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Pension Reform Requires Mutual Empathy, not Enmity

Attending a high school reunion after more than a few decades ought to be a memorable experience for anyone. Hopefully the occasion is filled with warmth and remembrance, rekindled friendships, stories and laughs. But as our lives develop and we build our adult networks based on shared values and common professions, a high school reunion offers something else; a unique opportunity to meet people we knew very well and still care about, whose lives all went in completely different directions.

My high school classmates chose a diverse assortment of careers. Some became engineers, some went into sales, some are entrepreneurs; some work in high-tech, some in aerospace, others in construction. And some are teachers, some are police officers, and some are firefighters. Without any exceptions I could observe, all of them made conscientious choices, all of them worked hard, all of them were responsible with their savings and investments. And now they’ve reached the age where whatever retirement plans they made are unlikely to change much.

How to ensure government pensions are not blown up by the next sustained market downturn is a complex challenge, complicated further by ideological divisiveness and political opportunism. On one side are powerful financial special interests in the form of the pension systems, and their government union allies. On the other side are poorly organized taxpayer activists whose grassroots strength, combined with fiscal reality, attract support from increasing numbers of local and state politicians. But caught in the middle are the people who served in government jobs, the overwhelming majority of whom did those jobs well, and have earned the right to retire with dignity. It’s personal.

Figuring out how to make government retirement benefits financially sustainable should be part of a bigger conversation, which is how all Americans are going to have the ability to retire with dignity. It is part of a conversation even bigger than that – how to nurture sustainable economic growth while coping with an aging population, environmentalist considerations, globalization, debt/GDP ratios at historic highs, and mushrooming new technologies that present unprecedented potential to eliminate human jobs. All of these mega-trends are this generation’s challenge, all of them are urgent, all of them are personal.

It’s easy to solve all of these challenges if you are willing to ignore reality and hew to an ideological pole-star. Libertarian answers to social and economic policy issues inevitably advocate privatization. Socialist theorists inevitably advocate state ownership. But both of these ideologies, in their most orthodox forms, are utopian. Libertarians envision a stateless, humane society based on personal liberty and private ownership. Socialists envision a stateless, humane society based on common ownership. If these extremes are so absurd, why is the center so uninviting?

It’s a long way from Silicon Valley to utopia, but in that fabled land, anchored by what was only referred to as San Jose back when we were high school students there, thoughtful futurists abound. Some think we shall all become independent contractors, linked by technology to virtual employment opportunities all over the world. They believe secure full time jobs will wither away entirely, and everyone will thrive as free agents in a wired world. Others think automation will eliminate so many jobs, and create so much abundance, that guaranteeing a minimum income to everyone will be feasible and necessary, whether they work or not. The conversation taking place among the Silicon Valley elite regarding the political economy of our future is helping to define that future as much as their innovative new products. It’s a conversation worth listening to without ideological blinders.

My classmates who chose careers in public service, just like my classmates who pursued careers in the private sector, are starting to retire. Just like everyone else – our friends, our families, our neighbors – they want answers, not ideology. They want constructive solutions, not controversial schemes. Is there enough room in the political center to permit a conversation that sticks to facts and practical solutions, or will the professional chorus of perennial opponents crush them, abetted by all those millions who are comforted by inflexible ideologies?

One ideologically impure, centrist way to save defined benefits would be to borrow concepts from Social Security. Reformed defined benefits would be (1) awarded according to progressive formulas, where the more someone makes, the less the pension benefit is as a percent of their final salary, (2) there is a benefit ceiling which no individual pension can exceed, (3) pension contributions in the form of employee withholding can be increased without commensurate increases to overall salary, (4) annual pension accrual multipliers, going forward for active workers, can be reduced depending on the system’s financial health, and (5) when necessary, pension benefits to existing retirees can be reduced, in order to maintain the overall financial health of the system. Often that can be as little as skipping a COLA.

When political professionals, volunteer activists, policymakers, commentators, analysts, or anyone else influencing the pension debate speak on the topic, they should imagine the following situation: With every word, they are looking into the eyes of two close friends or family members, two people nearing retirement, one of them about to collect a government pension, the other a taxpayer who will rely on Social Security supplemented by a lifetime of personal savings. People who didn’t create the financial challenges we collectively face. People we love.

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Ed Ring is the executive director of the California Policy Center.

The Case for Adjustable Defined Benefits

Notwithstanding the fact that “adjustable defined benefits” might constitute an oxymoron, as a concept it represents the only way that defined benefit plans can be sustained. Rather than throwing new employees into individual 401K plans, while they effectively subsidize legacy defined benefits for veteran employees and retirees, why not adjust defined benefits down to a financially sustainable level and let everyone participate?

