The bankruptcy filings of large municipalities, like Detroit and Stockton, Calif., highlight a growing problem that needs more than a temporary fix.
Many, if not most, municipal governments are awash in pension debt. Lots of states are in the same boat. Part of the problem is today’s artificially low interest-rate environment, which has played havoc with pension assets and liabilities. Part of the problem also is a long history of governments not making the required contributions to their plans. Now they don’t have the money to do so, and the debt has become debilitating. It’s gotten so bad that many cities have found themselves paying more for retiree benefits than they do for public services such as fire and police.
About 21,000 retired workers receive pensions from the city of Detroit; the average annual benefit for retired municipal workers there is $19,000. Retired police officers and firefighters receive an average of $30,500.
Moody's Investors Service recently said Detroit's bankruptcy could set a precedent for other financially distressed communities. Somewhat ironically, while Moody’s doesn't anticipate numerous defaults and bankruptcies, more could come if Detroit successfully reduces and restructures its debt and pension liabilities.
Many believe the best way to get out from under crippling pension debt is to close these plans to new hires and move employees to lower-cost defined contribution plans.
Other options include plan termination, asking employees to contribute more toward their pension and retiree health care benefits, tinkering with cost-of-living adjustments and not allowing public workers to “spike” their retirement earnings by cashing in vacation and sick time at the end of their career as a way to increase their retirement benefit calculation.
Here’s a closer look at each of these ideas:
Terminate the plan
Unlike corporations, municipalities don’t have as much flexibility to change their pension plans. They need the support of their state legislatures to make any substantive changes.
Although it can be tough to win lawmakers’ support, the idea of closing a municipality’s pension plan altogether and moving workers to a lower-cost plan is catching on.
So long as a municipality has enough money to pay all benefits owed to participants and beneficiaries, it can opt to terminate its defined benefit plan. To do that, the plan administrator must either purchase an annuity from an insurance company for its participants or pay the benefits some other way, such as in a lump-sum payout.
Proponents of this scenario say it may cost the employer more upfront in payouts, but will save money in the long-term by shifting those pension liabilities off the books.
Those who expect to receive pension benefits oppose the closure of the plan because their future security is tied to having those benefits. They feel they were promised a guaranteed benefit and to reduce it or shift it to a less secure option, like a defined contribution plan, is seen as a full frontal assault on their future security.
Corporations already are shifting their retirement assets away from defined benefit plans in droves. A recent survey by Prudential Financial Inc. and CFO Research Services found that nearly 60 percent of companies have either frozen accruals for all participants or closed their defined benefit pension plans to new entrants and many more said they were likely to do so within the next two years.
Switch to a DC plan, gradually
Some states including Florida are slowly reforming their pension plans. Rather than abruptly pulling any plugs, they give all of their employees the option to either enroll in the state’s traditional pension plan for government workers or to contribute to a 401(k)-type plan.
Beginning Jan. 1, 2014, however, all new hires in Florida government will automatically be placed into the defined contribution plan as the state phases out its defined benefit plan entirely.
DC plans are cheaper, of course, because they are mostly participant-funded rather than employer-funded. Employers can make contributions to these accounts and they have tax incentives to do so, but they aren’t required to. Critics of this shift point out that defined benefit plans offer one thing that defined contribution plans do not: a guaranteed benefit. That is the biggest negative in switching from a DB plan to a DC plan.
Requiring employee contributions
Florida began asking its state workers to contribute 3 percent of their earnings to the state’s defined benefit plan two years ago, triggering a wave. Today, most states require workers to contribute something to their own retirement.
Massachusetts has required its public-sector employees to make contributions to their defined benefit accounts for decades. Since 1996, they have been asked to contribute 9 percent of earnings into their retirement accounts. More governments are exploring this option because they want to honor their commitments to past workers but don’t have the funds to keep making the required contributions themselves.
Tinker with cost-of-living adjustments
According to the National Association of State Retirement Administrators, most state and local governments provide a cost-of-living-adjustment to reduce or offset the effects of inflation, which erodes the value of a worker’s retirement income. They also provide an inflation adjustment to their retiree pension benefits, which is particularly important for those public employees, like public school teachers and public safety workers, who are not eligible for Social Security. Most state and local retirement systems pre-fund the cost of a COLA over the working life of an employee to be distributed annually over the course of a participant’s retired lifetime.
Not surprisingly, the COLA is one of the first things state and local governments tinker with when it comes time to save money.
“COLAs are receiving increased attention as many states look to make adjustments to the cost of benefits amid challenging fiscal conditions and the current low-inflationary environment,” according to NASRA.
Since 2009, 11 states have changed the COLA affecting current retirees, five states addressed current employees’ benefits and six states have changed the COLA structure for future employees.
Many of these adjustments, however, are being challenged in court because they reduce a retiree’s long-term retirement income.
A popular way for public employees to boost their retirement income is to “spike” their final year of pay by cashing in a stockpile of sick and vacation time. The employee’s pension benefits are then based on the overall higher amount of compensation, rather than strictly on annual income.
Many industry experts attribute a good deal of the problems afflicting the public-sector pension system with spiking, which forces governments to pay out larger pensions than they might have expected. That’s why many states are now eliminating workers’ ability to spike their pay. They also are eliminating another perk: the ability to buy extra years of service toward retirement.
California, among other states, has outlawed spiking, though 20 counties in the state that don’t participate in the public employee pension system, including Los Angeles, continue to allow it.
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