Compensation & Benefits Review
The Problem As the average municipality employee nears retirement, he or she is eager to collect on the pension that has been accumulating and have access to the benefits earned over the years. Retirement benefits are often the incentive for maintaining workers in cities and municipalities. However, a new reality has taken effect over the past few years – municipalities, like large private companies, are facing serious problems with their defined benefit pension plans. Plan funding deficiencies are increasing with no prospects for increased contributions or reduced benefits. With limited exceptions in carefully monitored and fiscally responsible plans, sooner or later bankruptcy may become the only alternative for the plan sponsor except, of course, for municipalities. For these cities and towns that have dramatically underfunded pensions, there is but one option, and it is not bankruptcy.
The seriousness of the situation begs the obvious question: Who pays the funding deficiencies for the promised retirement benefits? If the plan sponsor is a private or publicly traded business, the Pension Benefit Guaranty Benefit Corporation (“PBGC”) provides plan termination insurance up to a modest annual payment for each participant (now slightly in excess of $45,000 per year) and will take over that portion of the promised retirement benefits from the plan sponsor in a Chapter 11 or Chapter 7 bankruptcy proceedingi. However, because the PBGC is a government created entity under Title IV of the Employee Retirement Security Act of 1974 (“ERISA”), the federal government must cover any deficiencies if the PBGC has insufficient funds to pay benefits. And where does that revenue come from? Of course it comes out of federal revenues. And where do federal funds come from? The taxpayers ultimately share the financial burden to bail out pension plans of failed, privately owned businesses.
What about the deficiencies in municipal pension plans? ERISA does not cover Employees who participate in a defined benefit pension plan so there is no plan termination insurance available. Chapter 11 is not an option for municipalities.
The Problem Defined
When we speak of pension plans and deficits, we are dealing with defined benefit pension plans, not defined contribution plans such as a 401K plan. In very general terms, a pension plan promises a retirement benefit payable upon attainment of a retirement age, often age 65. The benefit it commonly expressed as an annuity payable for life beginning at that age. The benefit can be computed and accrued in a number of ways; however, a simple method is to promise a retirement benefit as a percentage of final average compensation.
EXAMPLE: A pension plan has a retirement benefit of 50% of final average compensation. If final average compensation is $50,000, the benefit would be $25,000 per year payable for the lifetime of the participant. There is also a requirement that 50% of the benefit be payable to the surviving spouse of the participant if he/she is married if the participant predeceases the spouseiii.
The cost of a retirement benefit is the present value of the stream of annualized payments over the actuarial life expectancy of the participant computed as of normal retirement age. The computation also assumes that the amount will earn a reasonable return while the amount is being held in the plan, e.g., 7% per year.Once the present value cost of the benefit at normal retirement age is determined, the plan actuary will look at the current age of the participant and how many years are left until the participant attains normal retirement age, i.e., the working life expectancy. Although there are many ways that this cost can be amortized, think of it as taking the present value of the benefit at retirement age and dividing it by the number of years of working life expectancy. The annual amount so determined, and using the assumed rate of return in the plan, is the normal annualized cost of the retirement benefit of that participant.The plan sponsor can fund that annualized normal cost using various actuarial assumptions that are regulated by very complex pension lawsiv. If the sponsor funds the aggregate, annualized cost for all participants each year, the plan will be fully funded, i.e., there will be just enough assets to pay the retirement benefits promised by the pension plan. But what if the plan investments decrease in one or more years due to investment losses? Or what if a union requires a plan sponsor to increase benefits, e.g. increase the 50% benefit in the illustration to 60%? Or what if the private employer has a bad profit for the year and can’t meet the obligations. What if we have medical improvements so that we live longer and thus have a longer retirement lifetime not contemplated by current (or past) mortality assumptions for purpose of determining the benefit at retirement age? What if all happen at once?There are complex rules for amortizing the costs that are not funded currently on account of the above contingencies that involve, in part, amortization of losses and benefit increase over future years for reporting purposes, i.e., the missed contributions will be made up over future years. This can result in a generic term: A plan funding deficiency/plan deficit. That is what we are talking about – plans that have promised much more in benefits than assets then being held in the plan. It is “The Problem.”
