Pension Liabilities

The enormous unfunded pension liabilities of the State of Connecticut have hardly been discussed so far in the run up to the November gubernatorial election. Nevertheless, the question needs to be raised for whoever is Governor after the November election will inevitably have to reform the State’s employee pension plan or face the possibility of bankruptcy.

A relatively small but significant first step in reforming the system would be to freeze pension benefits for all existing State employees not covered by union contractual obligations. These employees would include non-union members and employees of the State’s executive, legislative, and judicial branches. It would also include all administrators in the University of Connecticut system. In the future these employees could participate in a defined contribution or 401k-type plan. This reform would still provide them with a retirement income, based on the vested value of the current plan as well as the accumulated value of the new defined contribution plan, a combination that would still be superior to what is available to citizens in the private sector.

This reform would reduce the State’s enormous pension liability while at the same time eliminate some major abuses. Here are some examples. Governor Malloy recently appointed a 66-year-old leading Democratic politician and lawyer to the State’s highest court. In four years the new judge will be eligible for a pension of $100000 per year for life. It takes 2.5 million dollars earning 4% interest to provide an annual income of $100000. The judge will contribute about 7% of his pay or about $10000 each year to fund his pension. Who will contribute the balance?

The Governor has appointed about a dozen lawyers over age 60 to the bench. Each of them will be eligible for an equally generous and impossible to fund pension. The outcry over the latest appointment was so great that in the waning days of the last session, the Legislature voted to slightly alter the judicial benefit formula, but only for subsequent appointments. The Governor’s picks were left on the gravy train.

During his tenure the Governor has also elevated about a dozen members of the State legislature to work in his administration. Legislators are considered part-time employees and make about $35000 per year. These appointments to high administrative positions, often with salaries in excess of $100000, have a dramatic effect on their State pension benefits. As legislators they contributed 7% of their pay to the State pension plan. At retirement their pensions would have been based on a percentage of their $35000 salary. Now they only need serve three years in their new positions to double or even triple their pension income.

A good example is the case of Andrew McDonald, a lawyer and long time friend of the Governor’s from Stamford. After many years in the State legislature, McDonald was appointed legal counsel to the Governor almost immediately after his inauguration. McDonald’s salary went from $35000 per year to well over six figures. Two years later McDonald was appointed to the State’s highest court with a salary of about $150000. When he chooses to retire, McDonald’s pension will be based on his highest three years pay and not on the $35000 annual salary he made as a legislator. How is it possible for pension actuaries to even calculate State pension liabilities when employees can have such dramatic increases in pay shortly before retirement? I estimate that despite his calls to deal with unfunded pension liabilities, Governor Malloy has added over $50 million to the State’s liabilities with just these few appointments.

Removing legislators and other political appointees from participation in the State pension plan does not involve breaking any sacrosanct union contracts. The plan for future judicial pensions was changed almost in an instant in response to public outcry. Not only will such a reform help to reduce the State’s unfunded pension liability but it should also provide legislators and other officials with an incentive to reform. Under the present system members of the State government were always on the same side of the table with the public service unions when it came to pension negotiations. Everything they gave to the unions also benefitted them since they were participants in the same plan.

Once political fat cats not longer have an interest in preserving the existing plan benefit formula, they might at last be willing to take on the larger issue of reforming the whole system. The lion’s share of the huge unfunded pension liability is the extremely generous contractually binding retirement benefits enjoyed by members of the various public service unions.

The benefits are extremely generous because the retirement income is based on the average of an employee’s highest three years pay. Most state employees start at relatively modest salaries and their pension contribution is a percentage of that amount. Someone who starts at $30000 is required to contribute about $2000 per year to the pension plan. That contribution will never be enough to adequately provide a pension thirty or thirty- five years later of 70% of one’s highest pay. For example, teachers starting today at $40000 will certainly be earning over $160000 by the end of their careers, and be eligible for pensions in excess of $100000.

Even though many public service employees gripe about their pensions, a simple comparison with Social Security will point out the disparity between the benefits that this minority enjoys and those enjoyed by the rest of us who are covered under Social Security. The pension benefit in Social Security is based on an average of earnings over a thirty-year period, and not on the highest three years. Teacher union leaders like to point out that Connecticut teachers are not covered by Social Security, but they react with horror at the suggestion that their Pension plan be replaced by Social Security.

So, how is it possible to reform the pension system without starting a Greek style revolution among our public service employees? Their pension benefits are guaranteed by law and contract. The Governor gave away the store two years ago when he promised no layoffs in exchange for some union concessions. On their part the unions did throw future State employees under the bus when they agreed that new hires would have a different type of pension plan.

