The Other Pension Fix

Absent reforms for incumbents, a five-year salary freeze may be the best solution for skyrocketing pension costs.
by | June 10, 2010

As public employers look beyond their worst year of financial cutbacks, they are coming to realize that the light at the end of the tunnel is an oncoming train. Just as revenues begin to recover ever-so-slowly from a skittish economy, they face skyrocketing bills for pensions and retiree medical benefits. Investment losses now require higher pension contributions; once the recession ends, employers cannot justify skipping their actuarial payments for OPEB retiree medical benefits. As reported in my last column, the Governmental Accounting Standards Board is now considering pension accounting reforms that would accentuate the budgetary impact in 2013-14.

In the light of these imminent cost increases, public managers are confronting union negotiators who have only begun to sense the size of this problem — and whose rank-and-file are mostly clueless on these issues. This sets the stage for some ugly collective bargaining. For many employers, a long grind of impasse resolution will lead to mediation and arbitration. It's going to be a stormy year, and many public employers will require professional assistance to help them, including both labor lawyers and independent experts to testify on prevailing compensation levels and more importantly, the trends in public employee compensation.

In states that allow public employers to change benefits for incumbent employees, the appropriate solutions should begin with revisions to the cost structure of the benefits plans to make them more affordable and sustainable. This would include raising the retirement age, reducing the pension multiplier, raising employee contributions, capping the retiree medical benefit, eliminating spousal and dependent retiree medical benefits, and limiting retiree medical benefits to a Medicare supplement. These measures will result in significant cost savings to the public employer, and employee contribution increases can be phased in over the life of a labor agreement or even longer. If the necessary employee contributions must be increased by more than 5 percent of salary during the contract period, the parties can provide for subsequent increases that extend beyond the contract life. That would set the stage for expectations and support the actuarial calculations needed to moderate employer contribution costs.

In some states — Alaska, Arizona, California, Illinois, Kansas, Massachusetts, New York, Oregon, Washington and West Virginia (and a handful of others where the law is less settled) — constitutions and court decisions have been interpreted to require employers to maintain pension benefit levels for incumbent employees. This generally limits public employers to fewer options to achieve cost reductions in their retirement plans: They can increase employee contributions, institute lower-cost benefit tiers for new employees and explore whether retiree medical benefits can be capped or reduced. Most employers are seeking to raise contribution levels and to institute new tiers with lower multipliers and higher retirement ages. Where attorneys have advised that OPEB retirement medical benefits are fair game, they are installing caps on incumbents' benefits and reforming them as well. (See my companion column on this topic today.)

If potential GASB accounting changes accelerate the amortization of swollen unfunded liabilities and value them more deeply, the above reforms may not stabilize employer retirement plan costs enough to balance their budgets in 2013 and beyond. Of course, we won't know until then whether revenues might grow sufficiently to offset these expenses — plus the costs of restoring workers to normal workweeks after two years of furloughs, the resumption of normal capital expenditures and equipment replacement and other pent-up cost increases. This leaves public managers in a quandary regarding the terms of their labor agreements. If they fail to look forward far enough to see the implications of imminent retirement-plan cost increases, they could box themselves into further layoffs at the end of the next contract period.

The Pay Freeze Solution. This gets me to the final lever available to public officials in the scenario we now face: a multi-year salary freeze to be thawed only when fiscal balance is restored. Until labor unions are prepared to step up the employee contributions to a full cost-sharing level and to accept all feasible reforms in pension and OPEB retiree medical benefits plans, public employers will have no other choice but to freeze salaries.

A salary freeze has long-term cost implications that go beyond the obvious budget-year savings: A long-term pay freeze dampens pension costs in the short run and potentially in the long run. After all, pensions are based on final average compensation, and if the employer freezes or curbs pay levels to less than the inflationary wage increases that the actuary normally assumes for several years, then future pension costs can be reduced. A five-year pay freeze would make a huge difference in pension costs, as ultimate retirement benefits would be reduced significantly across the board. Most importantly, the impact of these pension costs would immediately affect the pensions of senior incumbents who have gained the most from unsustainable benefits increases awarded in the past decade or two.

For employers with rich salary levels, this approach will work better than those whose pay levels are less competitive. As labor economists and human resources managers will attest, the labor market will ultimately determine whether pay freezes can be sustained in the long run. If salaries are frozen for a brief period but then followed by "catch-up" increases to achieve market competitiveness, the long-term impact on the pension fund could actually be negative, as future liabilities will then exceed the recent actuarial assumptions based on frozen base levels. So this strategy must be a long-term strategy and not a short-term gimmick.

For some if not many public employers, the most likely strategy will be a salary freeze for one or two years with a very tiny increase in the back years of the contract, coupled with a provision that additional salary increases will be paid if and only if the employers' revenues exceed the level needed to cover other equally necessary deferred costs and the yet unknown costs of retirement benefits. For example, a 10 percent cumulative increase in employer revenues might trigger a 1 percent increase in salaries or a 15 percent cumulative increase in revenues might trigger a 3 percent increase in salaries in 2013 — as long as higher pension costs do not consume more than half the revenue increases.

Welcome to the New Normal. In light of the unprecedented global uncertainty surrounding the prospects for economic recovery (such as the recent Eurozone financial crisis, and now rumblings that China may squelch its growth rate to cool off a housing bubble), public employers are in no position to continue unaffordable benefits or give away salary increases that their budgets cannot sustain. They must bargain for long-term cost reductions and this requires multi-year labor contracts. Employee associations will resist long-term freezes and "give-backs", so the only fair solution is to devise the kind of formula I have suggested above, which aligns the interests of both parties. If revenue-sharing and (GASB cost) risk-sharing are incorporated into the labor contract design, there can be a path to successful resolution of the toughest governmental labor negotiations ever held during an economic recovery. This is the best way to manage through the New Normal.

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