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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

Union Watch Highlights

Recent reports on union activity from around the web through November 12, 2010:

Super-sized pensions, and a doomsday scenario
by Bob Sullivan, November 12, 2010, MSNBC
In New York, a 44-year-old firefighter retires with a $101,000 a year pension, for life. Near Chicago, a parks commissioner quits and begins collecting a $166,000 pension – a sum sweetened by $50,000 thanks to a one-time retirement year windfall of $270,000. And in California, a former city manager pulls down $500,000 in retirement checks every year. As outrageous as those sunset stipends may seem, they are merely the most visible piece of what critics of generous government pensions say is a ticking time bomb of debt that is threatening to bankrupt a number of states by the end of the decade. (read article)

Labor Board’s Recent Decisions Tilt in Favor of Unions
By Melanie Trottman and Kris Maher, November 11, 2010, Wall Street Journal
Unions are increasingly looking to the National Labor Relations Board to seek favorable workplace rulings, and the agency is showing a willingness to reopen matters previously decided in favor of employers. Union leaders pushed earlier this year to get two new Democratic members on the labor-relations board, saying they needed to level the playing field with employers after years of decisions by the Republican-controlled board that unions said hampered their efforts to organize workers. Union hopes of getting major new legislation to boost their organizing all but died with Republican gains in the mid-term congressional elections. The Employee Free Choice Act, which would make organizing easier by enabling unions to bypass secret-ballot elections, was already stalled in a Congress fully controlled by Democrats. Organizing is a critical issue for unions. In 2009, the national rate of union membership had fallen to 12.3% from 20.1% in 1983. The NLRB can’t overhaul labor law, but it can make rulings on a case-by-case basis and set broader policies through administrative rules that could give unions more leverage with employers. (read article)

Orange County GOP vs. Unions? Get Ready for Phase 2
By Frank Mickadeit, The Orange County Register, November 8, 2010
Republican Party Chairman Scott Baugh in January laid down what I coined the Baugh Manifesto, which said: If a candidate for local office wants the party endorsement, he or she can’t take money from public-employee unions. Now, Baugh says, comes Stage Two: Teaching local elected officials to hold their own in union negotiations. To that end, Baugh plans to hold a major conference this spring, bringing in lawyers and others skilled in the intricacies of collective bargaining under the Meyers-Milias-Brown Act. Baugh says council members tell him they at times feel out-gunned. “We have to educate public officials not to get trapped into negotiations.” Last week, he said, some Costa Mesa council members felt they had no choice but to extend a contract four years because the alternatives were either try to pull back on deal points and be accused of bargaining in bad faith (with legal implications), or hold firm, go to impasse and impose a contract (with its legal implications). “It takes an enormous amount of political courage to go to impasse,” Baugh said. The conference is intended to get officials who want to rein in pensions up to speed. (read article)

Influence of teachers unions in question
By Mitchell Landsberg, Los Angeles Times, November 7, 2010
These groups have been slow to come to terms with the push for reform. Some see them as obstacles to change, and even union sympathizers agree that their voice in the education debate has been muted. Teachers unions have a well-deserved reputation for exercising political clout. With a nearly unparalleled ability to raise cash and organize their ranks, they have elected school boards, influenced legislation and helped set the public school agenda in major American cities for decades. Now, that clout is in question. (read article)

Unions, secular whites part of GOP’s California problem
By John J. Pitney Jr., Orange County Register, November 5, 2010
Size matters. California has 37 million residents, or 50 percent more than Texas, the next-largest state. Any one of our state Senate districts has more people than South Dakota. And our state is geographically vast, covering 156,000 square miles and a dozen media markets. The Tea Party movement, which had supplied so much energy to Republican candidates in other states, could not take root in such soil. Though the movement had financial support from outside organizations, it was mostly a kitchen-table, word-of-mouth affair. As Douglas Johnson of the Rose Institute has written, “California’s electorate is simply too enormous to reach one by one.” Any serious get-out-the-vote operation in requires vast technical resources and an existing network that can reach from urban barrios to desert communities. The only group that can pull it off on a statewide level is organized labor, which backs Democrats. (read article)

