Just as several states start curbing the powers of public labor unions to negotiate retirement benefits, two major nonpartisan state-level reports released recently have caused additional shudders in governmental labor circles. Both came from states with powerful public employee unions. Both recommend that state leaders move the employees' cheese — or face a financial meltdown in slow-motion over the coming decade.
The first report came from a bipartisan commission of a state legislature known officially as the Commission on California State Government Organization and Economy, and more informally as the Little Hoover Commission (after the bipartisan federal commission of the last century, which focused on economy and efficiency in government). The commission concluded that:
- "Pension costs will crush government."
- "The math doesn't work."
- "The system lacks discipline."
- "The system lacks oversight and accountability."
These are the words of a bipartisan, standing legislative commission — not a bunch of union-hating, anti-government pension gadflies. The formal public response of the major public pension administrators was perhaps predictable but a bit disappointing. The rhetorical theme of the state's pension leaders had less to do with the guts of the report and more to do with acting like a mother hen protecting her royal chicks. They missed the point that the status quo is clearly unsustainable and it's time to fix these plans by making ends meet. They cling to hopes that an economic recovery will salvage their investment portfolios and fuel new tax revenues — even while public employers cut services to pay pension bills. It seems to me their mission is delivering retirement benefits that are affordable, reasonable, sustainable, sufficient and market-competitive — not just delivering an uncontrollable income replacement plan regardless of cost and fiscal capacity. They seem to be treading water, rather than acting like lifeguards to save the desperate swimmer.
The second epiphany was a report by the Pennsylvania Institute of Certified Public Accountants (PICPA). Its leaders stated quite bluntly that "the simple fact is the pension systems for school teachers, public employees and state lawmakers are not sustainable in their current forms considering the fiscal challenges the state now faces." One of its prominent legislative members went on to say that in the 1980s, the state Supreme Court "misinterpreted the constitution when it initially stated the [incumbent employees'] benefits couldn't be adjusted." He was referring to whether public employees' vested rights are irreversible benefits formulas during their entire lifetimes.
Now, it's my lifelong experience that when CPAs tell you it's time to smell the coffee, you need to wake up and start looking for solutions. If this were the private sector, there would be Sarbanes-Oxley overtones to the PICPA report, with class-action lawsuits following shortly.
Where the cheese must move. Both reports focused on the obvious need to adjust pension and retirement benefits of current employees as well as new hires — a concept that until now was avoided by politicians across the country and is now a heated topic pending in several courts today. This article will address five key areas to focus these efforts when retirement plans are unsustainable and cost-mitigating actions are required to preserve a reasonable level of benefits and the fiscal integrity of the employer:
- Employee contributions must be increased in many plans
- Pension multipliers for future service should be adjusted downward, if unsustainable and excessive
- Retirement ages and minimum service periods must be increased, even for current employees
- Retiree medical benefits (OPEB, or "other post-employment benefits") must be scaled back
- Public employees' total compensation — including retirement benefits — must not exceed private-sector labor-market levels
Reform for current employees is unavoidable and necessary. Authors and analysts for both the California and Pennsylvania reports have come to the conclusion long held in my columns: The stock market alone cannot save today's pension funds from the $800 billion in underfunding problems that they have accumulated from overly generous benefits increases, a decade of stock-market underperformance, and employer underfunding. To make matters worse, nearly $2 trillion of liabilities of retiree medical benefits program are almost completely unfunded with assets invested to offset 5 or maybe 10 percent of the total bill for benefits already vested and earned. So the savings from pension reforms applied only to new employees cannot possibly save enough dough in the coming years to bail out these pension funds and the public employers whose tax revenues are growing too slowly to wallpaper over the long-term structural problems.
This leaves lawmakers with a dilemma in many states where the courts have determined through case law that public employees become vested in a benefit formula their first day on the job. That seems to be the case in California and Pennsylvania (according to the labor advocates) even though there is no explicit constitutional provision to that effect as there is in a few states. Employers will face court challenges any time they try to do what private companies do in similar situations: freeze the benefits of workers for service they have already performed and start a new, lower benefit level prospectively for future service. As I have written before, the federal Employee Retirement Income Security Act (ERISA) provides clear guidance that, for private-sector workers, past vested accruals are sacrosanct but future benefits accruals can be modified. What the California and Pennsylvania reports both suggest is that a similar standard should be invoked for public employees as well, even if that requires new legislation or even constitutional amendments that must then withstand judicial scrutiny.
