3. REAL PENSION REFORM FOR NEW YORK

The investment losses sustained by New York’s pension funds in the past decade have created deep holes that must be filled. The resulting pension cost increases de-scribed in this report cannot be avoided in the short term. Unlike officials in some other states, such as New Jersey, New York officials cannot ignore the problem by skipping or under-funding required pension contributions—if only because New York’s highest court has made it clear it will not allow them to do so.⁸

Article 5, Section 7 of New York’s Constitution guarantees that pension benefits shall not be “diminished or impaired”—which is widely assumed to mean that employees cannot be required to help pay for the rising costs for their future benefits, even benefits they have not yet accrued. As a result, New York government employees are benefitting from what a leading commentator on retirement finances has called the “public pension straddle option,” which allowed workers to collect bigger benefits financed by excess investment gains in the 1980s and ‘90s, while forcing taxpayers to cover subsequent pension fund investment losses.⁹

But it doesn’t have to stay that way. The Empire State can—and should—ultimately eliminate the intolerable financial risks, volatility and unpredictability of the existing pension system. From the standpoint of employers and taxpayers, the best way to accomplish this would be to shift new employees to defined-contribution (DC) plans modeled on the 401(k) accounts now prevalent in the private sector, or the 403(b) plan available to State University and City University of New York employees.

Instead of a single common retirement fund, a defined-contribution plan consists of individual accounts supported by employer contributions, usually matched at least in part by the employees’ own savings. These contributions are not subject to federal, state or local income taxes until withdrawn. Funds in the accounts are managed by private firms and invested in a combination of stocks and bonds. In a DB system, the employer promises to finance a future retirement benefit for a large group of current and former workers. In a DC system, the employer’s obligation is discharged immediately, through regular contributions to the retirement accounts of each employee. The size of the ultimate retirement benefit generated by a DC plan depends on the amount of savings and investment returns the worker is able to accumulate over the course of his or her working life. The downside risk of unanticipated investment losses and the upside potential for unanticipated investment gains are both shifted from the employer to the employee.

While a growing number of states have been making changes to their pension sys-tems—including 11 in 2010 alone—pure DC plans so far have been mandated in only two states, Michigan and Alaska. In the wake of the November 2010 election, at least six newly elected governors in other states were “looking favorably at some form of 401(k)-style retirement plan for public employees, adding to the momentum building nationally for a shift away from traditional guaranteed pensions,” the Pew Center’s Stateline web site recently reported.¹⁰ The Michigan experience, which began earlier and covers many more employees, is particularly instructive (see below).

An alternative to a pure DC plan would be a “hybrid” combining elements of both DB and DC plans. A model for this approach was recently adopted by the state of Utah, which closed its existing DB plan to newly hired employees. State workers in Utah now have a choice between a pure DC plan or a combined DC and DB plan—but in both plans, the tax-funded employer contribution is capped at 10 percent of salaries.¹¹ Thus, while employees share in the upside of investment gains, they must also share in the risk of investment losses.
 

The federal government adopted the hybrid model in 1984, when it replaced its own traditional pension plan for civilian workers with a combination of a small DB pension and a DC supplement known as the Thrift Savings Plan (TSP).¹²

The downside of a hybrid plan is that, by retaining elements of the DB pension structure, it also retains opportunities for the kind of steady sweetening that occurred when funding levels rose in the current system. The actuarial and financial accounting involved in the DB system is dauntingly complex, inviting the kind of buy-now, pay-later options that politicians often are unable to resist.

There need not be a single statewide model of reform. The next Governor and Legis-lature could create a set of new retirement plan options for local governments, school districts and public authorities to choose from. Some might opt for a pure DC plan and some for hybrids, while others might decide to allow their employees to choose between the two.

Pension reform can be justified as a matter of fairness as well as financial prudence. Taxpayers last year kicked in an average of $8.24 for every dollar of employee con-tributions to the NYSLRS, $6.64 for every dollar of employee contributions to the NYSTRS, and $8.73 for every employee dollar contributed to the New York City pension funds,¹³ and those ratios will rise steeply in the next few years along with employer contribution rates.

