By Mark Rosenfeld
As the national conversation focuses on government debt, judicial nominees, and immigration reform, almost every state in the US has been struggling with their public sector retirement accounts. The Pew Center on the States reports that 34 US States have less than 80% of the assets they need to cover promised retirement benefits for public sector workers. Seventeen US States have less than 70% of the needed assets and 8 States have a pension-funded status of less than 60%.
Forty-five US States have had to take action to help keep their public sector pension funds healthy. States have passed fixes to their public retirement problems, but none have done so in a way that results in a positive overall improvement for the state. The State of New York created a new tier of benefits that reduced employee retirement packages by an estimated 11%. Rhode Island overhauled their public employee retirement system, creating a new plan that provides a smaller retirement benefit to their workers than the previous generation. Arizona and Florida increased employee contributions and reduced pension benefits. As dismal and tumultuous as these changes seem, there is a public employee retirement solution that would have a net positive impact for every resident of almost every state.
To deal with public retirement solutions, state governments have typically done one or all of the following:
1) Increase taxes to pay more into the pension systems
2) Reduce or eliminate government services to redirect existing revenue into the pension funds
3) Change public employee retirement plans to reduce benefits and/or increase employee contributions
Whatever combination of these three options a state ends up pursuing, the net result has been negative. Increasing taxes on all residents to increase the retirement security of only public sector workers decreases the money available to private sector workers for their own retirements (among other expenses). Eliminating or reducing government services can be positive, when a reduction is needed, but a forced reduction to redirect revenue to pension funds is not beneficial for the state at large. Finally, increasing employee contributions while reducing the retirement package for public employees will reduce their retirement security, reduce their income available to spend during their working years and in retirement, and potentially lead to a greater reliance on state services to compensate for their smaller retirement package. None of these options in any combination is a net positive solution for a state.
Proponents of public pension reform insist that improving the state balance sheet is a priority for all state residents, but this position overlooks the more pressing issue of private sector retirement security. A National Institute on Retirement study in 2005 found that only 33% of private sector workers are offered a defined benefit pension plan, down significantly from the 75% rate in 1975. If the employer replaces the defined benefit pension plan then it is most often with a defined contribution plan, like a 401(k). A recent NPR report revealed that less than 50% of workers have access to a 401(k) plan through their employer. A Fidelity Investments analysis revealed that the average 401(k) plan had a balance of $75,900 in September 2012. This seems like a significant amount, except that Fidelity recommends a retirement savings goal equal to approximately 8 times a person’s salary by the time they retire. A recent survey found that nearly one-third of near retirement age Americans could be living at or near the federal poverty line when they retire. This private sector retirement problem is only made worse when states have to increase taxes to pay for public employee pensions. As approximately 10,000 baby boomers retire every day, many of whom will only have a 401(k) and their Social Security, states will start to see an increasing demand on safety net services for indigent seniors.
State governments are aware of this private sector retirement problem and have begun to take steps to encourage more retirement savings. California is moving forward on a plan to move private sector workers into a cash balance account. The outline of the plan calls for workers to contribute 3% of their wages into a 401(k)-like account that will receive a minimum rate of return.
States can adopt a California-type private sector retirement plan to help increase retirement security for private sector workers, and use these accounts to improve their public sector retirement account balances. Following a plan like this will result in a net positive for states. Illinois, which has the worst funded public sector pension plan, serves as a great example of this retirement solution.
Illinois: An Example of Positive Retirement Reform
Not only does Illinois have the worst funded public employee pension system in the United States, it has recently had its credit rating downgraded to the lowest of any US state, in large part because of public pension deficits. According to a recent report by the Woodstock Institute, only 53.4% of private sector workers in Illinois have access to any type of retirement plan sponsored by their employer. Additionally, for employees making under $15,000 a year, only 41.4% have access to an employer-sponsored retirement plan.
