New year; same old arguments.

McGee, Biggs, Podgursky P&I Op Ed

New Study Claims Annual Pension Costs Could Be Reduced By 62 Percent

A January 2014 paper from Public Sector Inc. examines benefit reform as “the key to a more sustainable public pension system.” It argues that a redesigned benefit structure with (1) an increased retirement age; (2) a broader final average compensation base on which benefits are calculated; and (3) no Cost of Living Adjustment (COLA) provides “the most promising opportunity to reduce pension costs and, therefore, pension underfunding.”

The paper was written by Carl A. Hess, the global head of Towers Watson Investment; Thomas J. Healey, a Senior Fellow at Harvard University’s John F. Kennedy School of Government; and Kevin Nicholson, a consultant at McKinsey & Company. Entitled “Public Pension Reform: Benefit Design as the Key to Sustainability,” the paper compares its approach with a baseline model in which a hypothetical public worker who is hired at age 30 and allowed to retire at age 60, uses final year of employment for “Final Average Compensation (FAC),” and is entitled to a 2.5 percent COLA increase after retirement.

Based on these criteria, which the paper’s authors say is representative of most public pension plans, they calculate a required accrual for pension benefits each year at 22.5 cents for every dollar of salary. By contrast, their paper finds that:

Increasing the retirement age to 65 reduces pension costs from 22.5 cents for every dollar of salary to 16.8 cents (a savings of 25.3 percent).

Changing the final average compensation base to the course of a career cuts pension costs from 22.5 cents to 15.1 cents (a savings of 32.8 percent).

Removing the cost of living adjustment reduces pension costs from 22.5 cents to 17.2 cents (a savings of 23.5 percent).

“In the unlikely case that all three of these changes were implemented,” the authors note, “annual pension costs could be reduced by 62 percent, from 22.5 cents to 8.4 cents per dollar of salary.” While they also acknowledge that “a reduction of this magnitude is improbable,” they point out that it nevertheless offers “a framework for understanding the potential for reducing through meaningful pension reform the current unfunded liabilities in the US.”

PublicSectorInc.org is published by the Center for State and Local Leadership at the Manhattan Institute for Policy Research. Both the Manhattan Institute and Public Sector Inc. are harsh critics of the defined benefit public pension model. Most recently, the Manhattan Institute hosted a “national conference” in New York City in October of 2013 entitled “Save our Cities: Reforming Public Pensions to Protect Public Services.” As has been previously reported in NCTR FYI, at that conference, Joshua Rauh, a professor of finance at the Stanford Graduate School of Business, claimed that public plans’ approach to accounting would end them up in jail if they were subject to private sector rules. Another panelist called for a Federal public pension bailout conditioned on conversions to defined contribution (DC) approaches.

Meredith Williams, Executive Director of the National Council on Teacher Retirement (NCTR) expressed dismay with the study and some of its assumptions and recommendations. “I don’t think very many public pension plans still use final year compensation in their benefit formulas, and I think a 2.5 percent COLA assumption is also on the high side,” he observed. “So I am not sure that their baseline model reflects reality,” Williams cautioned.

Also, he said that while lower COLAs have certainly been on the table in recent years as part of pension reform, doing away with them completely would be a drastic move that would end up costing money in the long run. “Even a relatively low inflation rate can seriously erode the purchasing power of a pension benefit over time if it is not adjusted,” he warned. Studies have shown that an inflation rate of 2 percent reduces purchasing power by 33 percent after 20 years and 45 percent after 30 years.

“With retirees living longer, these drastic reductions would put pressure on governments to provide increased assistance to some of our most vulnerable citizens, namely the very elderly,” Williams noted. “There is no free lunch, literally,” he pointed out. “Eliminating COLAs will ultimately mean higher government cost, and a reduced quality of life for so many who devoted their lives to educating our nation’s most precious assets—our children.”

“Public Pension Reform: Benefit Design as the Key to Sustainability”

Leigh Snell
Director of Federal Relations
National Council on Teacher Retirement
lsnell@nctr.org • (540) 333-1015