Yet the vast majority of New Yorkers do not enjoy retirement benefits even approaching those available to public employees. Nationally, less than one in five private workers has access to an employer-sponsored DB pension plan; as noted, most of those who have access to any employer-sponsored retirement plan are dependent on 401(k)-style accounts. Where traditional pensions still exist, their benefits are usually smaller—and, of course, are not guaranteed if a plan sponsor goes bankrupt or otherwise lacks the assets to make good on its promises.
 

The average retirement benefit for all state and local government retirees in New York as of 2009 was $27,601—more than twice the average company or union pension of $13,105.¹⁴ While many private pensions are reduced by a percentage of Social Security payments, retired state and local employees in New York collect full Social Security benefits on top of their pensions, which are also exempt from state and local income taxes.

The cost of replicating a stream of income equaling a typical public pension would be prohibitive for a private sector worker approaching retirement. For example, as of 2009-10, the median retirement age for teachers in NYSTRS was just over 59, and the median annual pension benefit was $47,000. A male private-sector worker would need to save $860,000 to purchase a guaranteed lifetime annuity paying the same income stream starting at the same age.¹⁵ Teachers in New York City suburbs retiring in their mid-50s can qualify for a stream of pension income that would cost $1.2 million to replicate as an annuity.¹⁶ These figures do not include the value of heavily employer-subsidized health insurance coverage, which most teachers also continue to receive throughout retirement. Retiree health insurance coverage is now even more rare than DB pensions in the private sector.¹⁷

If public employees were instead covered by DC or hybrid DB-DC plans like those described above, they would still receive benefits superior to those available to most workers in the private sector. But they would at least shoulder downside risks as well as upside gains of long-term investments. Taxpayers would no longer be ex-posed to potentially open-ended liabilities. And a retirement plan requiring workers to share more equally in the costs of their benefits would discourage the seemingly limitless varieties of pension gaming encouraged by the existing system.

State officials should not settle for creating a “Tier 6” that incrementally adjusts some existing pension parameters while preserving a fatally flawed system that exposes taxpayers to potentially open-ended liabilities. As New York’s previous experiences with “pension reform” demonstrate, even an ambitious attempt to reduce the costs of traditional pensions (such as the Tier 3 plan of 1976, as further explained in the Appendix) is likely to be undone at the first sign of a market upturn—and the financial implications of such changes will be poorly communicated to and understood by the public.

Any pension reform should retain the existing Taylor Law provision prohibiting col-lective bargaining of pension benefits—and that provision should be expanded to cover other retirement benefits. This is an essential step towards getting a handle on more than $200 billion in unfunded liabilities for retiree health coverage currently promised (but not constitutionally guaranteed) by state and local governments.

“True North” transparency

The state's pension funds need to release more information about the true extent of the financial risk to which they have exposed taxpayers, who are ultimately respon-sible for backing up the constitutional guarantee of pension benefits.

Robert North, New York City’s chief pension actuary, has become a national leader in this area by reporting alternative measures of funded status for each of the city’s retirement systems, as cited in this report. Following North’s lead, all of New York State’s pension funds should be required by law to annually calculate alternative measures including their Market Value Accumulated Benefit Obligation (“MVABO”), an estimate of which was the basis for our own calculations of funded status for the NYSLRS and NYSTRS funds.

For the sake of improved transparency, New York’s pension funds should also be required to:

• Calculate the statistical likelihood that they will meet their average target rate of return over time horizons of five, 10, 15 and 20 years. Such calculations are essential to evaluating all of the potential risks and benefits of policy changes such as the NYSLRS amortization plan.
• Post their financial results in consistent formats on the Internet, allowing for “searchable” text and spreadsheet versions of numerical tables, including quarterly updates of investments.
• Calculate projected cash flows—i.e., the benefits they expect to pay over the next 15-20 years, prior to any discounting.

