How Public Employee Pensions Make Income Inequality Worse

How Public Employee Pensions Make Income Inequality Worse

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Despite the stock market’s strong performance, public employee pension systems remain well below full funding and pressure on government budgets is building. Get ready for another round of battles over public employee benefits.

This month, UC Berkeley’s Haas Institute, a progressive research center, has stepped into the maelstrom, arguing that the problem is overblown. In a policy brief, analyst Tom Sgouros correctly points out that a pension plan need not be fully funded to continue making payments over long periods of time, and even questions whether 100 percent funding is an appropriate objective.

While Sgouros and like-minded public finance experts make some valid points, they may be surprised to learn that public employee pensions are becoming a driver of income inequality.

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Sgouros is right that, for most governments, pension underfunding is a not a near term solvency issue. Take CalPERS, the nation’s largest public pension system, as an example. Although only 73 percent funded, CalPERS is far from broke. As of June 30, 2016, it had $299 billion in net assets. In 2016, CalPERS collected $15 billion in member and employer contributions, while incurring $21 billion in benefit and administrative costs. Since 2007, contributions have been increasing at a 5 percent annual rate while expenses have been rising 8 percent a year. Over the long term, this is unsustainable, but a crisis is far in the future. Assuming expenses and contributions continue growing at historical rates and investment returns are zero, CalPERS would not run out of money until 2032.

Suggestions that the nation is facing a wave of pension-driven municipal bankruptcies are overheated. We have not seen a major city bankruptcy since mid-2013, and it is not clear that the few bona fide government financial crises that have occurred over the last decade were primarily the result of pension underfunding. Flat or declining revenue and a failure to maintain adequate general fund reserves better explain fiscal emergencies that confronted Vallejo, Stockton, San Bernardino, Detroit and Puerto Rico in recent years. Pension obligations come due over an extended time frame and at highly predictable rates, so it is hard to imagine them triggering an emergency without one or more other factors coming into play.

Fiscal hawks like me are prone to exaggerate the pension funding crisis for a variety of reasons. Many of us have accounting and financial management backgrounds, which engender a strong preference for balanced books. The fact that politicians make pension promises without setting aside enough funds to cover them under conservative assumptions is morally offensive. For us, witnessing that type of behavior is akin to an environmentalist seeing a smoke stack belching out greenhouse gases. Like the environmentalist anxious to draw public attention to climate change, we want the public to share our concerns about fiscal unsustainability — and can sometimes omit necessary nuance from our arguments.

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But critiques of pension funding may have pecuniary motives in some cases. For example, if governments can be convinced to increase funding levels, that means pension systems will have more money to allocate to mutual funds and other money managers. Since these financial players normally quote their fees as a percentage of assets under management, more pension funding leads to higher revenues.

If government agencies can be convinced to replace their defined benefit programs with defined contribution plans, financial interests stand to make even more money. Individually managed employer-sponsored retirement plans — known as 401(k) plans in the private sector — generate substantial fees for the firms that manage them. The median management fee for a 401(k) plan is 0.67 percent of fund assets, while the expense ratio for equity funds offered by 401(k) plans averages 0.53 percent. Combining these two amounts, we find that plan participants pay about 1.20 percent annually in overhead for shareholdings in a defined contribution plan. This compares with an average management overhead for defined benefits plans of only 0.43 percent. So moving employees from defined benefit to defined contribution plans can provide a windfall to the financial industry.

Pensions and Income Inequality
Although progressives may be right that the sky isn’t falling, they may be surprised to learn about the impact that certain pensions have on income inequality. In California, over 50,000 public sector retirees are receiving annual pension benefits in excess of $100,000 — and in many cases, way over $100,000. In a new video, California Policy Center profiles four retirees receiving up to $350,000 annually.

Related: $1.7 Trillion in Unfunded State Pensions Is Squeezing Vital Public Programs

These high-income beneficiaries are not the clerks, caregivers and bus drivers typically represented by unions like AFSCME and SEIU. Instead, they are retired managers, academics, physicians and public safety officers. Among the retired police and fire officers, many put in 30 years of service earning retirement credits at a rate of 3 percent per year. This entitles them to retire at 90 percent of final compensation, which is often “spiked” through last-minute promotions and payouts for unused sick and vacation time. The average California Highway Patrol officer who has retired since 1999 receives $96,270 per year and more than 1,000 CHP retirees collect over $100,000 annually.

Senior managers at public agencies have the power to affect retirement rules, allowing them to cash out in the process. In 2004, administrators in the inland California city of Redding convinced Council members to approve a supplementary retirement benefit program offered by Public Agency Retirement Services (PARS). A year-and-a-half later, Redding City Manager Mike Warren retired. Now, in addition to his annual CalPERS benefit of $198,000, he receives $50,000 each year from PARS. Warren’s total pension income of $248,000 annually is almost six times Redding’s median household income of $43,000. Meanwhile, the city now has to contribute $6 million per year to fund its supplementary pensions, a large burden for a struggling community of 92,000 people.

Policy Options
Reformers and progressives may be able to agree on policies that rein in the biggest pension payouts, as a matter of fairness and to free up public funds for other uses. But changes designed to contain windfall pension benefits are difficult to implement in states that have adopted the California Rule, which protects public sector workers from reductions in retirement benefits.

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One option that may get around this restriction is to impose a surtax on retirement benefits exceeding a certain level. For example, a state could tax retirement benefits over $100,000 at a rate of 25 percent, and benefits over $200,000 at a marginal rate of 50 percent. Such a tax would not impact anyone receiving a pension of $100,000 or less. If enacted, this policy would have to survive a California Rule court challenge and address the risk of retirees moving out of state to avoid the tax.

Another idea is to implement some form of risk sharing for benefits above a certain level. One problem with most defined-benefit plans is that taxpayers are on the hook when pension assets don’t grow at the sometimes lofty rates assumed. It may be fair to provide this type of security to public employees at lower income levels, but, at some point, funding this guarantee becomes regressive: with low-income city residents paying extra sales taxes to guarantee large pension payouts.

A way to address this inequity is to limit the annual service credit pension formula to salaries up to $50,000. For income above that level, member and employer pension contributions would be held in a separate account that grows at the same rate as that earned by the pension system. At retirement, this balance would then be annuitized and paid on top of the guaranteed benefit. This proposal has some similarities to a defined contribution approach, but the money remains in the public employee pension system, avoiding extra fees.

Public employee pensions are unlikely to trigger a tsunami of municipal bankruptcies any time soon, but the need to fund these plans is placing pressure on local government budgets and crowding out other spending priorities. Under the circumstances, it seems fair to ask higher income pension beneficiaries and future beneficiaries to contribute to a solution.