Later Retirement Doesn’t Harm School Districts’ Payroll Costs

National Education Association of Rhode Island President Larry Purtill is gaining some traction with his claim that having teachers retire later will hit local communities in the payroll. As described in an October 25 Providence Journal story by Kathrine Gregg (not online):

Sen. Walter Felag, D-Warren, asked the question that Larry Purtill, president of the National Education Association of Rhode Island, has asked on YouTube and elsewhere: how will city and town taxpayers be able to afford all of the top-scale teachers who would now be forced to work until they are 67 years old?

A top-step teacher averages $70,764 a year in Rhode Island; a first-year teacher averages $39,087, according to Purtill.

Purtill has not yet had his turn to testify before the legislators, but in other venues he argues: “If a teacher is forced to go from 62 to 67 to retire and would have been replaced by someone on Step 1, that is an additional $130,479 for one teacher over that five-year period. Has anyone thought about this, and figured it into the actuarial studies? I am assuming that unless state aid increases by a drastic amount, this cost will go directly to the cities and towns.”

There’s a reason Purtill stops his cost clock at five years: because after that point, the older teacher retires and a replacement is hired at step one. Obviously, that teacher will be making less, to start with, than a teacher hired five years earlier, so the scenario of a later retirement actually begins to save the district money. And the district continues to save money for the ten years it takes the new teacher to reach step ten, herself.

To put a number on this dynamic, I averaged all of the salary steps compiled by the Rhode Island Association of School Committees for the 2011/2012 school year. For easier comparison, I then removed the few districts that spread their steps over more than ten years, leaving me with 14 cities and towns. (To check for any distortion, I compared these districts to the broader average available for 2010/2011 and found them to be about 0.1% higher, overall.) Using these averages, I figured out the year-to-year step raises and factored in the 4% increase that the pension actuaries estimate that the overall step system receives each year, on average (inflation plus general increase). By this method, I found step one to be $39,175 and step ten to be $72,393.

It is true that a local district will therefore pay an extra $141,475 for five more years of the older teacher’s salary, compared with a replacement starting at step one. However, seven years after the delayed retirement, the savings in waiting to hire her replacement have erased the extra costs. By the time the later replacement reaches step ten, the district turns out to have saved $44,990, and that number holds for decades, until the year that the earlier replacement would have retired.

Remember that this is savings to the district on salary alone. Most districts offer retirees some sort of health benefit, which will erode the initial salary savings of earlier retirement. What’s more, a good number of districts only pay retiree healthcare until Medicare age, so pushing retirement beyond that point would eliminate the healthcare portion of districts’ other post-employment benefits (OPEB) liability completely.

An important note arises if we expand the inquiry to figure out the cost/savings of later retirement in terms of the older teacher’s pension. Such an analysis is difficult to perform, because changes to the retirement system over time have left a number of categories into which employees can fall; moreover, teachers can retire at various ages, with varying years of service, so an accurate comparison would require teacher-by-teacher analysis.

For illustration purposes, however, I assumed normal retirement at age 62 with 29 years of service on a non-grandfathered Schedule A. (That means the teacher receives the more generous percentage of pay that Schedule A provides but has the retirement benefit calculated as an average of his or her highest five years, not three years, as would be the case for a grandfathered Schedule A pension.) For the second scenario, I added five years to this teacher’s career, but followed the proposed pension reform such that the teacher only accrues an additional 1% of salary for each additional year of work. I did factor in cost of living increases for both scenarios, but I used the reformed rate, which ties increases to pension fund performance.

The upshot is that the later retirement saves the retirement system about $54,000 over the life of an individual teacher. But those savings only materialize under the terms of the proposed reform. Applying a later retirement to the current system, without other reforms, winds up costing money in the scenario I’ve described, because the starting pension rate and higher cost of living adjustments (COLAs) increase the total benefit by so much.

Whatever the case, under the current system, the teacher is working for 29 years and retiring for 25. Under the reform, he or she is working for 34 and retiring for 20. Put differently, under the current system (with all of my assumptions), the older teacher will be collecting retirement for almost the entire career of his or her replacement. Essentially, for just four years will the system be paying for only one teacher for one teaching job. Under the reform plan, that differential increases almost fourfold, leaving fifteen years of the replacement’s career unburdened by pension costs for the older teacher.

One needn’t run the numbers to get a sense of just how quickly Rhode Island and its cities and towns — collectively and individually — will save money.

