Saturday, February 11, 2012

The New Aristocracy


Despite the economic hard times there is a large class of Americans for whom there is no retirement crisis, no health-care crisis, and no employment crisis. Federal, State, and Municipal employees have no reason to worry. They all have defined benefit retirement plans that are guaranteed against market loss by taxpayers. They all have excellent medical insurance at virtually no cost. After a short period of employment, their jobs are virtually guaranteed and it is only with great difficulty that they can be terminated or laid off.

This class constitutes a kind of aristocracy that is entirely supported by the rest of the population that has nowhere near the benefits enjoyed by its members. The Federal government is the largest employer in the Nation and its size gets bigger every day no matter which party is in office. State and Municipal employees include police officers, firefighters, teachers, as well as an army of civil servants.

Retirement benefits are the least understood part of the compensation of the government class but they provide a good example of the disparity between the two classes. Virtually everyone in the government class enjoys the benefits of what is known as a defined benefit pension plan. These plans, which have largely disappeared in the private sector, provide a guaranteed lifetime income at retirement.

For example, in my home state of Connecticut a teacher can retire after 35 years of service on 70% of their final average pay. Final average pay is important. In Connecticut it means the average of the highest three years earnings, not an average of lifetime annual earnings. Teachers whose final average pay is $90000/year could retire as early as age 56 on $63000/ year for the rest of their lives.

Unlike the 401k plans prevalent in the private sector the defined benefit plan income is guaranteed by the State’s taxpayers no matter what return is achieved by the underlying pension assets. The town of Fairfield recently lost $40,000,000 on a Madoff investment and has just raised taxes in order to cover the expected shortfall. Although not the victim of a scam, the neighboring city of Bridgeport experienced such losses in the recent downturn that it had to come up with $25,000,000 to cover its shortfall.

The very generous pensions enjoyed by members of the government class in Connecticut seem miserly compared with some other states. On a recent visit to San Francisco  I read the local paper and found it full of news of the draconian budget cuts proposed in that nearly bankrupt state. San Francisco itself was being forced to cut essential services to balance its budget. Nevertheless, buried inside the paper was an article detailing the incredible pension benefits of its municipal employees.

The article referred to over 480 retired city workers and their survivors who are “knocking back $100,000 or more a year in pension money.” To keep it simple, if 480 people receive $100,000 per year, that’s a minimum of $48,000,000 a year in pension benefits. At 4% interest it would take $1.2 billion to provide $48,000,000 per year. However, in a low interest rate environment such as we’ve been through in the last few years, the pension actuaries must demand that even more be allocated to fund plan benefits. That is why so many of these plans are underfunded.

Budget difficulties in New York State and City have led to new taxes and fees. However, the generous pensions of retired New York State and City employees are not subject to either State or City income taxes. Could there be greater proof of the disparity between the two nations?

A call for pension reform does not imply criticism of government employees and their work. Like the rest of us most of them work hard at their jobs and deserve to be financially secure in retirement. Nevertheless, their defined benefit pension plans are dinosaurs that are crushing the rest of us under foot. They even prevent cities and states from hiring much needed teachers, police, firefighters, medical, and social workers.

How did such a disparity come about? Basically, defined benefit plan formulas were designed to protect employees, who were typically underpaid, from being destitute in old age. Until the last decade or so government salaries were too low to allow employees to save for retirement on their own. However, recent increases in salaries were not matched by modifications in retirement plan benefit formulas.  In Connecticut an attempt to change the average pay calculation formula from a 3-year average to a 5-year average failed largely through the efforts of the teacher unions and their friends in the legislature. Minor modifications in pension benefit formulas can produce millions in savings and still provide adequate retirement income for state and municipal employees.

Basing final average pay on the last 5 or 10 years of service would produce significant savings. Just ask the actuaries. Of course, the Social Security system, the primary source of retirement income for the rest of us in the private sector, uses 30 years to calculate final average pay. Using more years to calculate final average pay would also eliminate a common form of abuse where municipal employees find ways to significantly boost salaries in the last years of service.

A first step in the reform process should be the removal of elected officials, especially members of Congress and State legislators, from any future participation in these retirement plans. Their current pension benefits should be frozen, and future payments placed into a defined contribution retirement plan. Otherwise, they would have no incentive to modify the existing arrangements.###

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