New Premises for "Pension Prop 13"

Constitutional curbs for runaway public pension plans
July 9, 2009 AT 3:00 AM
Girard Miller
By Girard Miller  |  columnist
Girard Miller is the Public Money columnist for GOVERNING and a senior strategist at the PFM Group.

Last year, a California taxpayer group launched a ballot initiative to cut back the benefits provided by public pension plans in the Golden State. They failed to gather sufficient signatures to qualify for the ballot. It's uncertain whether anybody will mount a similar effort in the coming year. Meanwhile, the terms "pension envy" and "pension apartheid" are gaining popularity. Reports of six-figure public pensioners, pension abuses, public-private benefits disparities and an epic funding crisis are swirling throughout the blogosphere.

Putting pension reform on the ballot is a huge task. I'm not convinced that voters will ever get as agitated about imposing limits on public employee benefits levels as they do over tax limitations that directly affect their pocketbooks. Taking benefits away from police officers, teachers and firefighters is not an issue that most Obama voters will support, and they clearly form the popular majority today. But there might be a way for public leaders and taxpayer groups to re-frame the debate by shifting the focus from the size of the benefits to who pays for them.

Worsening imbalances. Public employees enjoy pension and retiree medical benefits that now outstrip the average taxpayer's retirement benefits. Those retirement benefits are largely paid at taxpayer expense, although it wasn't always that way. The average employee contribution to the nation's largest public pension plans today is about 5 percent of pay, which is approximately half of what taxpayers must sacrifice to pay the expenses of their employers' actuarial contributions. In the case of police and firefighters, the ratio is far more severely skewed, with many localities paying huge percentages of their base salaries annually into the pension funds. Once public employers eventually start funding their retiree medical-benefits plans on a proper actuarial basis, the ratio of employer-to-employee contributions will worsen.

To put these numbers into perspective, imagine private-sector employees getting a 200 to 600 percent employer match to their 401(k) plan contributions. Their company's shareholders would throw management out on their ears as irresponsible spendthrifts.

Taking on the sacred cows. State constitutions protect pension benefits. State statutes protect pension benefits. Judges and arbitrators protect pension benefits. Union contracts protect pension benefits. Older public employees have made lifetime financial plans on the expectation of current benefits levels. Taking away an incumbent employee's retirement benefits is therefore a virtually impossible task -- and changing the pension payout formulas by citizens' initiative is 'ballot micromanagement' at its worst. Instead, there is a more principles-based strategy that breaks the stranglehold public employee unions have gained over legislatures, city councils, school boards and pension boards of trustees: Make employees pay half the cost of their plans. Focus on the contributions ledger, not the benefits ledger, to balance the books.

When public employees see their share of the true costs of retirement benefits withheld from their paychecks, they will appreciate the high costs of those benefits and become less prone to demand further increases. Retirement plans will become genuine partnerships. Abuses, such as pension spiking, will be viewed as larceny by co-workers who will no longer look the other way as pension scammers siphon money from the trust fund at their expense.

Unlike the previous attempts by taxpayer groups to cut benefits of public employees, this approach would garner strong support of the nation's governors, municipal associations, school boards and other public employers associations because public employees' earned benefits would remain intact but fiscal balance and sanity would be restored to the system. By providing a legal structure that enables state and local governments to systematically eliminate their pension and retiree-health deficits and balance their budgets in the new economic era, this approach could transform the landscape of public finance.

In California, an amendment as crafted below could ultimately eliminate roughly 20 to 25 percent of the state's entire longer-term structural budget deficit, and wipe out over half the associated red ink in municipalities and school districts by 2012.

The following six provisions would be solid building-blocks for any proposal for a ballot initiative to re-assert taxpayer and electoral control of runaway public pension plans:

o Employees should pay half the cost of their retirement benefits (equivalent to a 100 percent employer match)

o Retroactive benefits increases require voter approval

o Prohibit pension holidays (assure reliable funding)

o COLAs must be properly funded

o Finance underfunded plans without reducing public services

o Preserve and balance the rights of retirees, employees and taxpayers

1. Require employees to bear half the cost. The public pension funding crisis will end quickly if employees are required to pay half the actuarial cost of their retirement benefits. Public employee retirement benefits would become immediately sustainable if workers share equally in the costs and the risk of their retirement plans, as I suggested in a prior column.

