Who Should Pay the Pension Bill?
As states face funding problems, retirees and employees will feel pressure to chip in.
Public pension and retiree health plans have become intergenerational Ponzi schemes: Today’s retirees enjoy rich benefits they never really paid for, while their grandchildren’s generation bears the brunt of that IOU. In the middle are baby boomers, who expect the benefits their elders now enjoy -- even after cooking up the rotten financial stew we’re now in.
Retirees understandably feel that they earned their retirement benefits and nobody should mess with them. In some states, they enjoy constitutional rights to untouchable pensions. Even when such legal protections are lacking, there are strong moral grounds to protect those who have left the workforce and have few options to compensate for benefit reductions.
The key issues for retirees are cost-of-living allowances (COLAs) and retiree medical benefits, also known as other post-employment benefits (OPEB). These are the spongier aspects of the retirement promise. In plans that built COLAs into their actuarial structure and promised perpetual COLAs by formula, the rights of retirees are pretty solid. Where politicians have declared ad hoc COLAs (when financial conditions allowed or political pressures overwhelmed them), retirees’ rights are far flimsier. This is particularly true at times like these -- when many states face serious pension underfunding issues.
OPEB benefits are far less well defined. In Texas, for example, the Legislature declared that retiree medical benefits are subject to legislative appropriation, which means there’s no legal guarantee of continued benefits. Retirees in such jurisdictions may face cutbacks on COLAs and dollar caps on their OPEB. In Colorado, Minnesota and South Dakota, pensioners have sued over decisions to trim retirement benefits, and more lawsuits along that line should be expected as laws are tested on this issue.
Incumbent employees have differing rights in various states. Many states protect employees’ pension rights for benefits previously earned, which nobody disputes. In some states, the constitution has been interpreted to mean that incumbents’ benefit promises cannot be reduced during their careers once they become employed. That leaves employers with only one tool to cut costs in their incumbents’ retirement plans: They must raise the employees’ contribution rates. This applies to both pensions and OPEB plans. At least a dozen states and many municipalities have raised employees’ contribution rates, often through collective bargaining. This trend will likely continue for several years and the ensuing two labor-contract cycles.
The next frontier in raising incumbent employee contribution rates may be the employees’ share of unfunded liabilities. In San Diego, where the city charter requires employees to pay half of their pension costs, City Attorney Jan Goldsmith has gone to court to compel incumbent employees to bear half the cost of the unfunded liabilities, as well as their current benefits costs. This makes employees liable for investment losses and actuarial shortfalls. Until now, my view had been that employees should not bear this responsibility. But in states where employees bargained for huge irreversible and retroactive benefits increases without making commensurate contributions, there’s a moral argument that a “clawback” to recapture part of those deals’ hidden costs is now appropriate.
Needless to say, the unions won’t share that view. But it may be the only practical solution when employers see pension costs double in the next three or four years. The only other realistic alternative in many jurisdictions will be a five-year or longer pay freeze for incumbent employees, and a hiring freeze for most of this decade, in order to pay for skyrocketing pension costs.
New employees are in a precarious spot. Everyone seems to agree that new employees’ retirement benefits are the easiest to reduce. Sadly this leaves us with a new generation of innocent workers who will toil side-by-side with culpable elders who get better benefits. That’s probably unavoidable, but they should at least be given two concessions. First, their payroll contribution levels for reduced pensions should be lower than their fat-cat baby boom predecessors, who should rightfully now pay more for their richer benefits. New hires should only be charged their fair share of the "normal" cost, which excludes payments for unfunded liabilities. Second, they should be given an option to join a hybrid-defined contribution plan as described in my September online column. That would give them a portable benefit with greater career and financial flexibility than their elders’ richer deals.