Kerry Cavanuagh of the Los Angeles Daily news wrote two excellent columns on the dire effect public sector pensions are having on LA County and City budgets.
She hit the nail on the head in both columns, but came to the wrong conclusion on one point. She suggested that a 401K style plan for new employees would not save as much as a reformed defined benefit plan.
She stated the rationale for her conclusion:
“The city’s pension proposals would only affect future hires, since existing employee benefits are protected under law. And that’s why pensions end up being cheaper than installing a 401(k) system. Los Angeles is still responsible for funding and bailing out the pension systems that serve existing employees and retirees. If L.A. created a separate 401(k) system for new hires, those employees would not pay into the pension system.”
“The city would have a growing liability of pension-collecting retirees, but fewer and fewer people paying into the system. The city would be responsible for ensuring the pension funds are solvent. Eventually, pensioners would die out and then the 401(k) option would realize cost savings, but that would be decades away.”
There is a term for what she described – a Ponzi scheme. That’s where current contributions are used to cover the accrued benefits or entitlements for former participants.
Many have accused the Social Security System as being the largest Ponzi scheme in the history of the world. While technically true, there is an important difference between Social Security and other public defined benefit plans.
Congress can amend Social Security benefit calculations and criteria without negotiating with unions.
Yes, there would be political flack if the retirement age was raised and contributions were increased, but it seems that most Americans are resigned to that.
Consider the recent announcement that there would be no COLA for a second year in a row for SSA beneficiaries. Sure, people were not happy with the news, but there will be little political capital lost as a result this November.
Try getting city and county unions to make meaningful concessions here. The politicians would not chance it for fear of losing their primary source of support. Instead, only symbolic reforms will be considered.
According to Ms. Cavanaugh’s article, the city pays almost $9,000 per year, per employee under the current defined benefit plan. By comparison, a 401K plan for new hires would amount to $4,635 per head.
Granted, the city is not doing a lot of hiring these days and it would take decades for the defined contribution plan to yield the savings we need. However, to use that as an excuse for not creating a new tier covered by such a plan is shortsighted.
The current system is bleeding the city to death. It will lead to our demise if it is allowed to continue. At some point, we will have to pay the piper big time to not only bail it out, but continue to pay in order to sustain it beyond that point.
That’s not a solution. It’s a slow but steady death – maybe not too slow.
We need to cut our losses now and prepare to finance the unfunded liability created by the sheer momentum of the current plan participants. Even that will be painful, but we are dealing with a cancer that must not be allowed to metastasize. We will eventually reach a tipping point beyond which recovery will be impossible without bankruptcy.
According to the Segal Company study cited by Cavanaugh:
“A reformed plan would cost $2,273 per employee. Reformed, in this case, would mean increasing the retirement age to 62 and penalizing workers who retire earlier, increasing employee pension and retiree health care contributions and imposing a major cut of retiree health care subsidies.”
“… those changes would cut city liability for new employees by 75 percent. And they would increase worker contributions by 44 percent.”
We will get significant concessions from the unions when pigs fly.
Also, what was the rate of return on investments assumed by Segal – 8%, a rate considered unsustainable by many experts including Warren Buffet? Cavanuagh does not state what rate Segal used. I would think if it were measurably less than 8%, it would have been disclosed in the study. Segal assumed an 8% return in the last plan evaluation it submitted to the city (as of June 2009; report dated April 2010).
Unfortunately both public and private sector entities are predisposed to using the highest rate of return assumption in order to cover up the bad funding news.
The private sector could be in for a rude awakening when more conservative and realistic international pension accounting rules under consideration ultimately take effect (interesting that it is a division of Segal – Sibson Consulting – that projects the use of a 6% return rate assumption if the rules are implemented).
GASB (Government Accounting Standards Board), the body that promulgates public sector accounting rules, will undoubtedly follow suit.
Even if the city succeeded in getting any concessions now, the pressure to reinstate older, more generous defined benefits will always be present, or at least as long as City Hall panders to the unions for votes and contributions.
Given the timidity of our city government to confront their union pals, you can bet they that any givebacks today will be offset tomorrow.
In the off-chance we are going to play hardball with the unions, then go for the gold and insist on a defined contribution plan as the plan model for new employees.
Anything less will lead to failure in the long-term.
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