The fact that pension finance is a relatively poorly understood area of employee compensation doesn’t let us off the hook to try to understand it. Certainly policymakers should have had a better understanding of what they were getting taxpayers into. During the bubble years of the internet and continuing right up until a couple of years ago, pension enhancements were being awarded around the state of California like candy, and why not – investment returns on pension funds were off the charts. But that was then.
Now that pension funds, and all investment funds, are no longer achieving the percentage returns they did during the internet bubble, then the real estate bubble – i.e., now that consumers and businesses can no longer access cheap credit to keep our economy overheated – everybody is getting a lesson in pension finance. And bankrupt government agencies are taking a harder look at what was promised during the boom years.
The way pension benefits are calculated is fairly straightfoward: When a person retires from government service, the number of years they have worked is multiplied by a percentage, typically between 1.25% and 3.0%, and that resulting percentage is multiplied by their final salary in order to calculate their pension. If a person had a pension multiplier of 3.0%, and worked for 30 years, for example, then their annual pension would be equal to 90% of the salary they earned in their final year of work.
There are many nuances to this – pension “spiking” where employees accumulate extra hours of overtime, or get a final large boost in pay, or cash in a percentage of sick-leave, in order to raise that final year’s pay so their pension will be proportionally higher. Retirees who claim a disability can receive 50% of their pension exempt from state or federal income tax, a benefit that invites abuse. But one of the more obscure nuances, and the subject of two recent court rulings, is the concept of awarding pension boosts retroactively.
In the case just ruled on by California’s 2nd District Court of Appeals, Orange County was attempting to reverse a retroactive pension boost that had increased safety employee pensions back in 2001 from 2.0% per year to 3.0% per year. This amounts to a 50% increase in the amounts of pensions to eventually be paid, since instead of multiplying years worked, for example, 30 years, by a factor of 2.0%, which equals 60%, the pension benefit would be multiplying 30 years by 3.0%, which equals 90%. Using that example, a person retiring with a final salary of $100K per year would now get $90K per year as their retirement pension instead of $60K per year. But Orange County wasn’t contesting the fiscal imprudence of such a generous boost, they were contesting the fact these benefits were conferred retroactively.
To explain the significance of this, take the example of someone who may have been planning to retire in 2002. As of 2001 they would have been completing their 30th year of work, and would have the expectation of receiving a pension equivalent to 30 times 2.0%, or 60% of their final working year’s pay. Suddenly, because of this pension formula boost, this worker will receive 90% of their final working year’s pay as a pension – 3.0% times 30 years working. This would occur, and has occurred, despite the worker – and their employer – never having paid monies into the pension fund to support a pension that is suddenly 50% more generous.
According to Orange County’s actuaries, the impact of this 2001 retroactive pension boost is to increase their pension liability (the estimated total amount that will have to eventually be paid out in retirement benefits to all current employees) by $187 million. And depending on what rate of return Orange County will actually earn on their pension fund over the next 10-30 years, that number could be quite low. Orange County argued in court that because the pension enhancement created a benefit – 3.0% per year applied to years worked to calculate the retirement pension – for years the employees had already worked and been paid, it amounted to an assumption of debt which requires voter approval. They lost this round in the 2nd district court, but it appears quite possible they will appeal to the California State Supreme Court.
In a recent ruling on a related case, California’s 3rd District Court of Appeals has upheld California’s Department of Personnel Administration in their case that argues – as did Orange County – that enhanced retirement benefits cannot be applied retroactively. This case centered on the court’s finding that the MOU presented to the Legislature back in 2002 did not clearly state the benefit enhancement would be retroactive, nor was a fiscal analysis provided showing the impact of retroactive application of the agreement.
In both of these cases there are several arguments brought forward, and the implications of changing the rules are far reaching. Orange County and one 3,500 worker unit of the state government are just the tip of the iceberg. Virtually all of California’s 1.8 million state and local government workers received pension benefit enhancements between 1999 and 2008. Reforming the system simply so these benefit enhancements don’t apply retroactively, would remove tens of billions in liability from California’s troubled state and local pension funds. There are many outlines of how to reform California’s pensions – but here is a list of the worker career timelines affected by various reform proposals:
1 – The worker’s careers during the period prior to retroactive benefit enhancement, that is, the period ending sometime between 1999 and 2008. Taking the formula down from 3.0% to 2.0%, or from 2.5% down to 2.0%, or from 2.0% down to 1.5%, etc., would mean for those years, retirees would use the lower multiplier they had worked – and contributed to their pension fund – under at the time. This would mean someone retiring in 2020 after 30 years work, for example, whose pension was enhanced in 2002, would get 18 years at 3.0%, plus 12 years at 2.0%, to calculate their pension. It would still be enhanced, but the enhancement would no longer apply retroactively.
2 – The benefit applied for current workers from now on. This is a harder reform to make because current contracts spell out what future benefits are going to be. Basically this reform would mean that from now on, benefits would be reduced. To use the same example as above, if both of these reforms were enacted, a worker retiring after 30 years in 2020 would get 2.0% for the years from 1990 through 2002, 3.0% for the years from 2003 through 2011, and 2.0% for the years from 2011 through 2020.
3 – The benefit applied for future workers. This is the easiest reform to make, because it doesn’t affect anyone who is already working under a contract. The plan here would be to award a lower pension multiplier to all new hires. If existing safety employees were getting 3.0% per year applied to their pensions, new safety employees go back to getting 2.0% applied per year to their pensions. The problem with this solution is that by itself, it doesn’t do enough. The savings wouldn’t be realized for 20+ years.
4 – The benefit as it applies to workers who are already retired. This is the hardest reform to make, since it affects people who are already retired and don’t have the ability to restart their careers or recalibrate their personal balance sheets because suddenly their pensions have been cut. But solutions are being offered, such as imposing a highly progressive tax on pensions that are “over the California median household income,” with the proceeds transferred directly back into the pension fund. Some of these solutions are quite creative and if finding solvency remains a challenging proposition, they may end up in front of voters on a ballot, or included in the list of options presented in bankruptcy court.
To read more about California’s two cases attempting to reverse the retroactive pension benefit enhancements, read the Sacramento Bee’s two reports on January 26th, “Court: Orange County deputies’ retro pension formula legal,” and “Court: Better pension benefits can’t be retroactive.” Also good sources on these rulings are The California Recorder’s story on January 26th “Public Pension Cases Yield Opposite Outcomes,” and Bloomberg’s report of January 27th entitled “Orange County, California, Retroactive Pensions Upheld.”