The following is the text of an address by Ron York to the National Association of Police Organizations Convention on July 23, 2005 in New Orleans, Louisiana, at the Ritz-Carlton Hotel.
The Future For Public Safety Pensions In California
Since 1996, the most contentious area of contract negotiations for police officers has been escalating health insurance costs. Although, the inflation rate for medical insurance continues to be considerably more than the general rate of inflation, 2004 saw this trend starting to subside. When the numbers for 2005 are released in September, we may see this rate below 10% for the first time in five years. But, like in the movie Jaws, just when you though it was safe to go back into the water a new shark appears. That new shark is pension costs. For the last year, I have heard city and state officials making predictions of financial ruin, unless something is done to dramatically to reduce public employees’ pension plan costs, especially police fire pensions. I hear it everywhere, even from cities with over-funded pension plans. They simply use San Diego as a surrogate to portray their fears. And what to you think they attribute this problem to? Greed!! Greed of police officers and firefighters. Stories are repeated that tell of millionaire police retirees, while cities and states go bankrupt. Virtually every proposal presented to address this greed and financial ruin has two elements – reducing the rate of contribution by employers and setting a ceiling on employer contributions. This is usually coupled with a conversion from defined benefit plans to defined contribution plans.
I am sure that everyone in this room knows the difference between defined benefit and defined contribution, but to be sure that there is no misunderstanding, let me give you the Cliff Notes explanation. A defined contribution plan is one where the benefits are explicitly guaranteed – a 75% pension based on your final year of income. Under this plan, the contributions a made based on the cost of providing the guarantee benefit. A defined contribution plan provides a fixed contribution – maybe 20% of annual earnings. When an employee retires, the benefits are determined by the amount of money that has been contributed and earned on the funds.
Pensions for public safety have been common for nearly a century. The original plans were what we call “pay-as-you-go”. No money is accumulated to pay for the pension. When an employee retired, the benefits were paid out of current tax revenues. Typically, it was a 50% pension after 20 years, with no vesting. If you left before completing 20 years you received nothing. The average retiree did not live as long as they do today. Even with these mitigating facts, the annual costs began to drastically increase. During the seventies, the federal government began to pressure employers to fund pensions as the benefits were earned. At that time, most governments closed entry into these plans and started a new plan that was currently fund. In addition, vesting of benefits was included in the plans. Suddenly, this caused a cash crunch for employers. Now not only were they required to pay for the “pay-as-you-go” plans, they were also having to prepay for the new plan. Eventually, this crisis was absorbed into the budget and all of the anxiety disappeared. Beginning in the nineties, the demands for the “pay-as-you-go” plan began to decline.
About this same time there was a push to increase the benefits to 75% after 30 years. This change was easily made. Although, the benefits increased by 50%, the fact that it was paid ten less years, the change was essentially cost neutral. For most departments this is where they are now, except for California and a few other departments. During the nineties, California was able to get their benefits increased to 90% after 30 years.
To fully understand what has occurred over the last year, we need to know key numbers. A 75% pension at 30 years requires that 20% of payroll be contributed each and every of the 30 years of employment. It can be paid by the employer, the employee, or combination of the two. For departments with many steps in their pay plans, such as Chicago, the contribution rate would be somewhat higher.
Much of the hysteria about pension plan costs is about California’s H.B. 400, which raised the 30 year pension from 75% to 90%. How did this change impact pension contributions? The ongoing contribution rate goes to 24%. This is rather simple to understand. The benefits were increased by 20%, therefore the contribution rate must be increased by 20%. Twenty percent of 20% is 4%. If the employer pays this additional 4%, it is the equivalent of a 3% increase in base pay. This is true because of the rollup costs associated with a base pay increase. Obviously, a 3% increase in pay will not bankrupt the employer. However, there is an additional cost – the new unfunded liability. A pension plan that was 100% funded would suddenly be only 83% funded, because of the grandfathering in of existing employees. To fund this liability over a 15 year amortization period will require an addition contribution of 6%. If the employer paid for the entire 10%, it would be the equivalent of an 8% base pay raise. While this would be sizable amount, it certainly would not be the financial ruin of any city. Keep in mind that it would be a one time incremental increase, not an escalating cost.