Matching contributions from public employees would offset the upcoming increases in annual required contributions that resulted from ill-conceived union-rigged benefits increases in the last decade and subsequent investment underperformance. To the extent that public agencies then have money available left to pay higher salaries to workers to offset their increased payroll deductions, they can bargain for better cash compensation. A new equilibrium in public employee compensation can be achieved through this cost-shift, and total compensation and costs will be more transparent and visible to all.

Public employees could continue to receive a 100 percent employer match of their pension and retiree medical contributions, which would be far more generous than the workplace retirement match received by 90 percent of the remaining taxpayers in the state.

Even with reform, taxpayers will remain liable for past service liabilities. It would not be fair to burden new and younger workers for legacy benefits earned previously by older workers and retirees. A proper solution to that funding gap will be discussed later. (See # 5 below). A three- or four-year implementation phase should be allowed, to provide a reasonable adjustment period. Existing labor agreements must also be allowed to run out (See #6 below).

Suggested ballot language: At least one-half of the actuarially required annual contributions for prospective service benefits under a defined benefit retirement plan shall be paid by the participating employees. The legislature shall implement this requirement incrementally to become fully effective on or before January 1, 201X.

2. Require voter approval of retroactive benefits increases. Regular readers of my previous columns know that retroactive pension increases are one of my pet peeves. These schemes enable today's politicians to grant a costly unearned benefit for past service to incumbent employees and charge the entire cost to future taxpayers. It's the worst abuse of intergenerational equity in the entire field of public finance. Although the Governmental Accounting Standards Board (GASB) may eventually require proper expense accounting as described in my prior column, the GASB cannot compel actual cash payments. Absent pension reform legislation, the only real long-term solution to this perennial problem is a constitutional provision similar to Prop 13's mandatory taxpayer vote before new taxes are imposed. If local politicians want to pay in cash for the entire actuarial cost during the term of a labor agreement, they can still award a retroactive benefits increase; but if they want to slip the bill to future taxpayers, then voters must first approve.

Suggested ballot language: A majority of voters must approve any retroactive benefits increase in a retirement plan that imposes a cost on a public agency which is not fully paid in the current fiscal year or before expiration of an authorizing labor agreement.

3. Prohibit pension holidays. To assure proper funding of retirement plans, politicians must be prohibited from skipping payments to the pension plan during recessions or when stock markets are frothy, as they have done in the past. Sound plan design requires consistent, reliable funding, every year. This includes retiree medical benefits plans. Otherwise, the costs to future taxpayers will inevitably increase. If public employees are to be expected to pay half the costs, then they need to be assured that politicians won't renege on their share. All retirement security advocates should support this provision.

Suggested ballot language: Public employers shall make their actuarially required annual contributions to retirement plans on a timely basis. Trustees and beneficiaries of the plan have a presumptive right to enforce this provision.

4. COLAs must be funded. Public retirement plans should be permitted to fund cost-of-living or similar inflation increases, as long as employees are paying half the cost, and the plan funds the COLA benefits actuarially. Ad hoc COLAs should be unlawful unless the plan is fully funded and designed to remain so even after the next recession depletes the funding ratio. To put that into numbers, it requires a 117 percent funding ratio at market peaks, as explained in my June 2007 column on "overfunding," written just before the peak of the last market cycle. Inflation increases in retiree medical (OPEB) plans should be subject to this discipline as well.

Suggested ballot language: A public retirement plan that increases retirees' benefits for the cost of living or healthcare cost inflation must incorporate such provisions in its actuarial calculations. Extraordinary or supplemental post-retirement benefits increase shall not be awarded without a vote of the people unless the plan's assets exceed its actuarial accrued liabilities by an amount historically sufficient to remain fully funded throughout a complete market cycle.

5. Remedial taxing and bonding authority. A viable long-term plan must enable public employers to properly fund their underwater pension and OPEB plans. A thoughtful constitutional amendment therefore should grant fiscally disciplined public employers the additional interim taxing authority to pay off past deficits which now total $2.5 trillion nationwide. Without cutting public services, we must properly amortize past service credits (unfunded liabilities) either directly through the budget or by issuing "benefits bonds," as described more completely in my previous column on model retirement plan legislation. This would enable public employers to issue pension obligation bonds or OPEB obligation bonds to fully fund their retirement plans deficits, and collect sufficient additional taxes to pay the debt service without obtaining a further voter approval. Alternatively, those who prefer to avoid debt can simply amortize their past liabilities actuarially through the annual budget. Elected leaders can choose the most cost-effective path to full funding.