Focusing on the main problem

Part-time attorneys with thriving practices are able to pile up retirement credits on the payrolls of multiple school districts.¹⁸ A retired New York City firefighter collects an $86,000 disability pension while running marathons.¹⁹ The state Legislature uses an actuary bankrolled by unions to evaluate proposed pension enhancements, whose costs are lowballed in what the actuary admits is “a step above voodoo.”²⁰ Some police retire with pensions exceeding their base pay.²¹ A former county hospital administrator qualifies for a $222,143 pension, and shrugs: “It may not be viable, but that’s the way the state structured it.”²²

These and other headline-grabbing scandals and excesses of the pension system nat-urally evoke public outrage, and also add to pension costs, but they are mere symptoms of a bigger problem. To borrow a software term, that problem is not a bug, it’s a feature of traditional DB pension plans in the public sector. Offering generous and guaranteed retirement benefits to government workers, while requiring them to shoulder only a minimal and limited share of the cost, inevitably exposes taxpayers to financial risk and volatility.

DB pension funds are financially and actuarially complex. They tend to demand new infusions of cash when it is in short supply—in the wake of economic downturns that stretch government finances to the breaking point. Tinkering with existing pension rules to address pension padding, double-dipping and overtime spiking won‘t change that.

Other benefit models can provide public employees with retirement security without threatening to crowd out vital services in a future fiscal crisis. DC or hybrid plans also would allow much less potential for abuse and gaming. The necessary next step in pension reform for New York is not to mend the existing system, but end it.
 

APPENDIX: A TRAIL OF TIERS

New York’s public pension plans are organized into benefit “tiers” based on hiring dates, as follows:

• Tier 1 benefits are available to all employees hired before June 30, 1973;
• Tier 2 covers all employees hired on or after June 30, 1973 and before July 27, 1976;
• Tier 3 covers employees hired on or after July 27, 1976, and before Sept. 1, 1983;
• Tier 4 includes all employees hired on or after Sept. 1, 1983, and before Jan. 1, 2010; and
• Tier 5 covers employees hired on or after Jan. 1, 2010.

The cutoff dates for each tier reflect the recent history of legislative attempts to con-trol runaway government pension costs in New York. The most generous pension plan is Tier 1, which requires no employee contribution and allows unrestricted re-tirement with full pension as early as age 55. Significantly, Tier 1 does not cap the final average salary (FAS) used as a basis for computing the pension. Thus, com-pared to employees hired after 1973, Tier 1 members have more ability to pad their pensions by working additional overtime in the year or two before retiring.

Tier 2, in the early 1970s, raised the basic retirement age to 62. Retirement at age 55 with the maximum pension is still allowed for Tier 2 employees, but is restricted to those with at least 30 years of service. Pensions are reduced for those with fewer than 30 years in the system who retire between the ages of 55 and 62. In addition, the definition of salary used to compute pensions is subject to a cap. Like Tier 1, Tier 2 requires no employee pension contribution.

The creation of Tier 3, during the darkest days of the New York City fiscal crisis, marked the first time most state and local employees in New York were required to kick in some of their own money—3 percent of salaries—towards their future re-tirement benefits. The retirement ages were basically the same as in Tier 2, but the cap on final average salary was slightly lowered. Pension benefits included an an-nual automatic cost of living adjustment (COLA). Most significantly, Tier 3 also included a feature common to private pensions: the pension benefit would be “offset,” or reduced, to reflect a portion of the retiree’s Social Security benefit starting at age 62. Tier 3 pensions initially were significantly less expensive for employers.

Tier 4, adopted just seven years after Tier 3, eliminated the Social Security offset and the COLA. For the first 16 years after its enactment, Tier 4 also required a 3 percent employee contribution. This tier also initially featured more restrictions on early retirement, which were loosened under a series of pension sweeteners in subsequent years. Tier 3 members can opt for a Tier 4 benefit, which in most cases is larger. Under pension enhancements passed in 2000, Tier 3 and 4 workers outside New York City, and most civilians in city pension plans as well, are no longer required to make pension contributions after 10 years of government employment.