Task Force Commentary: R.I.’s pension debt worse than admitted (by Jagadeesh Gokhale)

As part of the national task force that our Center has assembled, Jagadeesh Gokhale, from the Cato Institute, published the OpEd below that appeared in the Providence Sunday Journal, Oct. 23, 2011.

R.I.’s pension debt worse than admitted

JAGADEESH GOKHALE

WASHINGTON, DC -Rhode Island’s pension crisis reminds one of Greece, now slaving under externally imposed austerity — the fruits of engaging in systemic deceit.

Lavish retirement benefits, including automatic inflation adjustments, awarded to state employees have resulted in future pension obligations of $11.5 billion in today’s (2010) dollars. But the state has assets worth only $6.8 billion on hand to cover these obligations, implying a funding ratio of less than 60 percent.

In addition, the state provides other post-employment benefits (OPEB) to its employees (general employees, teachers, police, judges, legislators, and so on) — whose present valued obligation amounts to $8 billion. This obligation is completely unfunded — that is, benefits are paid out of current revenues each year.

Adding it all up, the official measure of total pension and OPEB liabilities as of 2010 is $12.3 billion and the unfunded component is $5.5 billion.

Taking the numbers at face value, the state must make up this $5.5 billion shortfall in retiree pension and OPEB programs by increasing the share of general fund budget devoted to covering accruing pension obligations and amortization costs.

State general fund revenues amounted to $5.5 billion in 2010, of which 4.2 percent is contributed to meeting current benefit accruals and amortization costs. The state’s pension obligation amortization schedule extends to about 20 years, but OPEB obligations will remain unfunded.

Unfortunately, the reality that is most likely to unfold in the future is much worse. The accounting methods used by the actuaries amount to sugarcoating the situation. The true magnitude of the Rhode Island’s pension and retiree health underfunding problem is larger by billions of dollars.

As economists have repeatedly asserted, because pension benefits are guaranteed, they should be evaluated by discounting future benefit flows using a relatively safe rate of return — on the order of 3 percent per year in inflation-adjusted terms. Pension actuaries, instead, use the much higher rate of return they expect on the pension fund’s assets — which are usually invested in risky private equities and bonds.

This accounting treatment undervalues (ignores) the risk that the relatively fixed and certain benefit obligations would have to be paid out of additional taxpayer funds because the pension fund’s asset portfolio suffers losses from a market downturn precisely when it must be drawn upon (sold) to fund benefit obligations coming due.

Discounting future benefit flows at a risk-adjusted rate of interest, however, is politically unpalatable because it results in a much higher measure of pension liabilities and increases the current funding burden on the state’s budget.

In the case of Rhode Island, the state’s Comprehensive Annual Financial Report for 2010 (the most recent available) specifies an expected return on pension assets of 8.25 percent. The present valued pension and retiree health liability reported earlier are calculated using that discount rate.

However, using a risk-adjusted rate of return in evaluating the pension liability, and incorporating a 2 percent annual growth rate of the retiree population, shows that the total accrued pension and health liability would be 56 percent larger — or $18.7 billion instead of the official total of $12.3 billion. And the unfunded liability component would be $11.9 billion instead of the officially reported $5.5 billion.

There are other concerns, as well, regarding the level of contributions being made by Rhode Island to amortize this liability and the management of the pension fund’s investment portfolio. Ongoing reform efforts are likely to affect current and future state employees, but the understatement of pension liabilities hides the size of taxpayer exposure to future pension funding shortfalls.

A thorough exploration of feasible pension reform alternatives in Rhode Island is urgently needed. Unfortunately, the underlying data on historical earnings, job tenure and other information on state pension plan participants has been kept under wraps by the authorities.

This impedes transparency and the ability of state lawmakers to analyze and draw upon new ideas on how to resolve the state’s pension funding dilemma and improve the programs’ financial condition over time. That has to change soon if there is to be any hope of dealing with this crisis.

Jagadeesh Gokhale is a senior fellow at the Cato Institute in Washington D.C.

Hybrid Savings Mean System Failure

The only argument that I’ve heard against my suggestion that the proposed hybrid pension system will be more expensive than the current system is that the hybrid offloads market risk onto the employee, alleviating the risk to the employer (i.e., us, the taxpayers). Moderate Party founder and gubernatorial candidate Ken Block made the point on Anchor Rising, and Gary Morse, pension adviser to the Republican who was almost governor, John Robitaille, called in when I was on Friday’s Dan Yorke Show to make a similar point.

