Rethinking Disability Pensions

Federal tax incentives invite abuses.
by | May 19, 2011

Disability pensions are under scrutiny again, as more evidence mounts that spurious claims are bleeding public pension funds and the nation's Social Security disability plan. At the federal level, the latest trustees' report shows that the Social Security disability fund will run out of money in just seven years, as claims for disability retirement have skyrocketed nationally in the wake of the last recession. Some local governments have begun to realize that their pension funds are being raided by well paid employees who have learned that they can collect pensions with federal and state tax advantages if they go out on disability instead of normal retirement.

In San Jose, California, the problem has become so acute that local officials are drafting a disability reform ballot proposal in an effort to rein in their runaway costs. Their audit found that a third of police officers and two-thirds of the firefighters are taking disability pensions which give them state and federal tax breaks estimated at $16,000 a year. The tax breaks are especially valuable to those making more than $100,000, which is why this practice proliferates in larger bi-coastal cities where safety officers are higher-paid. With that kind of financial incentive, it's no wonder that their disability claims far exceed the national average. This problem is not isolated to this one city. Public officials in other jurisdictions complain to me regularly that they see disability scams and would like to fix them. They shy away from action as they want to avoid emotional campaigns by public safety unions that portray fallen heroes as victims and not profiteers. (Note: To avert a 35 percent reduction of the workforce, San Jose's mayor is also proposing an emergency pension reform measure that would reduce benefits prospectively if upheld in court.)

We can all appreciate and respect the higher bodily and stress risks facing urban police and firefighters, as explained in my previous column on public-sector compensation. But the claims rates here go well beyond those attributable to urban environmental factors. There is a monetary element here.

If employees were responsible for half of the full actuarial cost of their retirement benefits, the abuses of disability pensions would eventually subside, as younger workers start paying for the costs of fishy claims by their elder colleagues. But the problem with that idea is that these costs are seldom if ever segregated out in the actuarial reports. They get buried in the unfunded liabilities and amortization schedules that are incomprehensible to most policymakers. It would be impractical to calculate the level of "abuse" by simply comparing high-risk localities with safer statewide or national averages.

A better solution would be to reduce disability retirement benefits by 10 to 15 percent for amounts in excess of average household income (about $50,000 nationally), which would offset the tax advantages. This approach could be implemented immediately through collective bargaining in most states, which would help reduce the tax-based abuses of disability pensions. Likewise, I would have thought that the disability pensions could be reduced locally by half the annuity value of federal and state disability benefits paid to recipients in that higher-income category. My research found, however, that this runs afoul of the federal statute which was affirmed by the Supreme Court in Rose v Arkansas. So further measures may be required to curb the abuses.

Some pension reformers suggest that the solution to this problem is to separate the disability insurance process from the pension fund altogether. One group has posted a draft statewide ballot proposal on its website that would replace disability pension benefits for new public employees with a disability insurance requirement. Their premise is that private insurance companies or nonprofit municipal insurance pools (commonly used for workers compensation) would be more judicious in their administration of disability claims than a pension board that is dominated by public employees whose sympathies are biased in favor of the claimant. Peer pressure in such situations is widespread and undeniable. Especially in light of the federal and state programs that already provide disability benefits for first responders, there is a clear need to integrate these benefits and avoid double-dipping. Union leaders have been negative about that idea, claiming that such arrangements would hurt dependent families. It remains to be seen whether this idea can move forward.

Municipal leagues and others that provide workers' compensation insurance should take a hard look at the feasibility of stripping away the disability pension costs from the pension funds, because a fair actuarial analysis would likely show that there is a real opportunity for cost savings here. The national city, county and management associations could provide leadership and technical support here, through their self-insurance networks and claims processing expertise. Even if the underwriting is left within the pension funds, the claims administration process could be shifted from the pension boards to an independent review panel of municipal designees that puts the taxpayers' interests on a level playing field with the claimants'. If nothing is done, I predict we'll see more ballot proposals in jurisdictions where the abuses are commonplace.

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