Opinion

Felix Salmon

Felix Salmon smackdown watch, pensions edition

By Felix Salmon
February 23, 2014

Many thanks to John Arnold for responding to my post about how he (and his foundation) should approach pension reform. We agree on many things, it turns out; but there’s one big area where we disagree, which is encapsulated most cleanly in the question of what exactly is going on in San Jose mayor Chuck Reed’s Pension Reform Act. I characterized Reed’s ballot initiative as “allowing governments to default on their pension obligations”, and “an attempt to renege on governments’ existing pension obligations”. Arnold says I’m entirely wrong about that:

Salmon repeatedly claims that my wife, Laura, and I and our foundation, LJAF, “support plans making it easier for governments to default on existing promises.” Nothing could be further from the truth. We strongly believe that pension reform should not aim to cut or eliminate benefits…

The initiative explicitly honors and guarantees the benefits earned for work done to date. The only question here is whether the employer and employees should be able to negotiate retirement compensation for work that is not yet performed. In other words, does an employee who was hired yesterday have the guaranteed right to earn pension benefits under the same formula for all future years of service? Under Reed’s proposal, cities in California could negotiate with employees, through the collective bargaining process, to change retirement compensation for future service just as they would do for salaries or health benefits. That change would have no effect whatsoever on benefits that have already been earned.

So, who’s right? In order to answer that question, it’s helpful to follow one of Arnold’s links, to a paper on teacher pensions which was put written by the Arnold Foundation’s Josh McGee. The paper addresses a serious problem: that “teachers accrue relatively meager benefits through much of their careers, and then abruptly become eligible for much more as they near retirement age”. For instance, here’s what happens for a teacher who enters the New York system at age 25, if you value pension wealth as the present value of your pension payments:

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For the first decade, the teacher accrues essentially zero pension wealth, while the value of the pension rises in value by $101,667 in the two years between age 61 and age 63.

Other school systems have even more dramatic backloading. Here, for instance, are McGee’s charts for Miami and Las Vegas. Look at the darkest line, the one showing “pension wealth” over time. In Miami, that wealth can jump by some $250,000 in just one year; in Vegas, the jump is more than $300,000.

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So here’s the question. Put yourself in the position of someone who’s been teaching in Las Vegas for 29 years. The way that John Arnold sees things, over that time, you’ve managed to earn pension benefits worth roughly $200,000. If you teach for one more year, then the value of your pension benefits soars to more than $500,000: effectively, between salary and increased pension benefits, you’re being pad about $400,000 for that one year of teaching. Arnold wants school systems to “be able to negotiate retirement compensation for work that is not yet performed” — which is to say, to be able to pay you much less than $400,000 for that 30th year of teaching.

But that’s a very self-serving view of what’s going on in this pension scheme. Las Vegas teachers get their $500,000 package in return for 30 years of teaching, not in return for the 30th year of teaching. There’s a big difference. And it’s a difference that Arnold, for one, understands.

When a 25-year-old teacher joins the Las Vegas system, Arnold believes (and I agree with him) that the government should pay real money into its pension plan, in order to cover the actuarial costs that she’s going to qualify for in retirement. He doesn’t think that the government should drag its feet and wait until she’s 54 before it suddenly pays in an extra $350,000 or so: that’s not how pension plans work. Instead, they work by putting aside a certain amount of money every year, so that everybody in the system can receive, when they retire, the benefits guaranteed by the system. Indeed, when Arnold complains about pension plans being underfunded, what he means is that local governments aren’t putting enough money away to cover the sums which will be owed, in the future, to teachers who today are in their 20s or 30s. Those sums — and those funding shortfalls — are real, and substantial.

Arnold and I agree on what has been going on here: governments have promised juicy pension benefits in the future, in lieu of paying higher salaries in the present. Sometimes, they’ve failed to fully fund those benefits. But the promises are real.

Let’s make up some numbers for the sake of argument, and let’s ignore things like healthcare for the sake of simplification. Take a 25-year-old teacher on a salary of $50,000, where the government needs to make annual payments of another $9,000 per year in order to fully fund her pension. Effectively, what’s happened here is that the government and the unions have agreed on a total package worth $59,000 per year, of which $50,000 is salary and $9,000 is made up of pension promises. How much are those pension promises worth after ten years of service, in today’s dollars? The answer is about $125,000, if you assume the government’s investments grow at a real rate of 4% per year. The government has a liability to the teacher, which might be funded or might be unfunded, of roughly that amount. (In fact, the promise is worth more than $125,000, because of the effect of other teachers dropping out of the workforce before they reach ten years of service.)