Election adds pressure to change public pensions
By Stephen C. Fehr, Stateline.org, November 4, 2010
Six newly elected  governors are looking favorably at some form of 401(k)-style retirement plan for public sector employees, adding to the momentum building nationally for a shift away from traditional guaranteed pensions. Tuesday’s election was in some ways the first national referendum on the future of public pensions, the cost of which has been rising in many states, counties and cities and is crowding out education and other popular programs. (read article)

Defeat of Prop. B Cements Labor’s Power in San Francisco
By  Elizabeth Lesly Stevens, The Bay Citizen, November 4, 2010
As election results rolled in, it became clear that San Francisco unions had trounced Proposition B, a measure that would have required the city’s 26,000 employees to contribute more toward their pensions and benefits. Once the tally was complete, 57.5 percent of San Francisco’s voters had sided with the unions. Union leaders appeared surprised by the lopsided victory. Proposition B had been promoted by Jeff Adachi, the city’s public defender, and backed by former Mayor Willie L. Brown Jr., Eric Schmidt, Google’s chief executive, and Michael Moritz, a venture capitalist. Throughout the campaign, Adachi had argued that the city’s escalating employee costs would eventually force San Francisco to file for bankruptcy, like nearby Vallejo. (read article)

Unions struggle at polls
By Jon Miltimore, Watchdog. org, November 4, 2010
A series of pension measures and ballot initiatives went against public sector workers Tuesday in what proved to be a tough day for labor. In California, voters in seven cities — San Jose, Redding, Riverside, Menlo Park, Bakersfield, Carlsbad and Pacific Grove — approved measures seeking to reduce public pension costs, and a half-cent sales tax in San Diego that would have prevented public safety cuts also was rejected. Public safety unions in each municipality opposed the reforms, but efforts to defeat the measures failed in what was a big night for pension reform advocates. (read article)

AFL-CIO says it helped Dems in Election
By Robin Bravender, Poltico.com, November 3, 2010
Big Labor is patting itself on the back for softening the blow yesterday’s elections had on congressional Democrats. And for all the credit it’s giving itself in helping liberal lawmakers hang on, labor isn’t sorry for the role it played in ousting embattled Democratic Sen. Blanche Lincoln. Tuesday’s election, which gave Republicans a commanding majority in the House and more power in the Senate, was a disappointment to union members, AFL-CIO President Richard Trumka told reporters Wednesday. But the labor group’s grass-roots organizing prevented “even worse” results in states like Nevada, West Virginia and California, he added. (read article)

Secret union ballot measure gains approval in Arizona
By Associated Press, Fox11az, November 2, 2010
Voters have approved Proposition 113, an amendment to the Arizona Constitution that guarantees the right of a secret ballot for employees deciding whether to be represented by unions. The immediate effect is minimal because employers already can demand a secret ballot in such votes. Making the requirement a constitutional amendment is an effort to pre-empt proposed federal legislation that is stalled in the U.S. Senate. The federal legislation, known as the Employee Free Choice Act, would allow a majority of employees to create a union by signing a card. (read article)

The Democrats and the Union Label

By Andrew Kohut, October 22, 2010, New York Times
The good news for the Democrats these days is that union members are one voting bloc that continues to strongly back their party’s candidates — and by a solid margin in our latest national poll, which otherwise finds a double-digit Republican lead in Congressional voting intentions. The bad news is that labor unions have fallen out of favor with the broader public, including independents who will cast the decisive votes in this year’s elections.
opinion on labor unionsPew Research Center Views on Labor Unions. Positive views of labor unions have plummeted since 2007. The Pew Research Center this year found just 41 percent of the public said they have a favorable opinion of labor unions while about as many (42 percent) expressed an unfavorable opinion. In January 2007, a clear majority (58 percent) had a favorable view of unions while just 31 percent had an unfavorable impression.  (read article)

Jack Dean is editor of PensionTsunami.com, formed to monitor developments in all three pension spheres nationwide — public employees, corporations and social security. PensionTsunami, like UnionWatch, is a project of the California Public Policy Center. Dean is a former newspaper editor and a past executive director of the Reason Foundation. He has been active in politics for more than three decades and currently serves as president of the Fullerton Association of Concerned Taxpayers.