Out of the pension thicket

How Can Local Elected Officials Control Employee Retirement Costs

Employee retirement costs are a growing burden for California governments. As CalPERS and other multi-employer systems reduce their expected rates of return, required employer pension contributions are rising rapidly, usually outpacing revenue growth. As a result, retirement expenditures are crowding out other spending priorities, and, in extreme cases, could trigger local government bankruptcies in the years ahead.

While some local leaders may be tempted to cut benefits for current and retired employees, pension benefit provisions are protected under current court interpretations of the California Rule. This may change due to an appellate court ruling in Marin County last year that will be reviewed by the State’s Supreme Court. But even in the event of a favorable ruling, CalPERS member governments would not see relief until a ballot measure permitting benefit cuts is approved by state voters, since the union-beholden state legislature cannot be expected to authorize reductions. So relief may be many years away, if it arrives at all.

Another tempting alternative is to lay off workers eligible for generous pension benefits and then hire replacement workers who could be offered more modest defined benefits or even a defined contribution plan. This strategy would likely trigger a lawsuit from laid-off employees claiming age-based discrimination. Courts are sympathetic to plaintiffs in such cases, so it is unwise to incur the court costs that such a strategy would require.

A less palatable alternative – declaring bankruptcy – also does not appear to work. Three cities that went through bankruptcy proceedings in recent years – Vallejo, Stockton and San Bernardino – did not reduce employee pensions, and ultimately made all payments to CalPERS. On the other hand, the small city of Loyalton appears to have avoided its pension obligation by simply defaulting on its CalPERS payments. The retirement system decided to cut pension benefits for city retirees rather than pursue the matter in court. With a population of less than 700, modest household income and very low average home prices, Loyalton does not appear to be capable of making the $1.6 million termination payment CalPERS demanded, so its situation may not offer much insight into how CalPERS will react to defaults by larger agencies.

Having considered some approaches that don’t work, let’s look into more promising alternatives. These include: (1) making extra payments to the retirement system, (2) contracting out services to private firms, (3) increasing employee pension contributions and (4) reducing Other Post Employment Benefits (OPEBs).

Extra Payments

Several California local governments are taking advantage of today’s relatively good fiscal conditions to make extra contributions to CalPERS. Each year, actuaries working for CalPERS and other pension plans calculate the amount member agencies must contribute. This amount, known as the Actuarially Required Contribution (ARC) or Actuarially Determined Cost (ADC), is intended to cover benefits accrued by current employees and to partially pay down unfunded actuarial liabilities. While agencies are legally required to pay this actuarially calculated amount, they can choose to pay more. By doing so, employers can more rapidly reduce or even eliminate their unfunded liabilities.

California agencies currently making extra contributions include Santa Monica, Calistoga (in Napa County) and the Orange County cities of Costa Mesa, Fountain Valley, Huntington Beach, Laguna Beach and Newport Beach.

This strategy is not without risks. If CalPERS suffers portfolio losses – as it did in 2008 and 2009 – these prepayments will be hit. Public agencies would then be obliged to make up these losses. Since most CalPERS assets are invested in equities and since the stock market has been rising for more than eight years, a near-term decline is a distinct possibility.

Contracting Out

The fewer public employees on a government’s payroll, the less exposure that government has to pension costs and risks. One way to lower headcount without reducing services is to rely on external contractors.

Many cities already contract with their counties for police and fire services. This approach doesn’t avoid retirement cost burdens: bills to the city include pension contributions for the police officers and firefighters provided by the county. Although they still pay pension costs indirectly, contracting cities can eventually avoid paying a share of the county’s underfunding by terminating their contracts and in-sourcing the services.

A better option would be to outsource functions to private companies that do not have expensive pension plans. Although theoretically possible, elected officials may have to overcome political hurdles before transferring services from public employees to private providers.

The City of Costa Mesa has learned about these challenges first hand. In 2011, the City Council decided to contract out 18 municipal services and send pink slips to more than 200 city employees. The public employee union went to court and obtained an injunction against the city’s outsourcing plan. Although Costa Mesa was ultimately able to dissolve the injunction, it ended up contracting out only two of the 18 targeted services and not laying off any employees. The city also incurred $1.8 million in legal costs, and agreed to reimburse the union for $375,000 of its legal fees.

Increasing Employee Contributions

Although employers cannot reduce pension benefits for current employees, they can require employees to contribute more toward their benefits. Since actuarially required payments to a multi-employer plan may come from either employees or the agency, every extra dollar employees contribute is one dollar less that has to be paid by the agency.

Changes to employee contribution rates often become contentious issues in labor negotiations. In many cases, employers get the union’s agreement to increase rates in exchange for a pay hike. If the pay increase and the contribution increase are identical, the net benefit to the agency’s budget and thus to taxpayers is zero. Elected officials need to ensure that pay and pension contribution deals generate real savings; otherwise, they are just window-dressing that misleads voters into believing that meaningful action has been taken.