If you ask Arnold, on the other hand, he’ll tell you that the teacher’s “benefits earned for work done to date” are basically zero — since if the teacher retired today, she would not be eligible for pretty much anything.

I disagree. I think that if the government has a liability — and Arnold is busy telling anybody who will listen that the government has a substantial liability, in this case — then the teacher has an equal and opposite asset. And it seems to me that the point of the Reed plan is to give the government the ability to take that liability, and — at least in the case of the teacher with ten years’ tenure — write it down to zero. Which would also have the effect of taking the teacher’s asset and writing it down to zero.

When you write down a future liability, you’re defaulting on your future obligations: that’s why I consider the Reed plan to be a means of reneging on existing promises.

Here’s another way of thinking about our hypothetical teacher: when she joins the school system, she’s granted a set of Restricted Pension Units, which vest over the course of 30 years. If she stays in the system until she’s 55, then those RPUs will be worth more than $500,000, in today’s money. But because of the way that money compounds, and because of the likelihood that she won’t stay in the system until she’s 55, the cost to the government of granting those RPUs, in year one, and also in any subsequent year, is only $9,000.

Nevertheless, those RPUs have been granted, and once granted, they belong to the teacher, not to the government. She can leave any time she likes, and leave most of her RPUs unvested. But that’s her choice, not the government’s. Unless the Reed initiative passes, in which case the government can essentially confiscate all of her unvested RPUs, and replace them with something else.

Now I agree with Arnold and McGee that there are better ways of designing pension plans, in a world where it’s not reasonable to expect teachers to stay in the same district for 30 years, and where it is reasonable to expect teachers with ten years’ service to have built up a meaningful retirement benefit, over the course of that decade, if they decide to move. I agree that if we were starting from scratch, we would design a plan which would look more like the grey upwardly-curving line in McGee’s charts, rather than the black back-loaded line.

But I disagree that if you’ve been teaching for ten years, then the pension promises that the government has made to you are, at this point, essentially worthless.

So here’s what I think should happen. First — and I agree with Arnold on this point — the government should make every effort to fully fund its existing and future obligations. Then, once those obligations are being fully funded, the government can start negotiating with the unions about ways in which to start offering choices to new teachers, and possibly even existing ones. If the government’s going to be spending $9,000 per year on your retirement benefits, where would you like that money to go? Would you like to join the existing defined-benefit plan? Or would you like to opt for something more like McGee’s smooth-accrual system?

The point is to ensure that everybody who has been promised something by the government has the right to demand that the government keep those promises. Not all governments keep all of their promises, but breaking promises is a serious thing: it’s called bankruptcy. We shouldn’t let cities and states get away with it by dint of a simple ballot initiative.

Update: John Arnold responds.

Comments
23 comments so far | RSS Comments RSS

Why is the debate only about teachers’ pensions? Unlike police, firefighters, and prison guards, teachers can’t work overtime their last year of employment to jack up their benefits, and retire at 50 at full pay. Is there a reason why, other than teachers tend to vote for Democrats and the three other large public employee groups vote for Republicans, that the pension debate focuses, seemingly without exception, on teacher pensions?

Posted by KenG_CA | Report as abusive
 

Pension accrual can’t be made linear because that isn’t how math works. The teacher who leaves after 10 years should be (and is) owed 1/4th of the net present value of their pension at 65. Lets use the 600k in the New Yorkers example. Divide that by 4 and we get 150k at 65. Now we’ll discount that back by 5% 30 times and we get $30,586.

The idea that my first day of work makes the terms of my lifetime of employment unalterable is absurd on it’s face.

And to partially placate Felix and TFF the TEA Partiers who want to claw back pension benefits already earned are equally crazy at the other end of the spectrum.