Federal court cases. Legislators seeking to enact retirement reforms along these lines face a gauntlet of state and federal legal issues. Right now, there are several cases pending in federal courts which address the issue of whether public employers can abridge or impair a contract with their workers and retirees giving them lifetime rights to benefits earned and to be earned. The key tests that keep coming up are (1) whether the retirement plan must be modified in order to survive and provide as many benefits as possible to vested participants, (2) whether the changes invoked are necessary to achieve that purpose, (3) whether the changes invoked are the minimum amount or level of changes necessary [thus doing the least harm to beneficiaries] and (4) whether the resulting benefit is a reasonable benefit. Clearly a pension reform plan that affects only prospective benefit accumulations will pass muster under these criteria as opposed to a law that also changes benefits retroactively. If a state enacts laws that protect the legal, vested rights of employees to benefits they have already earned, then the focus shifts to the level of contractual rights conferred to employees and whether there is a less harmful way to reform the plan.
Thus, it appears that a key test for courts to consider is whether the retirement system and its employer(s) are facing such distressed conditions that changes in benefits and plan design are now unavoidable in order to save the system. In that regard, the findings of a legislative body will likely weigh heavily in a court's thinking and should form a solid foundation for how the benefit reductions are structured. Likewise, a citizen's ballot proposal seeking to roll back benefits would be wise to include a rational and valid basis for determining when an "emergency" exists that would compel modifications of a contract. For example, a ballot initiative could declare that retirement plans must be adjusted if their funding ratio falls below a level of 79 percent on a market value basis and the employer's rising actuarial contributions require it to reduce the workforce or employees' cash compensation.
State law issues. At the state level, the first challenge facing some legislatures is constitutional. A few states have hard-wired their benefit promises into the state constitution and others have adopted language that suggests certain retirement benefits are a contractual right. If a constitution is involved, either by express language or by state supreme court decisions, then the only viable way to change the rules for incumbent employees would appear to be a constitutional amendment, which must then of course still clear the federal courts on a test of contract law. If the issues are essentially statutory, then the legislature would be free to change the ground rules with the caveat that federal contract law could still be an issue if there is a basis for claiming that employees were told they had a right to the continuation of a current benefits formula and that promise was authorized formally by the governing body in a statute, ordinance or resolution expressing clear legislative intent.
Against this backdrop of legal considerations, here are five areas where the laws will be tested or amended in coming years. These are the pressure points where employers and legislatures most need to mitigate retirement benefits costs of incumbent employees along the lines of the California and Pennsylvania reports.
Employee contributions. Employee contributions are the easiest plan feature to change in many cases. They are an essential topic to address before reducing benefits. Remember that one of the tests in some of the federal courts is whether the change proposed is the minimum necessary. If a retirement plan can be "saved" by simply raising employee contributions, and without reducing benefits, it would seem likely that this would be the most suitable and least invasive solution.
One would think that raising employee contributions is a no-brainer, but one large statewide pension fund has reportedly been advised that its participants may have a constitutional protection of their contribution rates. I know that sounds laughable to most of us, but policymakers must realistically anticipate such lawsuits.
Now, if employers also require current employees to contribute for the amortization of unfunded benefits they have been awarded, then matters become murkier. Such costs are not evenly distributed over the workforce, as older workers have higher associated costs. A solid case can still be made that current employees should share in part of that cost as well, if they were awarded benefit increases retroactively. I would expect, though, that a higher standard of proof and equity must be achieved. For example, it would not be fair to force new hires to pay for the amortization of retroactive pension benefits given to senior workers — that would shift costs to an innocent younger generation to pay for their elders' benefits. A reasonable test would be that no service cohort should pay more than half of the actuarial cost associated with any benefits awarded retroactively (e.g., employees with five years of service should not bear more than their share of such costs).
Pension multipliers. The next plan feature that could be adjusted prospectively is the pension multiplier. For example, there is no justification anywhere for a 3 percent pension multiplier when 2.3 percent is sufficient for public employees outside of Social Security and 1.7 percent is adequate for civilians receiving Social Security. A multiplier of 2.5 percent can be justified for public safety workers who retire outside the Social Security system at age 57. These multipliers will provide an 85 percent income replacement ratio commonly used by financial planners for retirement planning purposes, even for new employees. Even-lower multipliers could be justified for incumbents who have already accumulated higher-octane benefits, but there is no need to be punitive here. In all cases, these multipliers should be combined with realistic longevity-adjusted retirement ages.
