Pension Issues Inventory

Section links are to a proposal for simplification of the pension system (which has been filed as House 2930). House 35 is the Governor’s pension reform proposal.

Investment Risk — the possibility that earnings on invested funds will be insufficient to cover costs of future benefits.  Many analysts believe that the earnings available to dollar denominated pension funds in the last half of the 20th century will not be safely available in the first half of the 21st century.  Future taxpayers may face sharply escalating costs.

Current law will maintain large funding risks for decades.  House 35 makes no major reduction in risks for future taxpayers.

Alternatives:

• Dramatically increase employee or taxpayer contributions — not feasible or really desirable.
• Make the employee contribution rate non-binding for new employees so that it could be adjusted by legislative action if shown over time to be inadequate — weaken the statutory language which makes the rate binding (G.L. 32, s. 25).
• Make the employee contribution rate variable by a binding formula — to fluctuate slowly up or down by formula to correct for sustained deviations from investment assumptions.  Backstop very sustained drops with taxpayer contributions.  Sections 22-26.
• Shrink the compensation base and benefits proportionally — this will not change the funding ratio as all variables will change proportionally, but a smaller system means smaller risks.  Sections 12, 14.

Fragmentation — division of state and local pension system into 106 fiefdoms creates vulnerability to waste and corruption.

Current law provides for progressive migration  of investment management of current systems to PRIM if returns are inadequate, but leaves fragmentation substantially in place.  House 35 takes no additional action to consolidate system

Alternative: Enroll all new public employees (at all levels) in a single new system — over time consolidate all existing pension boards as their population under management dwindles naturally.  Use existing statutory framework and statewide oversight bodies to the maximum extent possible for the new system.  The existing statutory framework is designed to facilitate incorporation of new systems.  Sections 1-8, 10.  Manage funds through PRIM but in a segregated fund.  Sections 28-41.

Benefits of a consolidated system, in addition to strengthening administration include:

• The opportunity to implement other pension reforms and have new rules administered consistently by a new statewide board.
• Remove pension liabilities from the books of cities and towns (making them agents of collecting contributions and forwarding them to the state). Sections 5, 27.
• Segregate liability for a new system maintained permanently at full funding — a good-bank/bad-bank approach which will isolate existing funding deficiencies.

Unfairness to private employees — our generous public employee pension system makes most private sector workers into second class citizens, paying taxes to support benefits that are out of their reach.

Here are a few data points from federal compensation and income surveys — click here for more and for sources:

• Only 20% of private employees have defined benefit pension plans.
• Only 7% of private employees have defined benefit plans based on terminal earnings.
• For a person with a typical earnings history, Social Security benefits are only about 44% what a Massachusetts public pension would provide.
• Only 26% of men aged 65-74 have any form of corporate retirement (DB or DC plan, 401(k), etc.) — this figure may be somewhat understated by 10 or 15 points.
• Only 11% of private firms offer post-employment health care (which all Massachusetts public employees who are retired have).

Existing Massachusetts law enshrines a form of pension benefit that is vanishing in the private sector. Of course, private sector workers have social security and Massachusetts public employees do not, so it is fair to maintain some modest defined benefit.

House 35 does not fundamentally change the structure of pension benefits, although it does increase retirement age.

Alternative:

• Lower the ceiling in the definition of regular compensation to some cost-of-living-adjusted amount such that typical pension benefits would be on the same scale as social security — one approach would be to select 35% of the social security compensation and benefit base which would work out to $37,380 at current levels.  This would mean that the maximum state or local pension would be roughly $30,000 — a little above the social security maximum benefit for a single worker.  Sections 12, 14.
• Standardize full-pension retirement age for all employees at the same level, consistent with social security (age 67), except where there is a younger mandatory retirement age set by the personnel board.  Sections 9, 15, 17-20.
• Provide full automatic cost-of-living protection for the new reduced benefit (as social security does).  Section 16.
• For all income above the new ceiling, require deferral of 7.5% into the state’s deferred compensation plan.  Section 21.

