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Private Pay, Public Pensions and Some Real Math

Let's replace ideology with compensation analytics.


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Girard Miller

Girard Miller is the Public Money columnist for GOVERNING and a senior strategist at the PFM Group.

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Commented August 30, 2010

Of interest. I tried to send to the council but if unsuccessful this might be included in the Thurs...

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Last month's columns on generation gap in pension reform brought a flurry of comments from readers who objected to the concept of public pensions paying better benefits than private-sector taxpayers enjoy. Let me present the key issues that should be considered in evaluating the fairness of public-employee compensation including retirement benefits.

Historically, the "deal" with public employees was that the pay was lousy but the benefits were great. For most workers that meant the health insurance, holidays, vacation time and other fringe benefits were expected to be equal to or better than private employers, especially small businesses. Government employees' pensions originally were pretty frugal. Over time, however, the pension and retirement benefits granted to public employees have outpaced those offered in the private sector.

As corporations moved away from pensions and toward 401(k) defined contribution plans (because of the costs of pension insurance, the burden of private-sector accounting rules, and onerous federal regulations, such as ERISA), the gap between public and private retirement benefits has widened to rival the size of the Grand Canyon. This is especially so with regard to unreduced lifetime retirement benefits for workers in their fifties, and rich formulas paying as much as 3 percent of salary times years of service for life.

Meanwhile, many public-sector jobs now pay pretty much the same as comparable positions in private-sector employment, especially in various service industries. (There are notable exceptions in the technology, technical, legal and some management positions, where pay gaps remain.) To compete for new hires with private employers during the boom-economy years of 1999 and 2006, public employers escalated salaries. Because most recruits younger than 33 place little value on retirement benefits, the salaries and wages of public employees had to be raised to private-market levels simply to attract new hires. And during those boom years, the tax revenues of state and local governments were flush enough to pay the costs of higher entry-level compensation.

Now that the Great Recession has clobbered the economy and unemployment is 10 percent, many private employers (excluding Goldman Sachs) have trimmed their 401k contributions and their bonus payments. The result: Total pay and benefits of public employees rivals or exceeds many private employees', especially when you take into account the costs and value of the pensions and retiree medical benefits. With the demise of manufacturing employment, the public-private pay gap for unskilled and semi-skilled workers has vanished. No wonder that applications for firefighter positions outnumber vacancies by huge ratios.

As my recent column on fair public pensions explained, the average civilian public employee can reasonably be expected to contribute 15 percent of pay toward retirement benefits, including pension contributions, Social Security taxes and retiree medical plan contributions. Right now, very few pay that much. So, the first step toward compensation and retirement plan reform in the public sector is to begin requiring employees to contribute half the cost of their retirement benefits.

In the private sector, most employers pay less into their retirement plans, and nothing for retiree medical, so those employees really need to be saving 20 percent at the workplace or at home for the same purposes, plus their Social Security and Medicare taxes, to replace their earned income. Thus, the pay of public employees should mathematically be 9 to 12 percent below the levels of comparable private-sector employees, when the gap in retirement benefits is close to these averages. And this would assume that public workers pay their half of the costs of retirement benefits, including retiree medical, which few do. For those mainstream civil servants now enjoying a free ride on pension and retiree medical benefits, the salary and wage base should technically and arguably be 15 to 30 percent lower than comparable private employment.

Until unions and politicians accept realistic and sustainable retirement benefit structures, a strong case could be made for public employers to freeze salaries and wages in many job titles, and require higher employee contributions to retirement plans until the total cost of compensation is re-aligned with the rest of the labor market. The absence of new revenues to pay for rising benefits costs in coming years will compel this New Normal realism.

In some communities we may actually see de facto 5-year or even 7-year salary freezes until a new equilibrium is attained. And when pay raises are awarded, many employers will have no choice to but take them right back with higher mandatory employee retirement plan contributions. It could be a Dark Decade in public pay until compensation is realigned with fiscal capacity. With so many non-governmental workers unable to find other gainful employment alternatives, that may be where the market will settle.

Traditionally, there are other reasons that public sector pay should be lower than private compensation. Those would include (1) the relative job security of civil service and unionization in the public sector compared to more-volatile free-market conditions in the private sector labor markets, and (2) the social mission of public service. When I worked in local government and the non-profit associations that served them, we called this "psychic income." It didn't put food on the table or buy fancier houses, but it did provide some personal gratification that is often lacking in private employment. My experience with psychic income is that it lasts about 10 years, and then the Grinches at city hall and state offices begin to dishearten even the idealists.

Public employees will point out that they don't receive profit-sharing, bonuses and other private-sector perks that some workers in the private sector receive. However, the market sectors where such variable-pay features of compensation prevail are typically unrelated to most governmental employees' work. Bonus payments and profit-sharing are typically aligned with highly volatile revenue markets (such as the financial services industry) where such payments are cyclical and profit-dependent, and individuals are accountable for meeting sales and profit goals -- with a real risk of failure without civil service or union protection for underperformance. Such Darwinian "extras" are more typical in managerial positions with mobile professionals than rank-and-file.

Critics of my calculations will claim that public employers cannot possibly hire new employees by paying salaries that much lower than private compensation. If that is the case, then retirement benefits may need to take a back seat to the paycheck. However, there is another solution to this dilemma that would preserve the public-sector retirement-adequacy paradigm: Give all new hires an option to convert one-half of their retirement benefits to an explicit defined contribution benefit. The D.C. plan would be visible to the employees in quarterly account statements and portable so that it follows them from one employer to another or vests and accumulates early enough for them to see the value. When they see a big percentage of their salary going into a personal retirement savings account, they will appreciate its value immediately.

That approach also balances the risks and rewards of the retirement plan's investment returns more fairly between employers, taxpayers and employees. For those who want to stick with the security of a fixed public pension, that option can be retained -- with a provision that cost-of-living allowances cannot be guaranteed if the pension fund fails to achieve full funding. Otherwise we're right back to the soup we're in today.

In this lingering period of high unemployment, public employers will increasingly demand a new tier for retirement benefits, as well as new entry-level pay scales and more benefits cost-sharing by incumbents. Nobody likes the idea of employees working side-by-side and getting different pay, but that is where the market and the labor-contract legacies have left us. Let's not forget those technology workers who demanded higher pay during the dot-com bubble years because new entrants were commanding higher market pay levels. Senior public managers need to think through the parity and equity issues, design compensation plans that weather the ups and downs of the economy and avoid images of excessive compensation.

It's going to be even harder to attract, retain and motivate talented public servants in light of these harsh economics. Top-level managers face the double-whammy of lower pay and non-existent incentives for themselves plus little appreciation for the challenges they face in some labor markets while total compensation is excessive in others. I wish I could offer a rosier outlook, but unfortunately, the money just isn't there. So my analysis here is designed to describe the New Reality -- not because it's what I want to see, but because that is where the budgets will take us.


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