Let’s set aside for a moment the debate over whether or not defined benefit plans are just fine the way they are, and can survive with merely incremental refinements – eliminating spiking, raising contributions a bit, bumping the retirement age a few years. Those solutions buy time, but unless the investment market roars for another 30 years, they will not solve the problem. And in the context of equitable policy, that debate is moot, because if these plans are just fine, than nobody should object to reforms that will make benefits adjustable if and when they are no longer fine.

Three good examples of how adjustable defined benefits can be implemented are the proposed “Government Employee Pension Reform Act of 2012,” an California citizen’s initiative proposed by pension reformer Dan Pellissier that failed to qualify for the ballot, the City of San Jose’s “Measure B, Public Employee Pension Plan Amendments,” passed overwhelmingly by voters in 2011 and currently deadlocked by union court challenges, and the “Fifth Amended Plan for the Adjustment of Debts of the City of Detroit,” submitted to the court on July 25, 2014.

Here are summaries of what these plans do:

California’s proposed 2012 initiative, the Government Employee Pension Reform Act of 2012, would have allowed emergency changes – adjustments – to pension benefits if the pension system was deemed to be less than 80% funded. It would limit employer contributions to 6.0% of payroll for non-safety and 9.0% for safety, then add an additional employer contribution (approx. another 6.0%) to match what an employer would be required to contribute to social security. It then would have required employees to either contribute through withholding the balance of necessary funding required to maintain pension fund solvency, or participate in a new benefit plan as defined for new hires if they didn’t want to increase their pension contributions.

San Jose’s 2011 Measure B would gradually increase current employee pension contributions to 16% of pay, and offer “Voluntary election plan” (VEP) for current employees who don’t want to pay 16% for their pension. This plan limits – adjusts – an employee’s pension accrual for future years of service to 2.0% of final compensation times years worked and gradually raises age of retirement eligibility to 57 for safety and 62 for non-safety personnel. Measure B also revised the defined benefits for new employees to cap city contribution to 50% of plan cost or 9%, whichever is less, raised the retirement age to 60 for safety and 65 for non-safety personnel, and capped pension benefits at 65% of final compensation. It then authorized the city to suspend cost of living adjustments if the city declares a “fiscal emergency.”

Detroit’s proposed solution to their pension challenges takes place against a dire backdrop of economic and demographic implosions decades in the making and unlikely to ever confront a major California city. But the “triggers” they built into their revived plan, which retains defined benefits, provide useful ideas for Californians. Reviewing the “New GRS Active Pension Plan – Material Terms” (above link, page 58-59, item 12), the plan calls for implementing “risk shifting levers” at any time the funding level goes below 100%. They include, in order of application, and for as long as necessary, (1) no COLAs will be paid, (2) employee contributions will increase by 1% to 5% of base compensation, (3) most recently awarded COLAs will be rescinded, and (4) the benefit accrual rate will be decreased from 1.5% to 1%.

To reiterate: If defenders of California’s 83 public employee defined benefit systems are confident that incremental reforms as previously noted are sufficient to guarantee the financial solvency of these plans, then they should make no objection to permitting more drastic means – that effectively make defined benefits adjustable – should incremental reforms be insufficient.

Saving the defined benefit by introducing flexibility to the formulas accomplishes important goals. It protects taxpayers. It allows new employees to also have a defined benefit plan. It ensures veteran employees and retirees that the plan will never collapse completely in a financial downturn, leaving them with nothing. As an element of retirement security, a defined benefit system, because it pools the ongoing investments of thousands of participants, provides insurance against market downturns, as well as against unanticipated individual longevity. Anyone relying on an individual 401K must live with the dismal hope there will not be a severe bear market during their retirement, and that they die before they run out of money. The most compelling reason to advocate individual 401K plans for government workers is to protect the taxpayer. Making defined benefit plans modest and adjustable solves that problem in a more elegant way, but it may be naive to hope stakeholders can negotiate the necessary adjustment triggers in good faith, and implement them with integrity in the long run.

The best retirement security plan of all, implemented already for federal employees, and originally advocated by Gov. Brown before he settled for the decidedly incremental AB 340, is the “three legged stool.” That is (1) a modest – and adjustable – defined benefit, (2) a contributory 401K, and (3) Social Security. Requiring high income government workers participate in Social Security, because of its progressive benefit formulas that penalize higher income workers vs. lower income participants, would go a long way towards further stabilizing that system.

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Ed Ring is the executive director of the California Policy Center.