Tier 5: A lost opportunity

On December 2, 2009, the New York State Legislature voted to create a fifth tier of slightly reduced pension benefits for state and local employees hired after Jan. 1, 2010. However, while benefits in the new plan are less expensive than those in pre-vious tiers, Tier 5 does not live up to the “significant pension reform” promised by Governor David Paterson when he originally proposed the law. As shown below, the Tier 5 changes for members of the New York State Employee Retirement System (ERS) restored most key elements of the original 1983 Tier 4 pension plan, before those benefits were repeatedly enhanced in the 1990s.
 

The most significant difference between Tier 5 and the original Tier 4 benefits for ERS members involves the use of overtime in computing final average salaries. Un-restricted in all previous plans, overtime for Tier 5 ERS members will now be subject to a $15,000 cap, “indexed” to grow at 3 percent a year.

Teachers outside New York City got a different Tier 5 deal: their minimum retire-ment age will be raised only two years, to 57. The employee contribution for Tier 5 members of the New York State Teachers’ Retirement System (NYSTRS) will be made permanent at a slightly higher rate of 3.5 percent.

Members of the Police and Fire Retirement System (PFRS) hired prior to 2010 are mostly enrolled in plans requiring no employee pension contribution. Newly hired Tier 5 police and firefighters (outside New York City, and excluding state troopers) will have to kick in 3 percent of their salaries, and their overtime will be subject to a cap of 15 percent of salary.

Tier 5’s overtime limit for uniformed public safety employees is designed to curb the most egregious pension “spiking” abuses, but it still contains ample loopholes for padding retirement benefits. Consider, for example, the real life example of a recently retired Suffolk County law enforcement officer, whose final average salary of $122,841 was padded by an average of $14,639 in overtime and $28,772 in night differential, holiday pay, longevity pay and other allowances.²³ The same “pensionable” amount would have been allowed under Tier 5. However, the officer’s retirement benefit would have been 26 percent lower if it had calculation of “final average salary” had been limited to the base salary alone.

Governor Paterson first introduced the Tier 5 bill in the spring of 2009, but he se-cured its passage only after making a series of costly concessions to labor unions in exchange for their agreement not to lobby against the pension changes:

• The state’s two largest unions, the Civil Service Employees Association (CSEA) and the Public Employees Federation (PEF) won an unprecedented no-layoff pledge from the governor. (Paterson later sought to renege on the deal by an-nouncing layoffs in late 2010—but no layoffs seemed likely to occur before he left office.)
• New York State United Teachers (NYSUT) achieved its highest pension-related priority—a plan offering some teachers a chance to retire at age 55 after only 25 years of service. NYSUT also won the permanent enactment of a temporary law, annually renewed since 1994, that effectively allows its local chapters to veto any changes in retiree health benefits.
• Police unions were handed a four-year extension of the temporary law providing for compulsory arbitration of police and firefighter union contracts.

The employer contribution rates for Tier 5 employees will be about 20 percent lower than those for employees in Tiers 3 and 4. However, it should be remembered that Tier 3 initially promised even bigger average savings when it was adopted in 1976—only to be undone by the Legislature seven years later. Public employee unions and their allies in the Legislature will naturally pursue “tier equity” in pension benefits as soon as economic clouds lift—and the “reform” process will need to begin all over again.

Carving out special benefits

Over the years, various public employee unions have successfully lobbied the state Legislature to create special plans for specific employee groups within the tier structure, such as sheriffs, corrections officers and teachers. As a result, Tier 4 alone also encompasses 11 separate retirement plans.

Putting aside the often bewildering array of retirement options available under these different plans, virtually all Tier 3 and Tier 4 employees who have attained the five-year “vesting” point can retire from government service and start drawing at least a partial pension as early as age 55, with full benefits at 62. Civilian retirees with fewer than 20 years in the system receive 1/60 of their salary (1.67 percent) for each year of service. Those with 20 to 30 years receive 1/50 of salary (or 2 percent) for each year. For each year of service over 30 years, the pension includes an addition 3/200 (1.5 percent) of final average salary.

