Fixing California’s Pension Mess

Pruning benefits and switching to a 401-k-style system could save the system

Pension reform might not be the sexiest of political issues, but it may well be one of the most important. California state and local governments continue to struggle with the high cost of their employees’ retirement benefits. While some officials have tried to blame the problem on such things as a poorly performing stock market (and thus pension fund), the real cause is simply the unaffordable increase in employee benefits.

The argument of generations past, that government must offer greater benefits than the private sector to offset smaller salaries, clearly no longer applies. Today, government employees receive significantly higher benefits and salaries than their private-sector counterparts. According to a 2005 study by the Employee Benefit Research Institute, public-sector employees earn 40 percent higher salaries and 60 percent greater benefits than private-sector employees.

Despite strong pension-fund investment performance in recent years, the California Public Employees’ Retirement System currently has a long-term unfunded liability of $26 billion, and the state teachers’ retirement system has a deficit of nearly $20 billion. In addition, Controller John Chiang estimates the shortfall for the state’s retiree health benefits at $48 billion, which, according to the Legislative Analyst’s Office, may be too optimistic.

To address the state’s public pension problem, former Assemblyman Keith Richman has formed the California Foundation for Fiscal Responsibility, which is trying to place a pension reform initiative on the ballot in 2008.

The initiative focuses on bringing the state’s traditional-style, defined-benefit system, where retirees are promised a certain level of pay, more in line with private-sector compensation. It would amend the state constitution to limit pension and retiree benefit levels and would cover local and state government agencies. Among the initiative’s provisions:

  • Retirement ages for new, non-safety employees would be aligned with Social Security requirements (65-67 years in most cases), and public safety workers, such as police and firefighters, could retire at age 55.
  • Pensions (including any Social Security payments) would be capped at 60 percent to 67 percent of an employee’s final compensation.
  • Pension calculations would be made based on the average salary of the five highest-earning years. (California is the only state that bases pensions on just the single highest-earning year, which encourages “pension spiking.”)
  • Pension calculations would only include base salaries (no adding in accrued vacation time or overtime to boost pension payments).
  • Retroactive benefit increases and “contribution holidays,” where the state does not pay into the pension system in a given year because pension fund returns have been particularly good (thus forcing the state to make larger payments when returns are low or negative), would be prohibited.

The proposal is expected to save $500 billion over 30 years. The savings come largely from encouraging employees to work longer, which affords them greater income in the long run and reduces the amount of time (and costs) the government must pay for their post-retirement health benefits.

This plan would be a huge improvement over the current system, although I believe that nothing short of switching to a 401-k-style plan for new government employees will really correct things in the long run. Private companies have recognized that defined-benefit systems are unpredictable and, ultimately, unsustainable, which is why they have been switching to 401-k-style (defined contribution) plans for 30 years.

Under a defined-contribution plan, the government’s contribution would be a fixed percentage of payroll, which is predictable, and the state would have to come up with the money immediately to pay its share. By contrast, a defined-benefit system relies on all sorts of actuarial assumptions about future funding requirements that can be fudged or just be wrong.

Nevertheless, the CFFR initiative would be a big step in the right direction. There are many things the government should not be wasting our tax money on. But if those tax dollars must be taken from us, they should be used to provide actual services to the taxpayers, not to overcompensate government employees.