Posted by y2kurtus | Report as abusive
 

This one of those messes where whatever you do someone gets treated unfairly. You have to weigh the hurt of workers who won’t get what they might reasonably have expected against the claims of taxpayers and service users who are getting hurt in say Detroit. Also I don’t know how typical state workers retiring at 50 with 6 figure pensions is, but I’d start there – not teachers with relatively modest pensions

Posted by Mr.Do | Report as abusive
 

“teachers can’t work overtime their last year of employment to jack up their benefits”

Not true, KenG. First, it is pretty common for veteran teachers to take on additional responsibilities for the three years prior to retirement. (In MA they use the average of the highest three years of earning.) Coaching, or a supervisory position, or various leadership stipends. Second, the contract often includes longevity bonuses and sick-day buybacks, again designed specifically to boost the pension value. Third, while I was still in the public schools, the MA legislature voted for “Retirement Plus”, dramatically boosting the pension value for veterans with 20-25 years of service. The new system was tied to a higher contribution rate but teachers could convert by paying just three years at the higher rate. Many did so retroactively, walking away with a huge bonus that came out of the pockets of younger teachers.

THE SYSTEM IS COMMONLY GAMED, inflating pensions by 30% or more. Perhaps police officers can do so to an even greater degree, but graft is essentially the norm — and accepted by all participants in the system.

Posted by TFF17 | Report as abusive
 

“The teacher who leaves after 10 years should be (and is) owed 1/4th of the net present value of their pension at 65.”

Some truth to that. A teacher with 10 years service can stay in the system and collect a 20% pension at the age of 60. But that pension is based on the three highest years of earnings. If I work from the age of 25 to 35, and then leave for other employment, then my pension would be based on a salary that is 25 years out of date — and with 25 years of inflation prices are likely to double. Thus the real value of what you describe is closer to 10% than to 20%.

I’m confident that you understand the economics of investment well enough to know how ridiculous that is. At an 8% real return, with an inflation-adjusted savings stream, the value saved between 25-35 is approximately equal to the value saved from 35-65. To be fair, the payout for a teacher leaving at the age of 35 with 10 years of service ought to be 50% *and* carry full inflation protection. Obviously that is not going to happen.

And don’t feel you need to placate me. I want to kill pensions. They are a trap, not a benefit. Once you have 10-15 years in the system you literally cannot afford to leave no matter how much you hate the job. I left after ~10 years in the system and withdrew my contributions (plus 2% interest) at that time. If I hadn’t withdrawn and invested my contributions, I would be far poorer today.

Posted by TFF17 | Report as abusive
 

If you want to be kind to teachers, while curbing the pension burden, then switch to a defined contribution plan with matching contributions (6%/6%) and allow teachers to participate in Social Security.

* Social Security typically replaces something like 40% of the income, fully half the value of a full 80% pension.

* The additional 12%, if invested wisely, ought to be good for another 60% to 70% pension.

Posted by TFF17 | Report as abusive
 

For many if not all public employees including teachers, the term pension is used for what is in effect what private sector employees call social security. I wonder if this distinction is understood by readers, and do they think of pensions as an extra benefit over and above old age income insurance. Clarity would suggest that the writer specify whether his views are of a pension plan that augments social security or substitutes for it. In this specific discussion, it begs the question are public employees second class citizens which do not deserve the same old age retirement insurance that public sector employees do.

Posted by DRO75033 | Report as abusive
 

Suppose you have a pension system that is so generous its promises are not just unfunded but unfundable, based originally on a math error. California does — the 3%@50 public-safety pension. The formula is based on 3 percent of salary for each year worked, fully vested at 50. The Legislature created the first such plan in 1998 or ’99 during the dot-com bubble. They spread around over the next five years (and raised the bar for other public workers’ pensions) and are now a widely acknowledged disaster. For new hires, pensions have been widely switched to the more manageable, older formulas.

But that formula is plainly based on years worked. What on Earth is wrong with freezing the formulas for years already worked, shifting it for future years, and blending the difference when you retire? You’ve got 30 years in at 3 percent? You get your 90 percent. You’ve got 25 years? Your 75 percent is locked in, but for the next five years you get, for example, 2 percent per year, for a total of 85 percent of salary after 30 years. The rookie who just started gets his 1 year at 3 percent and the new formula going forward.

Everyone gets what they’ve already worked for. Everyone is working at any given time for the same terms.

And the notion that you can have a vested right to future benefits you haven’t yet worked for? It doesn’t add up. You can get fired. Your agency can dissolve. You could drop dead. Employment is a two-way contract.

Posted by BruceARoss | Report as abusive
 

I don’t understand how these systems end up so screwed up. How hard is it to institute a matching contribution plan (here it’s 7%/7%) and you get shares in the union retirement fund. You can cash your shares when you leave your jobs and either pay into your new fund at your new job or invest it yourself until you qualify to actually spend it without penalty. Couldn’t be simpler, yet all one hears is what a calamity everything is. One has to think there are some lawyers and bankers extracting lots of rents in keeping up whatever arcane forms of pension are still around.