Unless a moderate solution is found the State faces either dramatic layoffs, economy-busting tax increases, or even bankruptcy. However, it might be possible to get the unions to agree to a modification of the benefit formula that could be phased in gradually. For those retiring in the next three years Final Average Pay would still be the average of their highest 3 years pay. But for those retiring after, Final Average Pay would be the average of the number of years of service from the present to their actual date of retirement. For example, the pension of an employees retiring in five years would be based on the average of the five last years of service: for those retiring in ten years the pension would be based on the average of the last ten years of pay, and so on. Ultimately, final average pay would be based on the average of an employee’s entire working career.

The adoption of this new formula would not hurt anyone close to retirement. Those further away from retirement would still enjoy retirement benefits superior to anything available to citizens in the private sector. In addition, they would be able to supplement their retirement income by contributing to tax sheltered retirement plans available to public employees.

The new pension formula would allow the State’s pension actuaries to get a much better handle on the actual size of the unfunded liability. After all, how is it possible to really estimate the figure when no one can tell how much an employee will be making in the last years of service? The little reform would also put an end to the nefarious but little known practice called “spiking”, whereby employees find ways to dramatically increase their salaries in the last three years of service.

If this year’s candidates for state office refuse to support some kind of pension reform, whoever wins will have to be prepared to lead the state into bankruptcy.

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Tax Rates and Tax Cliff

     

Bush Tax Cuts and Federal Revenues

An increase in tax rates on the rich, or anyone else, does not always lead to increased government revenues. Historically, almost the opposite has occurred. Over 50 years ago, President Kennedy lowered tax rates and Federal revenues grew dramatically. President Reagan did the same thing with the same result when he took office.

Even the much-maligned Bush tax cuts did not reduce Federal revenues. In 2002 the Federal government collected 1 Trillion dollars in income taxes and 1.88 Trillion in total revenues. By 2007 after five years of Bush “tax cuts”, Federal income tax collections went up by 50% to over 1.5 Trillion dollars, and total government receipts exceeded 2.5 Trillion. In 2007 the total federal deficit was a mere 160 Billion dollars, the same it had been in 2002. Only with the recession did income tax revenues go down to 2002 levels although total government receipts stayed higher.

Today, total Federal government revenues are the highest they have ever been. Unfortunately, in the last five years massive government spending has far outstripped the increased revenues produced by the Bush cuts. Even if the President were to tax those making over $250000 at a rate of 100%, it would not come close to dealing with the massive debt roll accumulated during his previous four years in office.

Ironically for conservatives, it would appear that reductions in tax rates lead to increased government revenues and only enable more government spending. At the same time, it would appear that raising tax rates would actually lead to less revenue for Washington? Why should this be so?

In the last election campaign Governor Romney tried to make the point that lower tax rates would actually grow the economy and produce greater revenues for the Federal government. Most people, including those who should know like politicians and newspaper editors, could not understand the concept.

But there is another factor. Increasing tax rates only increases tax avoidance strategies both legal and illegal. Recently, a noted political commentator suggested a national lottery where people would be entered in the drawing for the huge payout if they would only submit their tax returns to audit. He estimated that 2 Trillion dollars of income goes unreported every year. His scheme is a crazy one but it illustrates the insanity of our whole tax system.

Increasing tax rates on the rich or anyone else will only encourage more tax avoidance since the potential reward gets greater. If someone’s income is taxed at a 50% rate rather than 25%, the potential reward for deferring, sheltering, or otherwise hiding income has doubled.

How many contractors do you know who prefer to receive payments in cash? How many people do you know who receive unemployment benefits, but who at the same time work “under-the–table” somewhere? If people in such negligible tax brackets risk breaking the law for such a small return, what do you suppose the prosperous will do?

For example, you can raise the tax rate on capital gains, but people will only pay the tax when they finally sell the asset that has increased in value. If the government raises the tax rate on dividends, corporations will just reduce or even eliminate their dividends. Investors will also cut back or even sell their positions in dividend paying stocks in anticipation of an increase in tax rates. I’m not making this up. Just recently, Costco announced a record $7 per share dividend before the end of this tax year. The company is headed by one of President Obama’s major supporters in the last election.

Inevitably, increases in tax rates never produce the expected tax revenues. Just look at the state of Connecticut. Two years ago newly elected Governor, Dannell Malloy, and an overwhelmingly Democrat legislature pushed through the largest tax increase in State history. Now, the expected revenues have failed to materialize, and the Governor’s hapless aides can only blame the failure of the economy to grow over the past two years. ### 

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