Retirement ages and service requirements. Here it gets trickier for incumbent employees. Almost everybody agrees that retirement ages must be raised to reflect increased longevity, as well as to bring the benefits in line with sustainable financing levels. One way to accomplish that is by extending the accumulation period and shortening the distribution period. However, it is not fair to raise retirement ages dramatically for older public workers who have already toiled for 20 years and are just a few years away from retirement. That does not mean they should skate through without working a little longer. As I have previously suggested, an adjustment for civilian employees' normal retirement age should not exceed more than 2 months for every year now remaining before a worker's expected retirement age. So a 55-year-old librarian now eligible to retire at 60 should not be required to work beyond 61 under a new age requirement.
In an era when older, tax-paying employees in the private sector must keep working another five years to restore their still-shrunken 401(k) accounts before they can afford to retire, this normalizing of retirement ages for public employees doesn't seem like too much to ask.
For public safety workers, the math is more complicated. They have shorter career spans and unsustainably early retirement ages under current plans that typically allow retirement before age 57. A requirement for those with less than 15 years of service to work an additional five years (if the current plan threshold is less than 25) would be reasonable, but it would not be fair to impose a five-year extension on those beyond age 50 with 20 years of service.
One standard that legislatures can adopt is a birth-year bracketed framework for required-age changes (e.g., no more than five added years for employees born before 1975, no more than two added years for those born before 1960). That framework should be coupled with an explicit individual employee's protection that any change in the retirement age cannot be so large that the actuarial accrued value of previously earned benefits would be less than the worker's full-career benefits under a higher-age requirement that would shorten the payout period.
This provision to preserve accrued actuarial values at the individual level would empower public employers to seek plan changes more aggressively. They don't have to over-compensate nine employees just to be sure that one grandfathered worker with an atypical service history is protected. Plan changes can be more rational as a result, rather than "gerrymandered" all around to accommodate a small group of atypical employees. And of course the actuaries will love it because it increases the demand for their services, which would still be a fraction of the costs of over-compensating everybody else in order to grandfather the outliers.
Retirement age changes must be considered for retiree medical benefits plans (OPEB) as well. As costs escalate beyond budgetary capacity, many public employers will find it necessary to sharply limit their medical benefits payable to retirees before they attain age 65 and become eligible for Medicare. The problem is that many of these early retirees now become eligible to collect such more expensive benefits simply by reaching retirement age under the pension plan. Therefore, statewide laws that would compel a higher, sustainable age for collecting retiree medical benefits may be the preferable solution in some states — especially when the vesting and contractual rights of public employees for retiree medical benefits are less clear under local laws.
Along with age requirements, service requirements can also be increased. Incumbent civilians (general employees) can reasonably be required to work for 30 years before earning full retirement benefits, and receive actuarially reduced pension and OPEB benefits if they leave earlier. For public safety, a 25 year minimum seems reasonable, again with transition and actuarial make-whole rules such as those proposed above for retirement ages.
OPEB formulas and CPI ceilings. Two general reforms that state legislatures must consider for OPEB plans are a requirement that taxpayer-funded medical benefits for retirees that are awarded before age 65 may not exceed a reasonable limit, such as the $15 per month per year of public service (which I have suggested in a prior column), and a CPI inflation-adjustment limit on the benefit to help control public employers' exposure to medical inflation. Such statutory constraints will still leave public employers plenty of latitude in formulating their benefits plans. Employers can offer richer benefits after Medicare age, and they can always use a defined contribution plan to supplement these benefits if they want to enrich the plan. But this will put a much needed limit on future taxpayers' exposure to runaway retiree medical costs.
Limit total compensation to market-competitive levels. A final feature of reform for incumbent employees should be a requirement to limit total compensation for salaries and benefits to the levels paid in the private sector for comparable positions. The formula should include the full actuarial cost of retirement benefits including retiree medical and pension costs using generally accepted accounting principles. If pension and retirement benefits are out of line, this provision will compel adjustments to assure that nobody collects excessive benefits at taxpayer expense. If unfunded liabilities of retirement plans push total compensation above private market levels, this circuit-breaker would force cash compensation lower or employee contributions higher, to restore equilibrium.
Current employees' cheese will move: It's just a question of when. Obviously there are enormous legal challenges facing retirement reformers, public employers and legislators seeking to close the multi-trillion dollar retirement funding gap during the lifetimes of today's public employees. As the bulge of the Baby Boom generation crosses age 60, many senior public employees will soon attain retirement ages under current schedules and skip away into retirement without bearing the burdens that younger workers and future taxpayers will inevitably face. Although we should not overgeneralize because many public employers nationwide have properly funded, frugal plans with reasonable and affordable benefits, more denial and delay by the derelicts will only worsen those sacrifices and heighten the intergenerational inequity of today's unsustainable systems. That's what the Little Hoover and PICPA reports are telling us: It's time to move the cheese.