A Good Definition of “Unsustainable”: Beneficiaries Negotiating Benefits Without the Benefactors PDF Print E-mail
Commentary/Politics - Editorials
Written by Kathleen McCarthy   
Thursday, 08 November 2012 05:01

Pensions are among the most important investments American workers and employers make. We work for years so that when the time comes, we can retire with enough income to live comfortably, enjoy the much-deserved leisure time, and engage in activities of our own choosing.

This week’s cover story examines Iowa’s and Illinois’ pensions, which, when coupled with health-care benefits, are in grave danger of insolvency, threatening to potentially bankrupt Illinois. This is due to the unsustainable “defined-benefit” pension plan that promises each employee a percentage of his or her annual income, regardless of the amount of contributions made by the employee, or on the employee’s behalf by the employer (the state’s taxpayers), over his/her years of service.

The defined-benefit pension plan has built into its calculations an annual rate of return on investment (ROI) of roughly 8 percent. The investment is the aggregate contributions from both the state and its employees into the pension plan each year. The presumed 8-percent gain is supposed to cover the expansive gap that is created by the difference between what was contributed and what is actually paid to each retiree. In today’s dollars, even 8 percent will not suffice, let alone current ROIs of 3 percent or lower.

Consider this hypothetical example for illustration purposes: A 25-year-old starts working for the State of Illinois with an annual salary of $50,000. If this person works for 30 years and retires at age 55, having had a 1.5-percent COLA salary increase annually, a state and employee contribution of 8.2 percent of salary annually, and an investment income of 4 percent annually, she would have a pension nest egg of more than $597,000. And let’s say, hypothetically, that this person lives to be 86 years old, or has 31 years of retirement to enjoy. And, over those 31 years, the pension fund continues to return 4 percent annually.

When she retired, her annual salary would have been $78,000 and, in this hypothetical case, the retirement benefit is 78 percent of salary when she retired – or just under $61,000 annually to start with. With a 1-percent COLA on the pension benefit annually, her second-year retirement benefit would then be just under $61,600. Even with the annual 4-percent investment return on the slowly diminishing retirement-fund balance, this person's pension runs out of money at age 66 and is in the hole $45,000 at age 67. And by the time this person dies at age 86, her fund balance is in the hole to the taxpayers to the tune of more than $2.2 million.

This is just for one single public-sector worker. Imagine what this figure looks like for some of the Illinois public employees who retire with even higher salaries, such as $200,000. (To do this math yourself, download the spreadsheet provided by the publisher’s father, Bill McGreevy, at RCReader.com/y/illinoispensions.)

Naturally, public-sector employees’ unions are fighting to keep the defined-benefit plan. Who wouldn’t? The calculation for determining employees’ average annual income can include any overtime and the value of some perks (such as gas allowances) – all of which allow for accelerated incomes over the final four years. Obviously, this can dramatically increase the average income used for calculating retirement incomes, grossly inflating retirement benefits and adding to the funding dilemma facing states, especially Illinois.

Conversely, most private-sector pension plans use some form of defined contribution, with the employee contributing a larger percentage into his/her account, and the employer contributing at some lower percentage. Some states impose a cap on the allowable contribution rate. Either way, the employee can choose the amount of risk he/she is willing to accept for investing aggregate contributions during the years of service. Upon retirement, he/she is entitled to the total amount in the account at that time, regardless of whether the account gained or lost money. There is no guaranteed ROI.

Defined-contribution plans provide for sustainable pensions, using reasonable expectations that can be met over time. Plus, these plans allow each employee to manage his/her particular appetite for investment risk. Defined-benefit plans carry no risk whatsoever to the employee, only to the taxpayer. It is an unreasonable burden due to the excessively large amount of risk, considering the model is tied to an annual ROI of 8 percent whether or not its achieved.

The rationale that defined-benefit plans should be maintained to remain competitive in attracting a qualified workforce is disingenuous. The public sector is the last employment arena remaining where excessive benefits are still provided. Add tenure and automatic increases in annual incomes to the mix, plus lower-than-average employee contributions to health-care premiums and costs, and higher-than-average wages compared to the same jobs in the private sector, and retention is hardly a problem.