In practice, these rules mean the basic pension for a 30-year employee of the state system is at least 60 percent of final average salary, rising to 75 percent for a 40-year employee. When federal Social Security benefits are added to the mix, many career New York State and local government employees can retire at more than 100 percent of their final salaries.²⁴

Police and fire

Most police officers and firefighters throughout New York can retire at half pay after just 20 years on the job, with no age restriction. As a result, those who are not promoted to a supervisory ranking usually choose to begin second careers in their early 40s, backed up by pensions often swollen by overtime in their pre-retirement, peak earning years. (In 1992, retirement at half pay after 20 years was also extended to New York City sanitation workers; however, Tier 4 sanitation workers must make an added 5.35 percent contribution per year to qualify for this benefit.)

Most members of the New York State Police and Fire Retirement System hired prior to January 1, 2010 are not required to make any contribution towards their own pensions. In New York City, employee contributions to the police and fire pension funds are determined by age. However, these pension contributions are partially to fully covered by the city through “increased take-home pay” allowances.

Endnotes:

8 McDermott v. Regan, 624 NE 2d 985 - NY: Court of Appeals 1993.

9 Girard Miller, “Top 12 Pension and Benefits Plan Issues for 2009: Part I,” Governing magazine, Jan. 22, 2009. http://www.governing.com/columns/public-money/Top-12-Pension-and-.html

10 “Election adds pressure to change public pensions,” Nov. 4, 2010, at http://www.stateline.org/live/details/story?contentId=526037

11 “Pension Crisis-The 2010 Utah Response,” presentation by state Sen. Dan Liljenquist, http://www.ncsl.org/documents/labor/Liljenquist_Pensions_LegSum2010.pdf.

12 Guaranteed pension benefits for post-1984 Federal Employee Retirement System members accrue at the rate of 1 percent of salary per year, which is half the maximum level available to New York State employees.

13 Data on contributions are from the 2009-10 financial reports for the respective pension systems. New York City contributions include those for transit workers and bridge and tunnel personnel employed by the state Metropolitan Transportation Authority.

14 U.S. Census Bureau, 2010 Current Population Survey.

15 Estimated payment for a Single Premium Immediate Annuity, partially indexed to inflation on the same basis as the pension, with an insurer who assumes a 3% rate of return.

16 Top scale in most suburban schools now exceeds $100,000.  With a final average salary of $100,000, a teacher with 30 years in the system would qualify for an annual pension of $60,000, which would require a single premium of $1.2 million to replicate as a lifetime annuity under the assumptions outlined above.

17 E.J. McMahon, “Iceberg Ahead: The Hidden Cost of Public Sector Retiree Health Benefits in New York,” Empire Center, September 2010, http:/www.empirecenter.org/Documents/PDF/iceberg-final.pdf

18 “Cuomo: 90 attorneys’ pensions ‘potentially fraudulent’,” Newsday, April 10, 2008.

19 “86G Pension for Marathon Man,” New York Post, July 6, 2010.

20 “Unions Bankrolled Analyst Vetting Pension Bill,” The New York Times, May 8, 2008, p. B1.

21 Pension information posted at www.SeeThroughNY.netshows 922 police and firefighters in the state system had pensions of $100,000 or more as of March 31, 2010.

22 “Padded Pensions Add to New York’s Fiscal Woes,” The New York Times, May 20, 2010, p. A1.

23 County of Suffolk, “Comprehensive Review of Pension Practices,” prepared by Suffolk County Executive’s Office and the Comprehensive Pension Reform Committee, Oct. 15, 2010.

24 For example, a 40-year state employee retiring at 62 with an final average salary of $50,000 immediately qualifies for a state pension of $37,500 and Social Security benefits of $12,948, yielding a total income of $50,448 that, unlike wages, is free of payroll tax and state or local income tax.