Posted by CDN_Rebel | Report as abusive
 

Felix – I would summarize your view as being that “future rates of pension accrual should not be reduced during an employee’s career.”

Do you also believe the logical corollary – namely that “future rates of pension accrual shouldn’t be increased during an employee’s career”? Because that ratchet effect – increasing benefits when pension plans appear flush – is a significant factor in how Calpers ended up in the shape that it is in today.

More broadly, the argument that the pension benefit has been “earned” on something approximating a linear scale is dubious because the employee could either quit or be terminated and be owed nothing other than the vested benefit. As for minimal levels of pension accrual in early years – I believe that this structure is by design as a retention tool.

Posted by realist50 | Report as abusive
 

CDN-Rebel – I will provide one specific and egregious example of how these systems get so screwed up. Detroit’s pension plans had a habit of granting pensioners a discretionary “bonus” or “13th check” in years when returns were higher than expected, so they were never prepared for any sort of multi-year period of subpar returns.

As I say, that’s a particularly egregious example. More generally, the problem is that these plans are largely overseen by people of a political bent – appointees, if not elected officials themselves – who don’t necessarily understand actuarial calculations. They have an obvious incentive to be optimistic, because being optimistic about funding assumptions puts off a tough decision. So not only do these boards gravitate toward optimistic actuarial assumptions – particularly optimistic assumptions about future investment returns – but they don’t necessarily understand just how ugly things look if returns are far lower than forecast. Combine that with politically expedient decisions to spend money on current projects rather than putting the needed money in pension funds, and eventually you develop severe under-funding.

The mindset expressed by Felix in this post also certainly doesn’t help, where once someone is hired their future accrual of pension benefits can only ever go up, never down, leaving the plan sponsor locked into payment obligations that extend out for 50 years or more.

Posted by realist50 | Report as abusive
 

TFF, all systems can be gamed, but what teachers can get away with is not in the same league as the firefighters, prison guards, and police. And coaching a high school sports team for a $750 stipend (not every state values its high school sports teams as much as Texas) hardly adds much to their retirement checks.

The problem isn’t that pensions exist, it’s how they are constructed. There is no reason (other than political) why they can’t be turned into retirement savings plans, funded by employee and employer, with interest paid by the federal government (they always need to borrow money, and insuring enough teachers have enough money put aside for retirement is a good way for the federal government to encourage people to become teachers).

Also, while you may have done well managing your own retirement funds, it’s guaranteed that if we leave that job to each individual, we will have a lot of them needing public assistance after they retire.

Posted by KenG_CA | Report as abusive
 

The problem with pensions is that when you see the people who have pensions they are not noticeably better employees than those without. They just happen to be a part of some guild. Down with guilds. They are inefficient and ill advised.

I would be totally cool with teachers or fire-fighters or whoever having significantly better retirement benefits than the rest of society if those benefits were based on merit and the quality of the employees and not based on the political strength of guilds…I mean unions.

I have worked with enough government employees to know they are no better or worse than other employees, but their benefits are typically ridiculous when they are unionized, because it is a promise that doesn’t cost anything today and politicians love that kind o promise.

Posted by QCIC | Report as abusive
 

QCIC, how do you measure the quality of a teacher? Is it based on how well they teach creationism? What candidates they supported for Board of Education? Test scores, do you want them to teach to the test?

What about the quality of a firefighter? Is it based on how many fires they put out? Property saved?

It’s really difficult to come up with metrics for determining how much of a pension, or even a salary people in these positions should earn.

The retirement benefits for people in the private sector isn’t tied directly to merit, only to salary, which is supposed to have some correlation with performance, but is usually not the case, union or not.

Regardless of whether there are unions involved, I would think we want everyone to have a good retirement plan, otherwise we would have a bunch of old people dying in the streets that we would have to scrape off the ground and bury, but only after we spend hundreds of thousands of dollars on their medical expenses.

Posted by KenG_CA | Report as abusive
 

@KenG, you are very knowledgeable, but on some matters I have more experience than you do. At the school where I taught, teachers regularly (with support from the negotiated contract) used special provisions to boost their three-year average by $20k or more. Sick day accrual buyback is huge — paying up to 150 days of unused sick time in a lump sum upon retirement. Also $5k or $10k longevity bonuses designed to kick in immediately prior to retirement. And that is even without any additional duties (typically $1k for being the advisor to a club or leading a curriculum committee, many times that for coaching).