Consequences:

• Withholding and benefits both go down in a proportional way for the defined benefit base plan.
• Public employee benefits would look like reasonably good private sector benefits — a defined benefit base comparable to social security and some level of additional savings under supervision of the employer.
• Fits with the goal of reducing investment risk.
• Greatly reduces all abuses and political problems around pension benefits — the incentives to abuse go way down when the benefit size is reduced.
• By including an automatic cost-of-living increases provides better income security for lower-income employees.

Unfairness among public employees — special deals for special classes of employees.  Most special pension rules have some reasonable motivation but they can never be fair to all employees — the endless stream of special interest pension bill proves this.

House 35 does little to address the internal inconsistencies of the system.  It does adjust the state police retirement schedule (taking their benefit accrual rate down from 3% to 2.5% like other public safety employees but leaving it at 3% for the first 20 years of service) and proposes a further study of the group classification system.

The only reform that will put an end to perceived unfairness in the group system is abolition of the group system.

• Where personnel has fixed a maximum safe age of 65, allow retirement with full benefits at that age but otherwise, for all new employees, use a single retirement benefit schedule without regard to groups.  Section 15.
• Eliminate early termination allowances and special treatment for judges, teachers, state police and correctional officers (new employees only).  Sections 17-20.

Of course, this reform will represents a big change for those categories who have in place early retirement rules.  But it will be much fairer to other workers who face similarly demanding jobs, who have not been able to win early retirement.

There are many demanding and dangerous occupations in the private sector — fishing and roofing, for example.  Social security does not start earlier for these workers.  Rather, if they wish to change fields at a certain age, they can, but they will need to keep working to retirement age in their new field.

Abuses — opportunities for manipulation of the system that allow people to earn greater benefits than they have paid for.  As long as the system includes many special rules, there will be abuses.

House 35 does attack a number of abuses. A more thorough going approach would eliminate the special rules that create the possibility for those abuses.

• House 35 eliminates discounted interest rates — “buyback interest” which is half of the actuarial assumed rate — for voluntarily delayed buybacks.  A stronger approach would eliminate discounted interest for all buybacks or better yet, eliminate all special group buyback rules.  Section 11.
• House 35 requires proration of group service when people change groups.  A stronger approach would eliminate group classifications entirely.  See discussion above.
• House 35 limits pension spiking by changing compensation levels.   The proposed anti-spiking rule makes sense, but it exempts bona fide promotions.  Bona fide promotions really are the problem — public employees complain that promotions are often used to reward insiders by bumping their pension and in all cases of big promotions, the pensioner will get much more from the system than they contributed.  A stronger approach would put in place a low benefit ceiling as outlined above, which would eliminate most spiking activity.    Another helpful measure would be to lengthen the income averaging period from 3 years to 10 years.  Section 15.  House 35 does extend the period to 5 years.
• House 35 eliminates special termination allowances.  This is a sound reform.  Section 17.
• House 35 also addresses some special circumstances not addressed in the attached legislation:
  • addresses recovery of payments to convicted pensioners.
  • eliminates the ability to receive compensation as an elected official at the same time receiving a pension and addresses interest rates on reimbursements of pensions by elected officials.
  • creates special procedures around legislation for individual pensions.
  • allows changed retirement option for same sex marriages.
  • reduces employee contribution rates to reflect some of its other changes.

One additional area, that we addressed in 2009 is the issue of public employees with hours that are too irregular to pro-rate for creditable service purposes (including elected officials).  Section 13 of the draft suggests a more comprehensive approach to this — allow earning of creditable service at a rate equal to the ratio of the actual compensation to the pensionable compensation maximum (set at roughly $37K in the draft).  So, anyone making at least that much would get credit for full-time service at that compensation level, but people making less would qualify for less creditable service, but at that annualized maximum compensation rate.  This approach gives a fair definition of credit for part-time service without violating the rule that one can pro-rate compensation or time but not both.

NOTE RE DISABILITY RETIREMENT:  There may be additional measures that we should implement around disability procedures, but I don’t have a perspective on those issues.  The approach in the attached legislation is to import existing procedures into the reformed system but track for disability retirees the reduced benefits structure defined for superannuation retirees.  Sections 42 to 44.