Retirement Rage

The high costs and rising profiles of public employee pension benefits are raising the public's hackles.
April 2004
John E. Petersen
By John E. Petersen  |  Columnist
John E. Petersen was GOVERNING's Public Finance columnist. He was a Professor of Public Policy and Finance at the George Mason School of Public Policy.

A recent article in Fortune magazine dubbed the public employee pension area as rife with scandal, an "outrage" akin to corporate chieftains walking off with multimillion-dollar compensation packages. That may be hyperbole, but there is no doubt that public employees, when ruminating over their fixed-benefit plans, have some heavy thinking to do.

Recent revelations regarding the creative and expensive use of DROPs- -Deferred Retirement Option Plans--for public employees have raised some hackles. The basic idea is that employees who are eligible for retirement can continue working and have their retirement benefits placed in a fund until they retire "for real." Sounds like a pretty straightforward deal, but the devil is in the details. DROP plans that allow for a very early retirement at high levels of final wage replacement and that have high guaranteed rates of return and cost-of- living adjustments can lead to distortions.

That happened in Houston after a very attractive early retirement plan--retirement at 45 years of age after 25 years of service with 90 percent of final salary--was presented in the early 1990s. It was such a lure that 44 percent of the work force quit over the next five years and a DROP was subsequently instituted to keep employees in place. It provided a guaranteed 8.5 percent rate of return on undrawn funds--a rate of return that might have seemed appropriate at the time but no longer is, what with low interest rates and the stock market bust of the 2000s.

Houston's DROP became a big loser for the city at the same time as the city's pension fund grew a deficit of $1.9 billion. As luck would have it, Houston voters got a second look at the DROP. A constitutional amendment in Texas to guarantee public employee pension benefits allows cities a one-time shot at dropping out of the amendment based on a referendum vote. With the support of the mayor, Houston citizens, provoked by the DROP excesses and worried about the pension-fund deficit, soundly defeated the pension guarantee provision in May.

The flap over the DROP bespeaks a larger changing reality for public employees. Public-sector employees are the last strongholds of the defined-benefit pension. Some 43 percent of public workers are unionized and 90 percent are participants in fixed-benefit plans. Meanwhile, in the private sector, where only about 9 percent are unionized (less than half the percentage of 20 years ago), participation in fixed-benefit plans has shrunk from 40 percent in 1980 to 17 percent today. Not only that, but public employees typically collect higher benefits as a percentage of final pay than do those in private-sector fixed-benefit plans.

Back in the go-go era of the 1990s, nobody cared that much about benefit bonanzas. The 401(k)-style defined-contribution plan, with its double-digit returns, was the retirement plan of choice, and the 8 percent or so return on the fixed-benefit plan seemed weak tea. Meanwhile, as pension funds beat the actuarial averages, enrichment of benefits in tight labor markets made sense. That view, of course, was dramatically reversed by the financial markets of the early 2000s.

Unlike defined-contribution plans, the defined-benefit plan does not crater in a down stock market. The benefits will be paid no matter how the market performs--they are usually guaranteed by the government employer. But because benefits are guaranteed, the contributions of the employer governments will need to be increased if the market returns are not sufficient. That means either cutting other expenses or raising taxes--or undergoing a challenge to the benefit package such as that seen in Texas.

The public sector is exposed to the charge that it can avoid keeping its plan adequately funded while the private sector, under federal law, must keep pumping money into the plan if it is not at an 80 percent funding level. That is one of the reasons that private funds are now heading for extinction. In the realm of global competition, private firms no longer can afford the pension benefit, which in other high-income countries is part of the social benefits provided by the government.

The eventual solution to public pension overload may look like California Governor Arnold Schwarzenegger's new-hire retirement plan, which will roll back benefits to where they were a decade ago. This tactic reflects the reduced-benefit plans that were introduced in the early 1990s to slow down public benefits. When times improved in the late '90s, however, many states equalized the benefits between younger and older workers.

One other consequence of recent pension problems may well be to increase the contributions that public employees now make to their retirement plans. All in all, public employee compensation is coming under increasing scrutiny, and that's not likely to put more money in the public employee's pocket.