Rather than writing a blank check, however, this extraordinary taxing authority must be made conditional on a permanent reform: the introduction of a defined contribution feature for new employees. This reduces the risk of a future unfunded liability. Thus, public employers who seek the additional revenues to pay off accumulated benefits liabilities would first have to restructure their plans -- to assure taxpayers that it won't happen again.

Nobody will be forced to institute a defined contribution (DC) plan. Employers who prefer to retain their current arrangements may do so, as long as they fund them properly. Only those jurisdictions seeking additional, non-voted taxing authority to pay off their previous pension and OPEB (retiree medical benefits) debts would be required to first establish a hybrid DC plan for the next generation. Benefits may not be increased as long as such taxes are levied. That way, taxpayers are assured of future cost relief in return for underwriting the legacy costs of today's unfunded liabilities.

This formula makes economic sense. Business groups and good-government associations should support a rule that balances government budgets and cuts the risk of future pension funding deficits by 75 percent through cost-sharing, actuarial amortization and an optional defined contribution feature. Retirees and senior employees who want to assure that their benefits can actually be paid from a fully funded plan, rather than relying on IOUs, would also be wise to support this concept rather than listen to their union bosses.

Suggested ballot language: A public employer that (a) establishes and maintains a defined contribution retirement plan for new employees before January 1, 2016, which (b) replaces or eliminates at least one-half the defined benefits previously provided with a commensurate employer cost reduction, (c) may levy taxes without limitation and without voter approval to fund that portion of the annual employer contributions required to actuarially amortize the predecessor plan's unfunded liabilities arising from employee service prior to (date initiative is qualified). Taxes for this purpose may also be levied without limitation to pay the principal and interest for debt obligations issued solely to finance the reduction of those prior unfunded liabilities. Retirement benefits shall not be increased so long as such taxes are levied, unless approved by the voters.

6. Sanctity of contracts, vested benefits and the public's right to change prospective benefits. A ballot initiative should make it clear that current retirees' benefits will not be reduced, that incumbent employees will retain all vested rights, and that every employee's previously earned benefits cannot be abridged. Existing union contract provisions should be respected until they expire. On the other hand, voters can require that an incumbent employee's prospective benefits for future service may indeed be changed. These ground rules already exist in some state laws, but including them in a ballot initiative will pre-empt union scare-tactic allegations that earned benefits could be robbed from retirees and employees, or howls that a constitutional amendment might revoke a current labor agreement.

Suggested ballot language: Nothing herein shall prevent a benefits increase if approved by the voters. Retirement benefits previously earned by public employees cannot be reduced. Prospective retirement benefits for future service can be modified through legal due process. This initiative will not abridge any provision of an employment agreement effective prior to (date initiative is qualified) for the duration of that agreement. Subsequent agreements shall conform.

A pragmatic political outlook. The spotlight must shine on how much public retirement benefits actually cost. If taxpayers see the bills they now are paying, it will be counterproductive for employee groups to argue that they can't afford to pay their half of these benefits. Trimming their employers' retirement-match back to a "mere" 100 percent will sound quite generous to most taxpayers. Plus, there is nothing in this approach that prevents a public employer from raising salaries to offset the employees' higher pension costs -- if such salaries are justified by labor-market conditions and the employer has any money left in its budget.

I don't make a practice of collaborating with interest groups, taxpayer associations or lobbying organizations, but these suggestions could provide the conceptual foundation for grassroots reform of public retirement plans. I would prefer to see governors and legislatures tackle this job -- as they were elected to do -- but many of them are now beholden to public employee unions that repeatedly block any serious efforts to enact pension reforms.* In states like California with constitutional tax limits, the statewide supplemental revenue authority in my proposal would require voter approval, so an initiative measure is necessary to restore proper funding.

In light of the cost avalanche that will hit public budgets when the full bills of their retirement plans finally come due, the ballot box may be our public retirement systems' only remaining hope for fiscal solvency and genuine long-term sustainability.

* Today's companion column on labor negotiations provides a road map for those brave enough to face down the unions.