Sustaining Public Safety Pensions: Making Choices & Cutting The Pie

Pensioners First – Don’t change the benefits!  Don’t take them away, but please do ensure that existing and future benefits will be preserved!  You don’t have to like the messenger or their potential solutions, but you must admit that their summary of the problems fits the Arizona Public Safety Personnel Retirement System (PSPRS) like a glove!

http://pie-network.org/buzz/summit-2012/reforming-public-pensions

Reforming Public Pensions

by Josh McGee of Laura and John Arnold Foundation
September 2012


Government budgets across the nation face significant distress. Although part of this hardship can be attributed to the worldwide financial crisis and recession, a hefty portion has been caused by widespread, unsound budgetary practices. Chief among these practices is the perpetual underfunding of public employee benefits. Failing to promptly address the public retirement benefit crisis would be economically catastrophic, endangering the retirement security of our public workforce, harming our ability to recruit and retain talented workers, and triggering bankruptcies of cities, school systems, and potentially even entire state governments.
The current structure of most public employee retirement systems subjects governments to unexpected cost increases that can be difficult to absorb. This is primarily because pension plans depend on investments to fund the majority of employee benefits. Retirement costs can increase dramatically when the economy struggles. As a result, policy makers are asked to kick in more money when they also are facing declining tax revenue and budget cuts. The result has been predictable—missed payments and growing shortfalls.


The states’ own estimates of the unfunded liability due to their retirement benefit promises grew to at least $1.38 trillion in fiscal year 2010, up from $1 trillion in 2008. Pension promises make up over half of the shortfall ($757 billion) while retiree health care and other benefits constitute the remainder. This estimate is likely only a lower bound for the true shortfall. Using standard private sector accounting rules, the shortfall estimate increases to more than $3 trillion, a sum that represents roughly one-fifth of the United States’ gross domestic product.

Without significant changes to the current systems, public retirement benefit payments will quickly begin to crowd out other discretionary spending. Crowding out can hit education budgets in two ways, both because a greater share of the governmental budget is devoted to the pension system for non-education employees, and because the education budget itself ends up flowing more to the pension system as well. Pensions will thus significantly reduce the resources available to the classroom.

To address this growing threat, policy makers must commit to comprehensive reform that accomplishes three goals:
1. Develop a plan to pay down the unfunded liability over a reasonable time frame.
2. Adopt a reformed retirement system that is affordable, sustainable, and secure. This system must ensure a secure retirement for workers while reducing the potential for unforeseen cost increases or missed payments that create future funding crises.
3. Ensure that whatever plan the state offers enhances its ability to recruit and retain a talented public-sector workforce. Retirement savings are just one piece of total compensation, and policy makers must be thoughtful about how they allocate their limited dollars.

Reforming the retirement system
Most public pension systems use the traditional defined benefit structure. Under a defined benefit plan, an employee’s retirement benefit is “defined” based on a formula that includes variables such as the employee’s age, service, and salary. The typical defined benefit plan provides the employee with an annuity that is equal to a percentage of the employee’s average salary over a specified number of years at the end of the employee’s career.
There are three primary structural problems Additionally, the incentives created by a traditional pension encourage workers to stay until they reach retirement age even if it might be preferable for them to change jobs. Moreover, such plans also provide an incentive for experienced workers to not work beyond their specified retirement age, because their total lifetime benefit starts decreasing.

Research suggests that public employees do not value deferred compensation at par with its cost. Governments are allocating too much money to deferred compensation, especially given that current compensation is a more useful and precise tool for attracting and retaining workers.

Unpredictable costs
Because defined benefit plans are pre-funded, pension plan sponsors must guess how much money to set aside today to satisfy future benefit obligations. These guesses involve highly subjective determinations about many variables that influence the true benefit liability, including the employee’s tenure, wages, and life expectancy.
Even if employers could accurately calculate the future costs of the benefits they have promised, funds’ investment returns create even more uncertainty. There is no guarantee that future returns will match historic returns, and economic shocks may make achieving the fund’s predicted return exceedingly difficult over a long period of time. Moreover, investment returns are often treated asymmetrically: when funds experience a period of returns that beat their prediction, the surplus is often spent on benefits enhancement instead of being saved for downturns.

Incentive to underfund
Because there is a substantial lag period between the time that the government funds benefits and the time that the government pays those benefits to the employee, it becomes convenient for politicians who face tight budgets to stop making the full annual payments to the pension fund; a practice that is indistinguishable from borrowing from the fund.
The defined benefit structure also creates a political incentive to make additional promises to employees in part to gain their political support. These promises will, in turn, be paid out in the distant future by the next generation of taxpayers and politicians.

Labor market distortions
The third deficiency of the traditional defined benefit structure lies in its effect on the labor market. Defined benefit plans backload benefits, meaning that employees earn most of their pension benefits late in their career. This creates an inherent inequity for short- and medium-term workers who are placed on a savings path that is unlikely to provide a secure retirement. Additionally, the incentives created by a traditional pension encourage workers to stay until they reach retirement age even if it might be preferable for them to change jobs. Moreover, such plans also provide an incentive for experienced workers to not work beyond their specified retirement age, because their total lifetime benefit starts decreasing.
Research suggests that public employees do not value deferred compensation at par with its cost. Governments are allocating too much money to deferred compensation, especially given that current compensation is a more useful and precise tool for attracting and retaining workers.

Solutions
The way to create an affordable, sustainable, and secure retirement savings program is to stop promising a benefit and instead promise an accrual or savings rate. This would mean that instead of committing to a fixed percentage of final average salary after a specified number of years of service, the employer would instead commit to contributing a fixed percentage of salary for every year worked. This would eliminate cost uncertainty by making benefits a constant percentage of earnings and by linking benefit promises directly to employer contributions. Under this approach, employers can be as generous as they desire with employees without the danger of underfunding. Promising a savings rate as opposed to a defined benefit also addresses the labor market problem by smoothing pension wealth accrual. Employees would earn a fixed percentage of salary per year for retirement, which would eliminate the back-loading of benefits and thereby solve the portability and equity issues of a typical defined benefit plan.
A shift toward promising a savings rate instantly fixes the structural problems created by the current system and can be implemented in a way that maintains all of the protections for workers that are hailed as the primary benefits of the current system (e.g., easy annuitization, managed investments, employer-employee risk sharing). There is a range of specific options for making this shift. The following is a summary of the most frequently discussed alternatives, each of which would move plan sponsors toward a financially sound system.

Click here for the remainder of the article: http://pie-network.org/buzz/summit-2012/reforming-public-pensions

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