis, by Lance Weiss, Tim Phoenix, William D. Eggers and Rick Davenport.

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