If we look at contribution rates in California, we will see that they have gone up much more than 10% of payroll. One California city is now required to contribute 48% of payroll. Obviously, something does not add up. There are three things that cause this gap. First, the investment strategy of pension managers became more aggressive during the nineties, which translated into higher risk. This increased risk resulted in large stock market losses. Second, the amortization period used for unfunded liabilities is unrealistically short in California. Last, but most important, was that cities contributed nothing for years that the fund was over funded. Remember, a typical 75% pension requires a 20% contribution every year. If there are years of zero contributions, there will need to be years with more than 20% contributions.
Look at Long Beach. Long Beach had an over-funded pension for many years. The city simply made no contributions during those years. Actually, it is even worse than that. The plan requires that the employees contribute 7%. Years ago, the union gave up a pay raise to get the city to pickup the employee contribution. Since the plan was over-fund, the city did not even contribute the 7%. If the pickup provision was not there, the employees would have been contributing the 7% every year. Now the city finds itself with a mandatory contribution rate of 24%. A ten percent increase might be substantial, but a 24% increase is down right painful. Let’s look at the circumstances that led to this. What do you think happened when the pension fund became over-funded? Did the city set aside the amount that they were contributing? No! The city immediately appropriated it for other areas. If they had continued to contribute at the normal rate, there would be no crisis today. First, there would be more money in the fund. Second, this annual money would not be committed to some other area.
So, what did city officials do? They immediately called Sacramento, screaming “fire”. And as luck would have it, Sacramento had just the man to put out the fire – the Terminator, Governor Arnold Schwarzenegger. Arnold may speak with broken English, but is no political dummy. He realizes that the secret to political longevity is to please the mostest and to alienate the leastest. Translated, this means your mayor wins and you lose. The Governor rolled out the three-prong approached that we discussed earlier – reduce benefits, cap contribution rates, and go to defined contribution plans. Police officers and firefighters mounted an aggressive campaign to “shout down” the governor. It worked. But, beware! He’ll be “baaack”. The approach used this year will not work next time. Arguments that tell anecdotal stories about widows and orphans being left high and dry will be debunked. This objection can be easily and relatively inexpensively removed with insurance. Arguing the self direct 401K plans are less efficient than large defined benefit plans will also be shot down. Even defined contribution plans can be managed and invested just like the defined benefit plans. Nothing requires that it be individual, self-direct funds.
In the long run, there is no difference between defined contribution plans and defined benefit plans, except for one thing – who bears the three internal risks. Under the defined benefit plan, the employer is the one bearing these three risks. The risk can result in either a loss or a gain. With the defined contribution plan, the employees bear the risk.
The fundamental factor contributing to the current crisis is the rules that dictate how pension plans are funded. It is that plain and simple. The problem is not Arnold Schwarzenegger. If Gray Davis had managed to avoid recall, it would have been him promoting the plan. Arnold didn’t give him a chance to be the bad guy. The worst mistake we can make is to personify the problem. No one individual is either the problem or the solution.
What does the future hold? The good news is that the stock market has rebounded and pension contribution rates will be going down. The question is whether the contribution rates decline before politicians are able to reduce benefits. Next year, we will most likely see Arnold II. To succeed this time we will have to do more than shouting louder than the politicians. We need a logical, but simple, response. If we can survive 2006’s attack, we will have dodged lightening, at least for this business cycle. But, this process will be repeated every seven to nine years in lock step with the stock market. What are our options? Obviously, we can do nothing and fight this fight every business cycle. I think this is a bad option. We could agree to go to a rational, defined contribution plan. The rise and fall of the stock market and the funding levels would not influence the annual contribution rates. It would be the same every year. There would never be a large increase or decrease in contribution rates. If I had to chose between the defined contribution plan or the status quo option, with its potential to be demagogued, I would chose the define contribution plan. I am probably the only person in the room with that opinion. The last and best option is get the funding rules changed. A requirement that employers must contribute a minimum amount every year, regardless of the funding progress of the plan would accomplish a lot. Allow plans to amortize unfunded amounts over a longer period. Change to a method of determining funding rates based on projected, long-term investment returns, not the current funding level.
Brand this into your mind: The current pension crisis is not the result of increased benefits The current pension crisis is not entirely the result of the stock market You are not the cause of the current pension crisis The real reason for the current pension is that cities have not been faithful in their contributions to the plan. If cities had been faithful, there would be no crisis today. My commission to you is to leave here today committed to: Forcing your employer to be faithful to their pension obligations And to never let your employer ever go a year without contributing to the pension plan The future of your pension plan is in your hands. Go out and demand that you receive what was promised to you.
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