California's Down Payment on Pension Reform
Four workers unions wake up and smell the coffee.
Last week's biggest news on the pension and payroll front was a report from Sacramento that California Governor Schwarzenegger's team has successfully negotiated two vital pension reforms. Four key unions representing 23,000 workers or 9 percent of the total state-level workforce reportedly agreed to raise their retirement ages for new hires by five years and to bump up the incumbent employees' contributions by as much as 5 percent of wages to help pay for their retirement benefits. Employee pension contribution rates of 10 and 11 percent will be well above the national average as a result. Savings of $2 billion annually would be achievable if these terms are adopted throughout the state workforce.
These pending agreements do not roll back retirement benefits of incumbents or control retiree medical costs. However, the California Highway Patrol union did also agree to begin paying 2 percent of salary toward their retiree medical (OPEB) benefits in 2013. New civilian hires will receive a lower multiplier of 2 percent during their service periods, a reduction from 2.5 percent, but public safety retained their generous 3 percent multipliers. Raising the retirement age for new employees to 60 for civilians and 55 for public safety is a sensible path toward ultimate long-term reforms at even higher ages. Thus, the governor's pending deal with these four unions is a landmark step in the right direction. Other state and local government agencies are likely to seek similar concessions from their unions, so this "template" offers an important precedent. State-level supervisors typically follow the benefits patterns of those reporting to them.
Financial news reporters hounded me last Friday, asking whether these reforms would put out the raging wildfire of pension costs. As you probably suspect, the answer to that question is a definite No. These pension reforms are much needed but will hardly offset the huge increases in pension and retiree medical costs already scheduled to hit governmental budgets between now and 2013 when new accounting standards are likely to become effective. At best they are a down payment on a much larger bill, and cynics would argue that they represent a stall tactic by labor leaders who know that worse is yet to come unless financial markets magically return the Dow Jones Industrials Average to 14,000 in the next year.
Why this is just a down payment. To put this all into perspective, many California public employers will face retirement plan costs exceeding 20 to 25 percent of salaries for civilians, and as much as 40 to 50 percent of salaries for public safety once (1) the financial impact of the 2008 bear market in stocks is finally recognized in the bills sent out by the pension funds; (2) they start making actuarial contributions for retiree medical plans; and (3) the latest thinking in governmental accounting becomes effective. Even with a 10 percent employee payroll contribution from workers exempt from Social Security, many California public employers will face huge cost increases that most budgets will not be able to sustain without service reductions, pay and hiring freezes, personnel attrition and similar cost cuts. A 5 percent increase in employee contributions is just the down payment on those bills.
I've already seen costs at these levels in other states, such as Maryland. Even without prospective accounting changes, county and city retirement plan costs will rise above 60 percent of salaries for public safety in some jurisdictions. The problem we're trying to solve is deeper than we can resolve with offsets of a 10 percent employee contribution and age 60/55 retirement dates for new hires.
A foundation for more reforms. What public managers in other jurisdictions must now do is to begin with these two key changes and build reform packages on that foundation. To achieve fiscal and political sustainability, retirement ages for public safety personnel hired today can be set at age 57 with 25 years or service, and civilian ages can be aligned at age 62 with 30 years of service or age 67 with 10 service years to match Social Security. Retiree medical benefits can be re-designed along the lines I described in my column two weeks ago. If it's feasible, contributions by incumbents can be set at 10 percent and then raised annually as necessary to equal half of the actuarial costs. If that takes five years, and if the ultimate employee cost reaches 15 percent of pay for those outside of Social Security, so be it. And nobody can justify a pension multiplier of 3 percent in the new normal world of public finance, even if they are outside the Social Security system.
For new hires facing higher retirement ages, hybrid plans with lower costs for everybody can provide a 50 percent defined benefit of 1 percent of pay times years worked — like federal employees get — and 50 percent in a portable defined contribution plan. Such plan designs will provide a valued benefit for younger workers, and can be funded with a lower contribution requirement than older workers must pay to keep their richer benefits. At the same time, the approach would give new employees an optional plan to save more for their retirement and dependents' health benefits.
Labor leaders acted responsibly. I would like to tip my hat to the labor unions who agreed to the California deal. They deserve credit for smelling the coffee regarding their extraordinarily generous pensions, especially the general employee groups that accepted a reduction in their multiplier. Ten percent employee contributions are a big move on their part (although not such a big deal, really, for employees exempt from Social Security taxes). They stepped up to the plate with a good-faith effort to share in the exorbitant costs of the irrevocable benefits they have previously secured, and for that they deserve a share of the credit. They have also taken responsible actions to curtail pension spiking which inflames California taxpayers. The civilian unions accepted an unpaid personal day each month, which cuts payroll costs by 5 percent. This replaced the current furlough system which hurts them deeply right now. These deals are hardly perfect, but they are far better than obstinacy and deadlock. Labor leaders deserve respect here, even from the pension-bashers.
They say that a good compromise is when both parties feel they took the short straw. As a California taxpayer still getting a short straw, I would rate this pension deal a worthwhile compromise — and the state's first important step to sustainable long-term retirement reform. Let's keep moving forward.
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