I’m not 100% positive, but I don’t believe the town signing the contract bears the cost of the pension in MA. They might make a contribution to the MTRB based on payroll, or that might be wholly covered by the state, but there is a strong incentive for the town and employee to negotiate a benefit that costs the town little but results in a huge payout from the pension fund to the employee.

Executive summary: the system is screwed.

Posted by TFF17 | Report as abusive
 

TFF, I realize you are far more knowledgeable about the teaching profession than I am; my exposure is being a student four decades ago and having a sibling and in-law who are teachers. And I’m aware of the deals you mention. But how do they compare with prison guards and policemen retiring at $100K/yr when they are 50 years old?

I’m a little amused at all of the anger focused on unions, public and private. They do just what management of big corporations do – negotiate the best possible deal for themselves. Unions are just capitalists at their core, no different than industry associations lobbying for tax breaks or reduced regulations, or defense contractors being awarded no-bid contracts at absurdly high prices. Everybody is working for the best deal possible. Instead of blaming unions, the anger should be directed at the corporate management and politicians who negotiate those deals.

But, yeah, I’ll go along with your executive summary.

Posted by KenG_CA | Report as abusive
 

Ken-

If you are in your mid 30s on and cannot tell how good an employee someone is after working with them on a few projects then you are an idiot. I work with both private sector and public sector employees all the time in my job. There is not a noticeable difference in ability. There is totally a noticeable difference in benefits packages for the unionized workers.

They have much better benefits and are generally stuck in their jobs because seniority is the be-all end-all of union jobs. This hurts new entrants and rewards coasting. It is a terrible system in this modern era when generic office workers are probably most valuable from 35-45 and start losing value quickly after that.

Posted by QCIC | Report as abusive
 

QCIC, so for public employees, who gets to make that call? A political appointee, so pensions and salaries become dependent on pleasing politicians. Like Chris Christie.

So let’s say we do away with pensions for government workers. What do we do when they are too old to work and can’t afford to live? Wait for them to get homeless and then die? Is that what a great nation in 2014 should do?

Posted by KenG_CA | Report as abusive
 

“But how do they compare with prison guards and policemen retiring at $100K/yr when they are 50 years old?”

Bet the prison guards and policemen do better. Even under the enhanced benefit (which is the legislative change which truly soured me on the system), a teacher hired at the age of 20 wouldn’t qualify for a full 80% pension until the age of 56. A teacher hired at the age of 25 wouldn’t reach an 80% pension until the age of 59.

Apparently they changed the system again in 2012? I’m curious about the new rules.

Posted by TFF | Report as abusive
 

http://www.latimes.com/local/lanow/la-me -firefighter-overtime-20140225,0,5653449 .story#axzz2uP8N4GP4

The average firefighter in Los Angeles was paid more than $142,000 last year.

Wonder what that will do to their pensions. Not too many public school teachers making that much,let alone the average teacher.

Posted by KenG_CA | Report as abusive
 

Different jobs, separate issues. But I agree, the pension system for teachers is closer to reality.

Posted by TFF | Report as abusive
 

As Henning Bohn makes clear here, it is suboptimal to fully fund pensions. Local governments can fund pensions by raising taxes, by cutting other services, or some combination of the two. The cuts and taxes are imposed mainly on owner occupants of homes who typically carry debt with much higheriinterest rates than the local government can secure.

Posted by BenWheeler | Report as abusive
 

@BenWheeler, you have that very confused. The interest rate on munis is only relevant if the local government borrows the money to fund the pensions. If they FAIL to fund the pensions, then they are in essence borrowing from the pension fund at a rate equal to the assumed investment returns (typically 8%+). They are promising to cover a gap that is growing at that rate.

That exceptionally high implied interest rate is the reason why towns are floundering under this burden. What may originally have been a manageable obligation has doubled every 9 years (with continuing underfunding exacerbating the problem further). Carry that out over a few decades and you have a “debt” that is impossible to meet.

What they SHOULD do is float bonds to fund the pensions in full. The borrowing costs, as you observe, are much cheaper. And if the rating agencies complain about that, then perhaps they need to tighten their belt a bit? Hiding the obligations in underfunded pensions doesn’t make them any easier to afford.

Posted by TFF17 | Report as abusive
 

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