Retirement Benefits and the Incumbent Employee Conundrum

Bill baby boomers for their retirement costs -- before they get away.
September 24, 2009 AT 3:00 AM
Girard Miller
By Girard Miller  |  Finance Columnist
The finance columnist for Governing.

Our nation's public pension and retiree medical benefits plans are facing a financial crisis unseen in this generation. Stock market losses in 2008 have reduced the funding ratios of the pension funds from 85 percent to about 70 percent. The remaining time to return them to full funding before baby boomers retire is getting shorter by the day. Retiree medical plans (known as OPEB for "other post-employment benefits") are in worse condition, almost entirely unfunded, because nobody ever bothered to set them up right in the first place. In many states, the cost of proper funding will be a 30 percent to 50 percent increase in pension and OPEB contributions in the next three years. In several states, the annual tab will double -- at least.

Regardless of political ideology, most public policymakers agree that, given the current financial squeeze, something needs to change. Typically, those who seek to reform these systems begin with new employees, because they are invisible. Over the coming decades, younger workers are likely to receive lower benefits than current employees. But what about incumbent employees? Shouldn't they share some of the load?

Here it gets tricky for public managers. The law is pretty clear in most states: You can't reduce pension benefits of retirees. And in most states, a similar rule applies to the previously earned benefits of incumbent employees: They are entitled to what they have already earned for past service. It's a property right, especially for those who have achieved vesting status. But with respect to their future work and the compensation employees receive for their services in 2010 and later, there are vast interstate and ideological differences of opinion about legal rights as well as basic principles of fairness.

It gets even murkier when the focus shifts from pensions (which sometimes are constitutionally protected) to OPEB retiree medical benefits, which some states view as "subject to appropriation" -- which means that elected officials could change their minds any time in the future, at least in theory. In fact, over half of the states have never bothered to create the legal structures necessary to properly fund retiree medical benefits, which adds to the argument of those who suggest that these benefits could be discontinued by an act of the employer and certainly could be discontinued with respect to unvested employees.

How can benefits be guaranteed by a previous legislature that never even bothered to set up a trust fund requirement to back up its promises? If a court were to hold that the legislature mandated those unfunded benefits for incumbents as a matter of law, but failed to provide the essential trust funding mechanism necessary to assure proper financing, then local governments should be able to sue the state for the unfunded mandate and a defect of statutory design.

Public managers now face a true dilemma as they seek to reduce retirement plan costs. If they only change the benefits plan for new employees, they produce very slim cost reductions in the next five years. Until these "new" employees become a significant portion of the workforce and aging baby boomers head off to pasture, the actuarial reductions will be minor in comparison to the swelling costs of providing current benefits to incumbent employees. But changing benefits for older workers -- even for their future service -- is a hot potato. In some states, the attorney general has ruled that it's off limits. The theory is that the benefits plan was part of the original wage bargain, sort of a social compact in the spirit of Rousseau and Hobbes. And at the very least, it is almost impossible to cut back benefits that are covered by a union contract until that contract expires.

So, what are the options for public managers and elected leaders seeking to rebalance their budgets and their governments' long-term capacity to pay benefits for retirement? The path of least resistance in many cases will be to bargain for or impose higher employee contributions. This strategy leaves the benefits for incumbents intact, but requires them to pay a fair share of the costs. I've written before about this strategy in a prior column and won't belabor the details here. Many would argue that this is actually the fairest solution because older workers typically earn more and will make greater contributions for benefits that they now value the most. A case could be made for age-based contribution rates that impose a higher percentage rate on older workers than younger workers, to reflect more accurately the higher value of their retirement benefits as they approach the age of eligibility. Actuaries can confirm that the cost and value of a defined benefit rise exponentially as retirement approaches, so age-based rates would align the senior employees' contributions with the increasing value of their higher benefit as it accrues in their later years.

If employees are unwilling to pay an increased share of the benefits, however, there is only one other way to balance the books actuarially without busting the budget: Change the earnings formula for work to be done in the future. Before heading down this path, however, public managers must brace for legal challenges and would be wise to first understand their state's constitutional and statutory environment with respect to retirement benefits for public employees. Then there is the issue of negotiating a benefits reduction for older workers when the union representatives usually are (you guessed it!) older workers. Then add to the mix the problem in many public agencies that the managerial people on the employer's bargaining team representing taxpayer concerns are (you guessed it!) older workers who would themselves have to eat whatever they cook at the bargaining table. So there are conflicts of perspective and even conflicts of interest to overcome.

Elected officials must take the lead here. I see countless examples of diligent, conscientious public finance professionals who already see the handwriting on the fiscal wall and try to present a rational case for plan reforms to elected officials -- who want to simply wish away the problem by procrastinating. It's easier for politicians to pass the buck to the next generation. But in this case, the imminent rising costs of retirement benefits are about to hit the operating budget with hurricane-force winds during the terms of today's newly elected leaders. So it's time for some serious study sessions to discuss the options, understand the laws which apply and set strategy. Every newly elected official's orientation session should include a 20-minute introduction to the imminent retirement finance problems they face during their careers in public service.

One thing I can predict with certainty: Employers who fail to bill incumbent employees for part of the cost of their retiree medical plans before 2012 will regret their delays. That's because the U.S. Congress will inevitably raise the Medicare tax, as I have explained in a prior column.

Failure to act on the benefits and contributions of baby boom workers will allow tens of thousands of near-retirees to enjoy a free ride at the expense of future taxpayers and future employees. That's an outright slap in the face of intergenerational equity -- and another burden we will leave to our grandchildren. If ever there were a time to take the proverbial bull by the horns, it would be now.

Girard Miller
Girard Miller | Finance Columnist |