The Depth of the Problem
Just how bad is the pension plan deficit problem? Answer: It is indeed a crisis.At the end of 2004, the PBGC deficit was 23.3 billion dollars. In 2005, it slightly fell to $22.8 billionv. However, the deficit was increased by United Air Lines and U.S. Airways bankruptcies which resulted in additional liabilities of 9.6 billion. The Congressional Budget Office estimates total the PBGC deficit in 2015 to be $87.7 billion. That’s a bleak outlook for private plans.2How about the public sector? A recent Standard and Poor’s report advised that the aggregate nationwide deficit for state plans was $284 billionvi. The S&P report also addresses just state pension plan deficits, not municipal plans. That is not to say that all states’ or municipalities’ plans have funding deficits. In fact, the Standard and Poor’s report indicates that Florida has the most solid plan funding of any state in the Nation. There were eight other states with an AAA rating as well. To be certain, many municipal plans are not in a pension funding deficit as well.A random sampling of more specific illustrations of underfunded plans in specific industries in both the private and public sector are indicated below.
Private Sector
The PBGC has taken over 291 pension plans in the steel and metals industry since 1975.The airline industry has never been a “rich” industry; however, it does have unions that have pressed heavily for retirement benefits. If the airline does not have profits on an ongoing basis, how will the pension plan be funded? Answer: funding deficiency. Illustrations are Delta, Northwest, United Air Lines, U.S. Airways, etc. They have all filed for Chapter 11 to shed their pension plans and their plan deficits to the PBGC (which is to say the liability has been shifted to the taxpayers.Other sectors are not exempt. The auto supplier Delphi Corp. filed for Chapter 11 in 2005. Since it was spun off by General Motors in 1999, GM will have funding liability for approximately $11 billion of accrued but unfunded benefits for 50,600 of Delphi employeesvii.General Motors used to be a candidate for this list. However, in the last few years, GM put billions of dollars into its pension funds to reduce or eliminate its funding deficiency from borrowings. It now is about even but also assumes that its funds will grow at 9% per year which is somewhat aggressive. Also, with the decision last year to eliminate 25,000 jobs, reduced profits in future years, should that occur, could create future problems in maintaining a sound pension fund.The Public SectorSan DiegoAccording to recent records, the San Diego pension system is saddled with a deficit of at least $1.4 billion which began in 1996 on account of employee benefit boosts and stock market losses.
The crisis has become more and more complex, with resignations abounding and criminal investigations arising. Members of San Diego’s pension board have been accused of padding their pensions by agreeing to renew the county’s underfunding practices.3Pension reform was a platform of San Diego’s mayoral race, and suggestions proliferate on how to resolve the problem. Concepts range from putting the pension plan into receivership with a call for reorganization to simply raising the age of retirement for city employees. Many options – which are frequently balked at – have called for employee contributions to increase the funding.
In Florida, many local municipalities are facing a similarly disastrous situation due to politically increased benefits which were passed without knowledge or consideration for accompanying costs. Long-term benefits have long-term ramifications with additional costs accruing exponentially. As more and more retirees qualify for benefits, municipal losses complicate the city’s ability to comply.New York Metropolitan Transportation AuthorityJust about everyone recalls the showdown last December between the New York Metropolitan Transportation Authority and the Workers’ Transit Union. The workers plan is so greatly underfunded that a $9 billion deficit was forecast for 2009. The MTA wanted to increase normal retirement age from 55 to 65 (thus increasing the funding period for retirement and simultaneously reducing costs due to a shorter retirement life) and increase employee contributions from 2% to 6%. We all know what happened: the New York City transit system was shut down for days in protest of the proposed changes. The proposed retirement age change and the increase in employee contributions were ultimately dropped.
Problem remains.
