Deep Freeze for Salaries

Thanks to the pension crisis, the public-sector should prepare for a 'lost decade' of compensation correction.
by | August 8, 2011
 

As I continue to monitor developments in the public pension world, a new theme is beginning to emerge. The only way to balance the books for some, perhaps many, state and local government pension plans will be to freeze public-employee salaries for most of this decade. Despite valiant efforts by labor groups to raise or restore employee contributions to help bail out pension plans, the math just won't work. Employers are facing daunting increases in pension costs and must soon begin to pay for retiree medical benefits as well.

The bottom line is that the cost of preserving today's benefits levels for current employees will be a long-term freeze in salaries for many, actual pay cuts in some distressed municipalities, and skinny pay increases for the luckiest — raises that still won't keep up with inflation. We won't see "catch-up" pay increases for years to come.

The problem in many states is that pension benefits cannot be rolled back for incumbent employees under state constitutions or case law. This asymmetrical bias toward ever-increasing benefits with a "ratchet effect" can be reversed for newly hired employees under what are called "new benefits tiers." But in some states it is impossible to trim prospective benefits accruals for current employees — even for their future service. In the 1930s, the classical economist John Maynard Keynes called wages "sticky downward" because of unionization and "wage illusion" during deflationary periods. The modern equivalent is public pension benefits that are now sticky downward.

This awkward and ill-conceived legal structure gives public employers very few tools to make adjustments to pension plans, which are now the primary drivers of rising governmental labor costs. The two commonly available "blunt instruments" are to raise employee contribution levels and to install new, lower benefits tiers for new hires. But when there are no new hires because the employer is shrinking its payroll to pay, the short-term savings from lower formulas for new hires are puny. And recent increases in employee contributions, although painful to the workers, are a mere drop in the bucket compared to the hefty increases in employer contributions now required to balance the books.

In the aftermath of the Great Recession, pension funds have been set back by 15 to 20 percent in their funding ratios — even with last year's notable rebound. What the naïve (or disingenuous) folks touting recent investment performance fail to admit is that pension liabilities have increased by about 25 percent in the past three years (roughly equivalent to 7.75 percent compounded) while portfolio assets are still underwater in a stock market that now trades 15-20 percent below its previous peak in 2007.

That is a lot of lost ground to regain, as I have explained in a previous column. As a result, the average pension plan is now only about 70 to 75 percent funded on a real-time basis when you strip away actuarial smoothing. Unless financial markets outperform their historical averages by magical amounts in the next few years, there is no way that investments alone can bail out these plans. Meanwhile, public employers have realized that the "New Normal" economy won't produce rapid revenue increases to offset rising pension and benefits costs. This puts the public employer between a rock and hard place. They can cut services by headcount reduction or find ways to trim payroll in order to cover rising benefits costs.

Which now brings me to the mathematics of public-sector pay freezes. Not only are they inevitable in many locations in light of the fiscal problems summarized above, a freeze in employee pay will ultimately help bring down the required pension contributions. That is because pensions for current employees will be based on their final average salaries. And if those salaries are frozen, the ultimate pensions that new retirees receive will be less than actuaries have been projecting.

Thus, an actuarially byproduct of public pay freezes is that they will eventually help offset at least a fraction of the astronomical employer contribution rates that will hit public budgets in the next two or three years. That alone won't be enough to fix the problem, but it will run counter to the rising trend in pension costs. By the latter half of this decade, some of those impacts on pension costs will begin to creep into the actuarial cost calculations as today's baby boomers retire at pay rates somewhat below the latest actuarial expectations.

This would all be wonderful and helpful from a prudent pension-funding standpoint, if that were the end of the story. But as you might expect, it won't be. As in physics, every action in the Wonderland world of pensions and public employee compensation has some kind of opposing reaction. Over time, today's frozen public-sector salaries will become uncompetitive. Employers will ultimately begin to raise cash compensation in order to attract new workers, and that will creep into the payroll. To the extent that public employers later play "catch-up", the latest pension assumptions will ultimately be more accurate than those that attempt to base themselves off of artificially suppressed salary levels in the middle of this decade. So there is a definite danger that another cycle of pension funding shortfalls could arise by 2020 if nobody is minding the store. Today's pay freezes could prove to be a head-fake.

To appreciate the inadequacy of "temporary" pay freezes as a long-term solution, let's remember that liabilities for current retirees are entirely unaffected by today's payroll changes. Younger workers will likely retire at pay levels determined in the distant future regardless of what they are paid today. In fact, those younger employees under-contribute to the system now while their pay is frozen, which will eventually cause an unfunded liability if their pay reverts to a higher equilibrium level later in their careers.

Only a permanent reduction in public sector compensation to levels below actuarial assumptions will have a lasting impact of major magnitude. For a subset of public employees (most often the unionized), that is plausible if they were indeed overpaid going into the Great Recession, but that population will be a winnowing minority as this New Normal period of governmental austerity wears on.

So the temporary impact of pay freezes on a small segment of the intergenerational "river" of participants who happen to be Baby Boomers nearing retirement today is relatively unimportant when they ultimately reach the national lake of pension liabilities.

In simplistic terms, even if one-fourth of all current and future public-sector retirees now alive were to experience a 15 percent "compensation correction" through pay freezes over five years (versus actuarial assumptions of 3 percent salary growth), that would reduce a typical pension plan's total liabilities by only 5 percent. Five percent improvement on the pension fund's balance sheet is not enough to move the dial materially in light of 25 percent asset deficiencies in today's financial markets. Nonetheless, it's a worthwhile and equitable measure to employ for workers whose benefits cannot otherwise be touched under law, if the plan is underfunded.

I'm not going to obsess now about the 2020 scenario sketched above, but just want to remind public employers (and especially those at the bargaining table) that the strategy of freezing salaries has its limits and won't be a magical fix for the pension fund. You can help restore balance with long-term pay freezes, but you won't be able to avoid higher employer and employee contributions as a result. For employers in states that allow prospective benefits reductions for future service of incumbent employees, that solution needs to be put on the table as part of a complete and balanced solution. And don't forget that all this does nothing to solve the mounting OPEB funding crisis for retiree medical benefits that are completely unrelated to salaries. Those costs will continue to mount every year until caps and controls are installed, and employees begin contributing to those plans as well.

For the record, I'm not suggesting that freezing public sector pay is a good thing. In the long run, the taxpaying public will suffer from the talent exodus already underway in state and local governments. My experience in the public sector and working with many dedicated public servants is that governmental salary compensation is relatively reasonable overall — with some visible and annoying exceptions. But the total-cost-of-compensation numbers don't fit the cramped budgets right now, and the public remains unwilling to bear higher taxes to bail out the pension fund losses. Most of them don't receive comparable benefits — especially the "early retirement ages" which remain a flashpoint as aging Baby Boomers in the private sector keep working longer than they had ever dreamed they would.

That leaves public employers with very few options besides those mentioned above. So state and local hiring to fill retirement vacancies, as well as salary levels, will be retarded for several more years to come. Welcome to the public sector's "lost decade" of compensation correction — it's a bitter pill for many in public service.

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