Saving Defined Benefits Requires Lower Pensions for Existing Workers and Retirees

Among pension reformers there is a spirited ongoing debate regarding what might constitute a financially sustainable yet equitable solution. On one side there is a call to do away with defined benefits entirely, replacing them with defined contribution plans. The argument is compelling; with defined contribution plans, when the participant retires, they survive on the assets they have invested, and the employer has no contingent liability whatsoever. This is an appealing scenario to anyone who fully appreciates just how close our public sector pension funds are to financial collapse. But some of the ways defined benefits are characterized by their detractors are inaccurate.

For example, defined benefit plans are often referred to as “Ponzi schemes,” based on the premise that pension funds depend on new participants making contributions in order to fund the distributions being made to retirees. But the scam used by Ponzi (and Madoff) was to let new investors fund interest payments to existing investors, while all the while making the promise that existing investors had a claim on their original principal investment and could have it back at any time. Defined benefits do not offer a return of principal. If incoming contributions, plus interest earned on assets under management, offer sufficient extra capital to fund distributions, a pension fund is sustainable. A Ponzi scheme by definition is not sustainable.

Slightly more apt, but still inaccurate, is to characterize defined benefit plans as “Pyramid schemes,” based on the same premise – that their solvency depends on new participants making contributions in order to fund the distributions being made to retirees. But Pyramid schemes only work when an expanding number of new entrants buy into the scam. As soon as the number of new entrants in a given year is not, for example, twice as plentiful as the number of existing participants, a Pyramid scheme collapses, and the last ones in lose everything. Properly managed pension funds do not require an increasing number of entrants.

It doesn’t take a lot of imagination to see the problem with putting everyone onto an individual matching 401K plan, i.e., convert everyone to a defined contribution plan. Every participant is on their own. No matter how generous the employer matching may have been, and no matter how much money they may have put away during their working years, if any retiree’s investments lose their value, they will be financially ruined. And even if their investments perform to expectations during their retirement, they will continuously have to worry about how much they can spend, because should they be fortunate enough to live longer than average, they may still find themselves penniless.

Hence there are two distinct virtues to defined benefit plans, both based on the fact that these plans allow large numbers of participants to pool their risk. This means that even though some participants may live longer than average, their income is secure their entire life, because by definition whoever collected more from the plan by living longer than average had their higher than average withdrawals offset by those whose lifespans were shorter than average. And because risk in a defined benefit fund is shared across generations of workers, during eras when investment returns are low, existing workers guarantee extra cash coming into the plan to keep it solvent, and during eras when investment returns are high, surpluses are fed into the pension fund that can also be used to make up the shortfall during lean years.

The only way defined benefits as they are currently structured for California’s public employees can remain solvent is if annual investment returns go into the double digits and stay there for the next 20 years. Even if that happens, contribution rates may have to go up. And if that doesn’t happen, the likelyhood that anyone is going to be willing to pay the required higher contributions is virtually nil – whether it is the participants themselves who are (at least according to Gov. Brown’s AB 340 pension reform that was signed into law on Sept. 12, 2012) going to eventually have to pay 50% of the required contributions through withholding from their paychecks, or taxpayers. So how can defined benefits be saved? A question that big defies concise answers, but it is unlikely that any financially viable, equitable solution can be found that will not affect existing workers and existing retirees. Here are some options:

  • For all pensions to existing retirees over $50,000 per year, whenever necessary, reduce the pension payout by an amount proportional to the amount the existing pension assets are underfunded. Restore them – but not retroactively – whenever and to the extent the funds move back towards being 100% funded. This can be accomplished by declaring a fiscal emergency.
  • For all participants still working who are unable or unwilling to afford to pay 50% of the required pension contribution – should it skyrocket in the face of persistent low returns to the fund – offer them an opportunity to accept a smaller defined benefit that they can afford. This can be done pursuant to AB 340.
  • Impose a ceiling on pension benefits to retirees, based on the principle that pensions are supposed to ensure retirement security, not lavish affluence. Similarly, establish a floor for pension benefits to retirees, based on the principle that employees at the low end of the pay scale are nonetheless entitled to retire with an income sufficient to live with dignity. Assuming the pension ceiling is realistic, the savings from establishing a ceiling for benefits will greatly offset the costs of establishing a floor on benefits.

If the annual rate of return currently projected by most pension funds, 7.5%, is lowered, for example, to 5.5%, it will probably be necessary to consider all of these options in order to save defined benefits.

Preserving defined benefits will require hard choices. But defined contribution plans should supplement pensions or social security, not replace them. And comparing defined benefits – or social security, for that matter – to Ponzi schemes or Pyramid schemes are specious arguments that do not belong in serious debate.

References:

Local Pension Reforms and Proposed Reforms in California Since 2010

Statewide Pension Reforms and Proposed Reforms in California Since 2010