Fair Pay for Public Employees: A Question of Efficiency

Designing a compensation system that is both fair and promotes efficiency is a real challenge.
by | February 2, 2011 AT 5:00 PM

Finally, something everyone can agree on: Public employees should be compensated fairly. While excessive pay for public employees is unfair to taxpayers, inadequate pay is not only unfair to public workers, it's inefficient. Agreed? Good.

So, what's fair? Ahh. Let the arguments commence.

Right now, a debate is raging over whether public employees are overcompensated.

A USA Today article notes that in 2009, federal employees earned $123,000 per year on average in pay plus benefits, compared to just $61,000 in the private sector. Even state and local employees averaged $70,000. At first blush, it sounds like public pay is way out of whack.

Not so, argues former Secretary of Labor Robert Reich. In his article, The Shameful Attack on Public Employees, Reich disputes the idea that public employees are overcompensated. According to Reich, "Even if you include health and retirement benefits, government employees still earn less than their private sector counterparts with similar educations." That last phrase covers a lot of territory. Reich contends that 48 percent of federal workers hold college degrees, compared to just 23 percent of their private-sector counterparts, and that on average the degree of difficulty of public work more than justifies any salary differential.

Indeed, the debate over public pay usually centers on averages. But here is the Goldilocks truth: Among any group of public employees, some are underpaid, others overpaid and still others are just paid about right.

Even among cohorts earning off the same pay scale, such as union teachers, janitors or firefighters, inequity prevails. The best employees are paid the same as the worst. How is that fair? Often, union contracts prohibit basing pay on performance. Seniority -- and the byzantine steps and lanes that go with it -- means that governments reward endurance rather than productivity. Does that make sense?

Fair pay is often in the eye of the beholder. Anti-government types will loudly complain about the New Jersey turnpike worker who made $321,985 or the Boston police lieutenant who made $271,882. On the other hand, public-sector managers know how hard it is to attract capable lawyers, accountants and IT professionals who are being offered more money in the private sector. Does government overpay or underpay? Yes, it overpays and underpays.

Then there is the whole question of pensions. While most of the world has moved to defined-contribution plans, or 401(k)s, the public sector is mostly still immersed in the defined-benefits world, a world where the public-sector employer -- and hence the taxpayer -- bears all the risk. During the recent stock market downturn, the typical taxpayer saw the value of their own retirement account decline. At the same time, they discovered they were on the hook to make up public pension shortfalls -- a double whammy that doesn't seem fair.

The structure of retirement benefits can have a huge impact on organizational effectiveness. Today, most public pensions are based on years of service and age at retirement. As a rule, these systems follow a "hockey stick" curve, meaning the value of retirement benefits increase dramatically over the last few years of service.

This creates a circumstance where employees in their late 40s and 50s can become financially trapped in their jobs. It often becomes economically prohibitive for these public employees to look elsewhere. The result is disgruntled yet immovable workers, frustrated managers and underserved taxpayers.

Some communities have taken steps to alter the playing field. Back in 1998, the city of Orlando, Fla., mandated that all new hires (except public safety employees) would be covered by a defined-contribution plan. Orlando's plan enhances the portability of retirement benefits, which is important in an era when individuals often change jobs multiple times during their career. The Orlando plan isn't ungenerous -- the city contributes between 7 and 10 percent of pay -- but it gives Orlando predictability and insulates it from the shocks of market downturns. Orlando wisely chose to "grandfather" in all existing employees, which avoided some messy politics.

Similarly, Utah closed entrance to its legacy defined-benefit pension system in 2010, offering new hires either a 401(k)-type defined-contribution plan or a hybrid plan. Though unions resisted the change, polls found that Utah voters supported the reform. The state contribution is capped at 10 percent, except for public safety.

Unlike defined-benefit plans, capped contribution systems are harder to game. The political temptation to sweeten retirement benefits for current workers has contributed to the massive underfunding of post-employment pension and health-care benefits -- hence the "trillion dollar gap" currently facing state governments.

Overpaid? Underpaid? Go ahead and knock yourself out with that screaming match.

But while you're at it, tackle this question: With the exact same pot of money we are spending today, couldn't we design a better compensation system? Some questions to consider: How can our compensation approach promote more efficient operations? Should seniority always bring higher pay? How can we attract and retain good employees yet make sure underperformers aren't rewarded?

Designing a compensation system that is both fair and promotes efficiency is a real challenge. Too many people, however, obsess over the size of the compensation package while ignoring the detrimental impact that the structure of both the pay and pension systems can have on operating efficiency.