A Proposal for State and Local Government Pension Reform

State Representative Will Brownsberger
Boston, MA

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Overview

Currently, in Massachusetts, public employees who serve for more than ten years are eligible to receive a pension. The pension amount is computed by multiplying the highest compensation level that the employee has received (three-year average) by a factor that works out to 80% for a full career of service. Public employees do make contributions to a fund to cover their future pension benefits. There are many special rules that provide for different computations of benefits to different groups of employees.

There are five fundamental problems in the state-local pension system as it works today: Complexity and resulting lack of transparency, high investment risk borne by taxpayers, disparity of benefits between public employees and private taxpayers, unfairness across groups of public employees, and recurring abuse.

Some have proposed eliminating the defined-benefit pension plan in Massachusetts. However, this would leave public employees without a basic retirement income guaranty – they are not eligible for Social Security. The alternative developed in this proposal is a radically simplified defined-benefit pension plan for new public employees. The plan would pay benefits comparable to Social Security benefits.

This proposal has been fully developed as legislation and filed as House 2930 in the 2011-12 legislative session. The present submission has been excerpted from documentation available at http://willbrownsberger.com/index.php/archives/6159.

Dimensions of Proposed Reform

Administrative Simplification

Currently, state and local pensions in Massachusetts are administered through 106 separate systems. They are all under the supervision of a single oversight board that has played an important role in setting standards. However, the administrative fragmentation creates vulnerability to waste and corruption and makes it harder to evaluate the overall condition of the system.

Current law provides for progressive migration of investment management of selected local systems to the state’s retirement investment board (PRIM) if local investment returns are inadequate, but leaves fragmentation substantially in place. It is not designed to change the actual administrative cost of pension benefits.

The reform proposal would enroll all new public employees (at all levels) in a single new system. Over time, all existing pension boards would be consolidated into that system as their population under management dwindles naturally. The proposal uses the existing statutory accounting and legal framework and statewide oversight bodies to the maximum extent possible.

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

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

Reduction of Investment Risk

Investment risk for future taxpayers derives from the possibility that earnings on invested employee contributions will be insufficient to cover costs of future employee benefits. Pension fund administrators in Massachusetts are assuming that they can continue to achieve historical average investment returns. However, 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.

The proposed reform would limit taxpayer investment risk in two ways. First, by reducing the size of the promised benefit, the proposal would proportionately reduce taxpayer risk. The proposal would define “regular compensation” to exclude amounts above a low ceiling subject to cost-of-living adjustment. The ceiling would be set at a little under $40,000 initially, so that full-career benefits (computed as 80% of highest earnings) would work out to a figure comparable to the maximum Social Security benefit.

This will not change the share of risk borne by taxpayers, as both employee contributions and employee benefits will change proportionally, but a smaller system means smaller risks.

Second, instead of locking in contribution rates (currently at roughly 10% of salary for most public employees), the proposal would make the employee contribution rate variable by a formula — to fluctuate slowly up or down to correct for sustained deviations from investment assumptions. Taxpayers would backstop sharp investment losses, but the system would assure that if investment returns in the 21st century are lower than in the past, employee contributions would correspondingly rise.

Parity with Private Employees

Our generous public employee pension system makes many private sector workers feel like second-class citizens, paying taxes to support benefits that are out of their reach. Few private sector workers have access to defined benefits other than Social Security and Social Security is less than half as generous as Massachusetts’s government pensions.

By creating a defined benefit that is scaled at the same level as Social Security, the proposal puts public sector workers on the same retirement footing as private sector workers. In addition to capping benefits, the proposal would 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.

The proposal would enroll all public employees in a deferred compensation savings plan so that, like employees at better private sector firms, they would have the ability to build tax-advantaged savings in addition to their defined benefit. The plan would require deferral of 7.5% of income above the compensation cap.

Finally, the plan would provide for automatic cost-of-living increases. In this respect it would be an improvement for public employees, especially those in lower paid jobs, who presently do not necessarily receive COLA’s and typically only receive them on a fraction of their pension. Social Security does provide COLA’s, so this feature would maintain parity of benefits.

Parity among Public Employees

The pension system as it exists today creates tangible unfairness among public employees — special deals for special classes of employees. Most special pension rules have reasonable motivations, but they create strong perceptions of unfairness among employees who do not benefit from them. The endless stream of special interest pension bills testifies to this.

The only reform that will put an end to perceived unfairness is abolition of the group system, which allows different employee groups to retire at different ages. For public safety jobs, where the personnel board has set a mandatory retirement age, the proposal would allow retirement with full benefits at that age (65). Otherwise, for all new employees, the proposal would use a single retirement benefit schedule without regard to groups. The proposal would eliminate early termination allowances and special treatment for judges, teachers, state police and correctional officers (new employees only).

Of course, this reform diminishes benefits for new employees in those categories that benefit from 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.

Reduction of Abuses

The existing complex system creates too many opportunities for clever people to take more from the system than they have earned. A radical simplification will eliminate most of those opportunities. Additionally, a low benefit will remove the incentive to abuse the system for most employees. The reform does attack some specific additional problems:

• It eliminates discounted interest for benefit buybacks (when people leave the system, withdraw their benefits and then seek to return) and eliminates all special group buyback rules.
• It lengthens the income-averaging period from three years to ten years. This will eliminate the opportunity to game final termination levels.
• It rationalizes the computation of benefits for people who serve part-time or irregular hours (like local elected officials) specifying a pro-ration mechanism.

The Path to Reform

The challenge of pension reform is often perceived as a political challenge. But first of all, it is a cognitive challenge. Developing motivation for change depends on an understanding of the need to change. Understanding the need for change requires exploration of three areas that are each abstract and technical: the pension system itself, private sector income security, the financial outlook for the U.S. economy and how that will affect the equity markets. The latter, of course, is not only technical, but also broad, uncertain and obfuscated by political and marketing spin. It is hard for most people to find the time to develop an informed gut feel for the pension issue.

My personal approach to the issue is to try to contribute to the understanding that will ultimately lead to change first by a) investing heavily in developing my own understanding; (b) looking for ways to communicate that understanding. My publications at willbrownsberger.com are part of both of those efforts.

I expect that we will see progress on the pension issue in the present legislative session, but I expect that it will take a few more years of sustained work before wholesale reforms like those outlined here will be enacted. It will then be several decades before reforms are fully implemented. The proposal as framed applies only to new employees.

This reflects constitutional constraints on changes to pension promises. Over time, though, existing employees may choose to shift to the new system because it offers some advantages, especially in portability of benefits. Governmental units could accelerate that movement through collectively bargained incentives.

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