One option that may be less objectionable to some unions is offering less expensive benefit packages to new hires. The state’s 2012 Public Employee Pension Reform Act made a step in this direction by limiting benefit formulas available to new hires, but individual agencies could go further. Ideally, new employees would receive a defined-contribution plan only, thereby eliminating the agency’s pension funding risks for these new hires.

Another alternative that may be acceptable to unions is to vary employee contribution rates with system costs. In this case, employees would actually save money when their pension system’s actuarially accrued liability goes down – which can happen in years that CalPERS investments perform well. But if the Actuarially Required Contribution (ARC) rises, employees would have to contribute more, somewhat offsetting the agency’s increased costs. This type of cost sharing was recently implemented for new public safety employees in Arizona, in the wake of a pension reform proposed by the Reason Foundation and supported by public safety unions. The approach better aligns the interests of employees and taxpayers, which may improve labor relations going forward.

Reducing OPEBs

Relative to pensions, California public agency employers have more flexibility to reduce Other Post Employment Benefit liabilities. When Stockton filed its municipal bankruptcy petition in 2012, it immediately eliminated retiree health benefits. The bankruptcy court denied an employee’s petition for a restraining order – allowing Stockton’s decision to stand. Ultimately, the city agreed to make a lump sum payment of $5.1 million in lieu of providing future retiree health care – an amount that was less than 1% of the city’s $544 million OPEB liability prior to bankruptcy.

Nor is it necessary for public agencies to undergo bankruptcy to reduce OPEB costs. In 2009, San Diego imposed a cap on the per-employee cost of health benefits. A retiree sued the city, claiming she was entitled to increased benefits in line with the increasing cost of her insurance. But the Court of Appeals ruled in favor of San Diego. The California Supreme Court declined to hear an appeal, leaving the lower court’s decision in place.

Thus, it appears that California public agencies are entitled to cap, reduce or even eliminate OPEBs. While eliminating retiree health benefits entirely would yield the most budgetary savings, it may be politically impossible in many jurisdictions. An alternative strategy could involve the use of Covered California, our state Obamacare exchange that now appears likely to survive federal Republican healthcare reform efforts.

Generally, it is more expensive for a public agency to provide health care to retirees under age 65 than those who have reached that age. The reason is that retirees who are at least 65 years old are eligible for Medicare, and thus the state or local agency needs to provide only a wrapper policy to its older retirees. This wrapper – or Medicare Supplement Policy – may help with the cost of deductibles or copayments normally required of Medicare beneficiaries; it might also cover all or part of Medicare premiums. Because the federal government pays most of the medical costs incurred by its beneficiaries, the cost of these wrapper policies is relatively low compared to insurance products required for those younger than age 65.

Under Obamacare, individuals and families below age 65 with income above 133% of the federal poverty line (FPL) can purchase insurance policies on Covered California. Those with incomes between 133% and 400% of FPL receive a federal subsidy toward the payment of their insurance premiums.

By switching retirees under age 65 to Covered California, public agency employers can leverage two potential sources of cost savings. First, insurance products on Covered California can be accessed by a larger pool of individuals. The more individuals in any insurance pool, the less risk faced by the insurer – who now has more premium income to offset the possibility that one or more insured individuals will be affected by a condition requiring millions of dollars of health care. Some of these savings will be passed along to customers, especially because the health exchange increases price transparency and thus competition.

The second source of cost savings is the availability of the federal subsidy for those with incomes between 133% and 400% of FPL. Many public sector retirees fall within this income range, and can thus obtain subsidies – allowing their former employers to shift costs onto the broader shoulders of the federal government.

According to a National Bureau of Economic Research working paper, California state and local governments could save $142 million per year from switching retirees below 65 to Covered California The authors estimate that another $33 million of potential savings are available by switching lower paid retirees – those below 133% of FPL – to Medi-Cal. Given concerns over insufficient access to providers experienced by Medi-Cal beneficiaries, this latter cost savings opportunity may be reasonably seen as “a bridge too far” by many public sector employers.

The idea of transitioning public sector retirees to an exchange is not new; in 2013 a special Retiree Healthcare Benefits Commission in Chicago recommended this option to Mayor Rahm Emanuel, citing potential annual savings of $61.5 million. Later that year, the city reduced OPEB benefits under its own plan and suggested that retirees consider moving to the exchange on their own as an alternative.

One option for California agencies would be to transition all pre-Medicare retirees to the exchange and then provide a cash payment that could be used to offset the cost of premiums, deductibles and copayments. This payment should be based on the retiree’s income, phasing out entirely for former employees receiving pensions in excess of $100,000.

Conclusion

Unless and until our state relaxes the California Rule, local elected officials lack the silver bullet necessary to take down spiraling employee retirement costs. But as we have seen here, officials still have a number of options that may restrain the growth of this expense line.