Saturday, April 21, 2012

Pension Spiking

Connecticut Governor Dannell Malloy
with political apointee Andrew McDonald

One of the ways in which public service employees augment their pension benefits is to rack up substantial amounts of overtime. It is not uncommon for police and fire chiefs to use overtime in their last years of service to substantially increase retirement income.

Elected officials have little incentive to curb this practice, known as "spiking", since they benefit from the same system. 

Consider this example from the highest level of Connecticut state government.  Almost the very first step that Governor Dannell Malloy took on taking office was to appoint a number of Democrat state legislators to posts in his new administration. Not only did this move more than triple the salaries of these appointees, it also does the same thing to their future pension benefits.

The Governor’s first appointment was Andrew Mc Donald, a Stamford lawyer, who had been making only $30000 per years as a state legislator. All Connecticut legislators are considered part-time. I believe that he had six years service as a legislator. If he had spent four more years in the legislature, his pension at age 60 would have been 20% of his pay or about $6000 per year. But if he spends only the next four years in the Governor’s office at a salary of $130000 per year, his pension at age 60 will be about $26000 per year. That doesn't seem like much but at 4% interest it takes $650000 to provide an annual income of $26000 per year. It only takes $150000 to provide $6000 per year. In effect, the taxpayers of Connecticut will add about $500000 to his retirement fund in just four years.

I don’t question his salary at his new position but what incentive will he have to reform the pension system and do away with "spiking"?

Most State and Municipal employees are covered by what is known as a “defined benefit” pension plan. There is nothing inherently wrong in this type of retirement plan, but it is very important to consider how the benefit is defined. Defined benefit plans provide an employee with a guaranteed lifetime income at retirement. The amount of the pension is based on a simple formula that includes three factors: final average pay, years of service, and a percentage of pay for each year of service.

For example, a State employee with a final average pay of $100000 and 35 years of service would usually get 2% of pay for each year of service. The employee’s pension would then amount to 70% of pay or $70,000 per year for life. Often the plans will provide a cost of living increase every year thereafter. If the State’s actuary used a 4% rate of return, it would take $1,750,000 to fund this pension.

Consider what would happen if the formula was tweaked a little. What if “final average pay” was based not on the highest 3 or 5 years of service, but on highest 10, 20, or even 30 years of service? The retirement formula used by Social Security is based on a 30-year average. In that case the State employee’s pension would be comparable to what most of us get from Social Security. Someone retiring today at age 66 would get about $28000 per year from Social Security.

I realize that a reform of this nature runs the risk of fomenting a Greek style revolution. But there is a way to phase it in gradually and begin to turn the pension ship around. It would be easy, just, and fair for the State to say that anyone retiring in the next three years would have final pay based on the highest three years of service. But for all others final average pay would be based on the number of years from now to their actual retirement. For those retiring in 10 years, average pay would be based on the highest 10 years; for those retiring in 20 years average pay would be based on 20 years, and so on.

This reform would lessen the effect of "spiking" on future pension benefits. Policemen, Firemen, Teachers, and other state employees all deserve their pensions, but no one deserves a pension that has been artificially inflated by tacking on huge amounts of overtime in the last years of service.

Finally,  there should be a cap on all retirement benefits. In the Social Security system retirement benefits have a cap. Employer and employee contributions to Social Security stop when compensation exceeds about $90000. Even if an employee earned substantially more than $90000, the retirement benefit would be based on no more than the cap.

Pension plans were originally instituted to provide a secure retirement for employees whose salaries would not enable them to save for retirement on their own. Why is it necessary to provide public pensions for doctors in State hospitals who make in excess of $250000 per year? Why is it necessary to provide pensions for athletic coaches who make over $1000000 per year?  Once these state employees pass the cap level, their high incomes should allow them to fund the rest of their retirement on their own. They already have access to tax-sheltered 401k type plans.

Elected officials and political appointees like Andrew Mc Donald should be excluded from the pension system.  This reform is small but significant since these are the people who will largely be responsible for reforming the system. Again, what incentive do they have to reform a system of which they are such beneficiaries? ###

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