The City of Dania, Florida, eager to attract city employees and reduce turnover, has created an incentive program to draw municipal workers to the city and to remain there. Among the incentives is an excellent benefits package – but there is a significant mandatory employee contribution requirement: an 11.66% of earnings contribution was required prior to October 1, 1999. Because of funding issues for promised benefits, the employee mandatory contribution percentage was increased to 19.74% after that date to fund their retirement benefits; however, the City agreed to make the 16.08% of the mandatory contribution percentage for the employees in lieu of scheduled wage increases. The employees are thus bearing a significant part the cost Plan funding.Houston, TexasOften, the problem with municipalities is that the benefits offered to employees are just too rich. The Christian Science Monitor quotes an actuary that an age 40+ employee in Houston earning $40,000 per year could retire at age 65 with retirement benefits valued at $2,700,000viii.4
Options to Solve the Problem
Plan sponsors have only three basic alternatives to correction of pension plan funding deficiencies without prospective restructuring of plan benefits. That is because under ERISA, accrued benefits cannot be reduced retroactively by plan amendmentix. In the case of a municipal pension plan to which ERISA does not apply, the accrued benefits are an enforceable contract between the municipality and its employees.First, they can invest plan assets more aggressively to earn a higher rate of return that the actuarial interest rate of the plan assumes (currently around 7%). However, as we all know: the greater the return of the investment the greater the risk of negative yields. More aggressive investment policy is not the proper solution.Second, the plan sponsors can ask their employees to contribute more of their salaries to the plan. Most municipal plans require an element of employee contribution to their pension plans. There are, however, limitations to how much a municipality can ask its employees to contribute to their own retirement. See the City of Dania, Florida, and the NY Metropolitan Transit Authority cases discussed, above.Third, the municipality can (and may have to) make greater contributions. This is ultimately “where the buck stops.” However, who funds the municipalities’ revenues? The taxpayers do, of course.Private plans have the same limitations on correcting funding deficiencies as do municipal plans although private plans also have, in some cases, the ability to reorganize under Chapter 11 of the federal Bankruptcy Act and thus shift their pension funding deficits to the PBGC. It should be noted (as below) that a revision of the terms of the pension plan, which apply only to future years, can reduce prospective funding costs and plan liabilities if the plan can be amended.There is also the legislative option for private plans. ERISA was passed in 1974 in response to the mismanagement of funds by the private sector in defined benefit plans and to provide enforcement rights to participants. As complex as ERISA is, it does not appear to be sufficient to remedy the Problem. It is clear that the ever increasing pension funding deficits and the shifting of this burden to the taxpayers through the PBGC has occurred during the ERISA “watch.” Congress and the White House have recognized this problem. Both the Senate and the House have three pending pension bills which still need to be reconciled because of large differences in how to address these problems. It is difficult to balance fiscal, plan sponsor and participant interests without a remedy hurting one of the affected parties.
For example, does one make funding pension deficits stricter to reduce them? It could put a financially week company out of business including its employees who are plan participants. If the funding periods are lengthened, the pension deficits could grow larger. If actuarial assumptions or accrued benefits are changed, participants could be hurt. The three pending bills x include the following:
5• The insurance premiums to PBGC would be increased for sponsors of underfunded plans• Benefits to some participants could be reduced by changed the actuarial method of computing lump sum distributions
• In some cases benefits could be retroactively reduced
•Certain underfunded plans would be frozen• Incentives to encourage early retirement would be eliminated in the House version
• Both versions would freeze benefits where underfunded plan where there is less than 60% of the benefits are funded• One of the House bills would allow airlines 20 years to fund their deficitsThere are estimates that 22 million workers could be affected by this legislationxi.
As with most legislation, there are other aspects of the legislation that go beyond the pension plan Problem which may present hurdles to final passage. The lobbyists are alive and well!From a private plan sponsor perspective, the trend is clearly discontinuance of pension plans and the adoption and/or enhancement of 401K plans. This effectively shifts the risk of retirement investment from the plan sponsor to the participant. A 401K is a defined contribution plan that does not guarantee any retirement benefits (note the sad Enron 401K situation). Rather, retirement benefits are measured by the contributions (hence the name) and the earnings (or losses). What is there at retirement is what you get. Nothing guaranteed. Most 401K plans also permit lump sum distributions whereas pension plans typically permit only annuities and thus no ability to “overspend” one’s retirement benefits prematurely. Pity the poor spendthrift in a 401K plan upon retirement!As mentioned earlier, benefits in a pension plan can be reduced prospectively or the plan frozen, i.e., the assets remain invested within the plan until retirement benefits are paid. If the plan’s investment returns exceed the internal growth rate, the plan could become more financially sound over time.The resolution of the muncipal pension problem is complex and does not have as many solutions.
Should/can federal legislation authorize take action to govern municipal plans without violating States’ (and cities’) rights? Is the ability of taxpayers to vote and remove local government officials a sufficient remedy? Do taxpayers have the information to even make these decisions? Most governing bodies do not understand pension plans, or if they do, it may take advantage and use that knowledge to increase benefits for a select few among them and then leave the funding deficit to subsequent elected official. Certainly, the legislature of each state should take the lead to reform6laws governing municipal and state plans. Now who watches over the state plans – remember the Standard and Poor’s study on state plans, above?Defined benefit pension plans in both private and public use are dinosaurs that should be discontinued and replaced by defined contribution plans (such as 401K plans) in future years. It is a sad conclusion, because pension plans were designed to watch over and take care of the participants in their retirement. Too bad someone wasn’t watching the pension plans themselves more carefully.In the end, everyone – and their descendants – will ultimately and for a long time, pay the price for unfunded pension benefits nationwide whether arising from private pension plan deficiencies or public pension plan deficiencies. It’s the truth that few want to admit or face.
