Last month's GOP tidal wave swept new governors and legislators into office with a pledge to shake up the public pension world. At least six new governors are exploring the idea of replacing traditional, unsustainable public pension plans with something like corporate 401(k) accounts. San Diego Mayor Jerry Sanders has also announced a proposal to replace city pensions with a mandatory defined contribution plan for new employees, the largest U.S. city to consider that strategy.
Unfortunately, what works as a campaign slogan won't work very well for most state and local governments.
The real world is far more complex place. Not that it's a bad idea to reduce the nation's reliance on pension plans as the primary vehicle to fund state and local government employee retirement plans. But genuine long-term solutions will require more than a quick oil change. We need to rebuild the transmission and retread the tires as well.
Legalize 401(k) or "401x". First, Congressional Republicans should push to legalize 401(k) for the public sector since they were the ones who outlawed them. Ever since the Reagan tax reforms of 1986, federal law prohibits state and local governments from offering 401(k) plans unless they were then in place already . So we need to stop referencing defined contribution plans for public workers as "K" plans when they are really 401(a) defined contribution plans — at least in the governmental policy media. A 401(a) plan has fixed, non-discretionary contribution rates for employees and employers, unlike the more flexible 401(k) plans in the business world.
States and localities should first lobby Congress to universalize the 401(k) plan so that public employers could use that instrument just like everybody else. It's been called "401x" in the trade press, which would be a universal defined contribution plan that would work for government and nonprofit employees exactly as it does for private sector workers. The public employee unions will resist this idea if there is not a provision to allow police and firefighters to withdraw savings before age 59 1/2 as they can with 457 deferred compensation plans, but that is a manageable technical problem. All it takes is one paragraph to eliminate that objection.
Cap, don't eliminate, pensions. Second, the idea that public pensions should simply be replaced entirely by 401 plans is an inferior strategy. It's even worse when politicians carve out the public safety employees from their defined contribution policy proposals in order to maintain their union support in the polls. Talk about duplicity! Any claim that this exemption is necessary to "attract and retain" police and firefighters is just rhetoric. It's been proven elsewhere that a reasonable hybrid plan can easily provide market-competitive benefits, and few police and firefighters ever job-jump to new employers to glean bigger pension benefits. Those who follow the public opinion polling will tell you that such carve-outs actually turn voters off, because the "9/11 halo" long enjoyed by the first-responders has been tarnished by widespread reports of their $100,000+ pensions.
What would serve the taxpayers better is a ceiling on public pensions equal to the median family's household income. Right now, that averages $50,000 nationally and $56,000 in the more affluent, populous states of California and New York. That level still assures employees of retirement security — which is the mantra of the pension advocates. Nothing needs to change for pensions of lower-paid employees. But a ceiling at this level would compel those earning more than twice the median American's earned income (to produce a pension that exceeds average household income) to share investment risks with their employers. It also prevents egregious "spiking" abuses through abusive overtime pay, vacation and sick leave accruals, and bonuses. That irregular and extraordinary income belongs in a defined contribution plan where it can't be abused the way pensions invariably are.
Closing a public pension plan entirely to fund a 401(a) plan is like cutting off one's nose to spite the face. A closed pension plan can no longer assume perpetual investment returns and must adopt a more conservative investment portfolio to meet its obligations. That reduces its actuarial discount rate and thus increases employer (taxpayer) contributions for current employees. Costs of running a collective pension trust are inherently cheaper than the individualized accounts required in defined contribution plans. A defined benefit plan can also provide a less expensive lifetime annuity than employees can buy from an insurance company. So elected leaders should use the most efficient vehicle to provide the foundation of retirement security. There is plenty of room for defined contribution plans to provide the remainder of the retirement benefit with far fewer abuses. Even the most prominent pension-reform organization in the nation has recognized these benefits and now endorses a hybrid solution.
Require employees to pay half the risk-free cost of their benefit. The fastest way for most public employers to reduce pension and retiree medical benefits (OPEB) costs is to require today's employees to contribute more to their retirement plans. My previous columns have advocated that employees should pay one-half the normal actuarial cost, which is the cost of the current service period's benefit. Normal cost excludes employer-borne unfunded liabilities that have resulted from poor plan design and investment losses.
What I have lately realized in the course of reviewing testimony and attending public hearings by the Governmental Accounting Standards Board is that employees should be paying one-half of the risk-free value of their benefit. I described this concept more completely in this week's companion column, so for this discussion I'll simply explain that new employees and those who received retroactive pension benefits increases should pay for the true cost of a risk-free benefit. Even though I don't agree that the risk-free rate should apply to governments who will bear the investment risks, it is only fair that most employees should pay their half of the true cost of a guaranteed annuity. Otherwise we are selling an annuity to employees at a fraction of its actual cost. This paradigm shift will make a huge difference in the employer's net cost, and is only fair in the aftermath of a decade of pension fund underperformance and disingenuous retroactive benefits increases.
Reform retiree medical benefits. New governors, legislators and elected executives will do their constituents far more good by focusing as much attention on their retiree medical benefits plans as they do the pensions. These so-called OPEB (other post-employment benefits) plans are twice as toxic to taxpayers as the pension fund. For employers that have naively awarded employees a lifetime of medical benefits that begin in their 50s, it is time to re-think that failing strategy. There is no private-sector labor market retention issue here, so that excuse doesn't work. Lifetime-guaranteed early-retirement medical benefits need to go the way of the Edsel and the dodo bird — and be replaced by defined contribution plans for pre-Medicare benefits. Public employers can still provide a modest Medicare supplement as a guaranteed defined benefit with employees paying half that cost, but that is about as much as taxpayers should be expected to provide. The sooner these adjustments are made, the sooner public employers will be able to award salary increases and fill positions vacated by retiring employees who cannot otherwise be replaced because of their exorbitant unfunded retirement costs.
Allow for voluntary opt-out. Employees who don't want to pay half of the full actuarial cost of risk-free, fuel-injected pensions and early retirement medical benefits should be given a chance to opt out of those programs and select a lower-cost option. Even better, they can be incentivized by retiree medical plan reform to keep working to age 65 — which will benefit the pension funds more than any single pension fund reform can ever achieve.
Require competitive benefits. Finally, the state legislatures should require that public employee retirement benefits be competitive in the real-world labor markets. This term can be defined to mean that the benefits do not exceed the level sufficient and necessary to attract and retain employees in the public and private sector labor markets from which they are recruited. Such a market test will outfox the unions that have played the labor arbitration game by comparing their benefits only with themselves. For example, the retirement benefits for laborers in trades from which firefighters are typically recruited are far less generous than the pension and retiree medical benefits that union firefighters win through collective bargaining and labor arbitration. The same goes for transit workers who never compare themselves with comparable positions in the private sector. When are public employers going to wake up and realize that the rules of the game are rigged against them — and the taxpayers who foot the bill?
These four items should be the top legislative agenda for governors seeking to reform public retirement systems, and the opening demands for public managers entering labor negotiations. In the next Management letter, I will explain the collective bargaining strategies and preparations that should accompany these general policy initiatives.