The Illinois legislature should establish a state-run cash balance retirement plan for all workers, public and private. A cash balance account would require a certain level of contribution from the employees’ salaries, and potentially a contribution from the employer into employees’ state retirement account. This money could be pooled together and invested. Each individual would have a notional account that would be credited with interest every year, for example, 2.5%. These accounts should be structured similar to a 401(k) plan with rules dictating at what age an individual can redeem their account and should endeavor to receive favorable tax treatment.
If Illinois instituted a 2% employee contribution with a 1% employer match, the State would collect approximately $9.775 billion a year. The 9 billion dollars would be invested by the Illinois State Board of Investments, or another similar State authorized investment board. Any investment return greater than the promised interest rate, 2.5% in this example, would be used to pay down existing public pension liabilities.
The Illinois State Board of Investments currently assumes a 7.5% investment return annually. After a 2.5% interest return is paid to cash balance account holders, there would be a 5% annual return to pay down existing public pension liabilities. Over a 10-year period this would pay off 29 billion dollars of existing Illinois public pension liabilities, and all existing liabilities would be eliminated within 30 years.
The State of Illinois would pay down its existing pension liabilities, while increasing the retirement savings for all of its workers. These workers will have access to their cash-balance accounts when they retire and they will receive back all the money they paid into their accounts with interest. The revenue generated by the cash balance accounts should be used to pay down the public sector amortized unfunded liabilities, while the state continues to contribute the normal cost of the benefit.
A Positive Model
The state of Illinois, and other US states, can implement this positive solution to pension reform and tackle three large (and growing) problems simultaneously: 1) public sector retirement debt, 2) private sector retirement security, and 3) state budget pressures. These problems are being faced by dozens, if not all, US states. If the creation of a state-run retirement plan can solve the pension problem in the nation’s worst-funded pension system, it can be used by other states facing similar public pension problems.
This plan does call for a tax increase on all workers. As discussed previously, tax increases to pay for only public sector retirements are not beneficial to the state on the whole. The tax increase called for in this cash balance plan actually ends up being returned to the taxpayer with interest. The tax increase paid by the employee and the employer ends up benefiting the employee when they retire and have access to their cash balance account. This increases every worker’s retirement security, and the tax increase paid by workers is returned to them in full with interest. The current retirement system in America relies on employer-sponsored retirement plans, and this solution creates a system that all employers will participate in within a given state.
There will be several important legal issues to navigate in developing this plan. States will have to work through existing ERISA laws that apply to retirement plans, and should focus on creating plans that will receive favorable tax treatment. The state is not the employer for the majority of employees, and this will create a legal gray area with the application of laws that apply to employee benefit packages.
States may need to develop these plans as an opt-out model, wherein an employee has an account created automatically. The overall goal of this plan is to improve public pension balance sheets and help workers save more for retirement. Any worker that chooses to opt out of the plan should face an income tax that replaces the revenue lost by the state. The legal issues here are navigable and the problem is dire enough to motivate creative compromise.
States in different fiscal health can offer differing cash balance account return rates. States that do not need revenue to pay down unfunded public pension liabilities can offer plan participants a higher interest rate or remove penalties for opting out. The revenue generated by these accounts could also end up replacing or reducing other currently imposed taxes. This could even produce a situation where a resident’s tax burden remains unchanged, but their retirement savings are greater. States should also implement protections on the cash balance accounts, such as automatic termination if return rates are not met for a specific number of consecutive years or guaranteeing the returns with existing public pension fund assets.
A Retirement Solution for all Workers
Previously implemented reform efforts for the public sector pension problem have not produced a solution that has an overall positive impact for states. This plan would create a positive solution to the retirement problem by increasing the retirement security of all workers, stabilizing public pension fund accounts, and protecting the retirement packages of public sector workers.
Mark Rosenfeld works as a political consultant for Paladin Political LLC, a Chicago based political consulting firm. Mark has previously worked as a consultant to various electoral campaigns and also served as the Staff Assistant to the Cook County Finance Subcommittee on Pensions.