Consider that in Iowa, 90 percent of the state employees and retirees make no contributions to their health-care costs. Iowa is one of only six states that still pay 100 percent of employees’ health care. In Illinois, the state pays 5 percent of an employee’s premium for each year of service up to 100 percent after 20 years. Iowa’s recent Executive Order 78 asked state workers to voluntary pay 20 percent of premiums, with only one taker so far: Polk County employees are now contributing $15 to $25 toward their premiums.

This lack of employee participation toward health-care costs is so far out-of-whack with the private sector that it rises to absurdity. Most private-sector employees are paying as high as 50 percent of their premiums for health-insurance coverage, including employers’ contributions, and as low as 18 percent. Iowa’s employers are mandated to pay a minimum of 50 percent of each employee’s premium if the company offers group health insurance. In Illinois, the private-sector employees pay on average 22 percent of their premiums. The national average premium for single coverage is $900 per month. There are also out-of-pocket expenses, deductibles, and other costs related to health care that are largely absorbed by the states on behalf of their employees, unlike the private sector, where employees absorb all those costs.

Iowa and Illinois state employees are not to blame. The real problem lies in the process that provides such generous employment contracts that have no fiscal basis for financial sustainability – specifically, negotiations between union leadership and public-sector bureaucrats and politicians, none of whom actually pays the contracts. The absence of taxpayers, who ultimately do pay the contracts, from the table becomes a glaring one, especially with so many conflicts of interest among those who are at the table.

Unlike public-sector unions, private-sector unions work efficiently and are of great benefit to both labor and management. Negotiations can be tough, but are mostly reasonable because both parties have high stakes in the game, and both benefit from a positive outcome. Management cannot succeed without labor, nor can labor thrive without management. Therefore both sides at the table ultimately have the same goal: to make the company profitable so all can earn a better living.

Public-sector union negotiations basically ignore one of the primary stakeholders – the taxpayers. The state bureaucrats and politicians are only concerned with their own stake in the contracts they negotiate, both financially and politically – as are union leaders. State bureaucrats, politicians, and union leaders’ retirement packages are reflective of the terms they negotiate among themselves. The problem is that none of these parties is negotiating with the proper skin in the game. In other words, they are not negotiating with their own money. Instead taxpayers are deliberately put at risk for what are fast becoming unaffordable benefits for state employees. The beneficiaries are negotiating their benefits without the participation of the benefactors. This process, too, is unsustainable

Politicians not only participate in most negotiated benefits, but they simultaneously secure union membership votes, which go a long way in providing job security for both the politicians and the bureaucracy. Not to mention the enormous campaign contributions that flow from union coffers, thanks to membership dues. Union leaders also keep their jobs, and retain membership in return for securing generous benefits. This produces an abundance of political leverage. Thus, the circle is closed.

But what of the taxpayers’ representation in such negotiations? They are saddled with far larger risk than reward, and the endless cycle gets more precarious and unmanageable with each year. It is an exponentially ballooning crisis that requires negotiators to come back to earth.

There is no question that the pensions cannot continue as they are currently structured. The politicians and bureaucrats know it. The union leaders know it. The public-sector employees, whose pensions are on the line, know it. And the taxpayers know it. The ones who don’t know it – yet – are our children, who will end up with the bill for all of it regardless.

Meanwhile, the public-sector employees are understandably relying heavily on the legality of their contracts to be upheld and satisfied, rather than entertain reforms to the plans under which their contracts were generated. Most of us would not argue with the premise, just the wisdom. If the pension funds are not available, then what? The notion that taxpayers will have to pay more and more taxes to cover public-sector pensions is a slippery slope. Not only would likely tax increases not cover the widening gaps from ever-increasing pension-fund obligations, but taxpayers will only tolerate abusive taxation for so long before their votes will trump those of the union. And one thing is certain: Politicians will usually bow to the more formidable voting bloc.

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