My response has been to suggest that, while the objection may be true, the entire pension reform relies on the 7.5% rate of return that the state’s actuaries have assumed. As a reminder, the current system is a defined benefit plan, which promises employees a certain retirement package; the hybrid system would decrease that benefit but put money into a 401(k)-style plan for each employee to fill in the gap. Right now, the major problem is the liability for defined benefit promises already made, and the hybrid doesn’t make those go away.

Unfortunately, I haven’t come across “what if” data from the actuaries that allows a real comparison of the system’s health with different rates of investment return. One can, however, infer the effect of the Retirement Board’s recent lowering of the return rate assumption from 8.25% to 7.5% from the latest actuarial report. Specifically, the Board dropped the rate of return by 9%, and the normal cost of an active employee’s pension (that is, the percentage of payroll that must be put aside to fund an individual employee’s retirement) went up by 22% for state workers and 18% for teachers.

For an accurate “what if” scenario, the actuaries would have to apply the different assumptions to their models, but purely for the sake of illustrating my point about the cost of the hybrid plan, I’ve assumed that same return-rate-to-normal-cost ratio applies consistently to the equation. If that’s accurate, then the hybrid plan doesn’t cost the taxpayer less than the current system unless the market returns less than 5% on investment:

The solid lines show the effects of an under-performing market on the current defined-benefit plan; the dotted lines show its effects on the hybrid plan. And, yes, the lines do cross eventually. However, under those circumstances, the total cost for the pension system to the employer, even under the reform, will be well above the annual cost that currently has everybody in a panic — over 60% of payroll for teachers and nearing 80% of payroll for state workers:

Of course, the solid lines, which track the current system, show just how scary the situation will be if the General Assembly does nothing, and a defined contribution component ought to be part of the solution (if not all of it). That doesn’t mean, though, that reformers should take the system on the table just because it incorporates some worthwhile concepts. If this reform passes, it’ll be years before the panic level rises sufficiently for further action by elected officials, and by that point hundreds of millions of dollars will have been siphoned into untouchable defined-contribution accounts.

As with Cars, a Hybrid Pension System Will Cost More

The complexity of the pension problem comes in the multiplicity of angles from which the numbers can be presented. When it comes to the cost of current employees’ pensions, General Treasurer Gina Raimondo’s hybrid pension system will cost more than the system that’s already strangling Rhode Island.

The headline grabber — because it’s such a large figure — has been the unfunded liability. Essentially, that’s the difference between the benefits promised over the amortization period and the accumulated resources expected to be available to pay them.

It’s critical to realize that both sides of that equation are predictions. General Treasurer Gina Raimondo induced her recent shock to the pension system by leading the Pension Board in a reduction of the predicted annual market return on the system’s investments of just 0.75%, from an 8.25% expected return to a 7.5% expected return. In tweaking its assumptions, the board effectively increased the unfunded liability of state worker and teacher pensions from $5.40 billion to $6.83 billion, according to the most recent actuarial report. The overall problem, however, requires predictions about everything from a female desk clerk’s life expectancy upon retirement in twenty years to the average raise that RI school committees will give to their teachers over the next several decades.

Although interested parties like to pick and choose from among them, various factors have contributed to the existence of the liability. Given the lag time between a particular year’s pension payments and its full effects on the system, elected officials have had plenty of incentive to promise future benefits that outstripped the budget dollars that they were actually willing to put aside in the present, and union leaders have been happy to play along, expecting those promises to be fulfilled somehow, someway.

Another factor has been the market. Even responsible officials, who put aside every penny that the actuaries called for would have wound up underfunded, because the actuaries were basing their predictions on an 8.25% return, when the system has only realized 2.51% per year, considered over the past five years, 2.28% over the past 10 years, and 6.57% annually since 1995.

And then there are all those predictions. The actuaries currently expect a female teacher who retired last year to live for 24.2 more years. They predict that the same teacher retiring in 2030 will only expect an additional 1.1 years of life,  or 25.3 years of retirement. With the rate of advancement in medical technology, does that really seem plausible?

The incentives and unpredictability of pension planning are what make defined-contribution option so attractive. With a defined benefit, the employer promises employees a certain amount of future income, and it is up to the employer (or, in the public sector, the taxpayer) to make sure that the money is there; with a defined contribution, the employer promises to put a certain amount of money aside, and future income will depend on the plans and investment returns of the specific employee. The dollar amounts may turn out to be exactly the same, but it isn’t a “liability” in that the employer hasn’t pledged to make up the difference for unmet expectations.

Leading up to the release of Treasurer Raimondo’s pension reform proposal, advocates for public workers and retirees have been downplaying the importance of reducing this liability by separating the theoretical cost of pensions for current employees from the amount that municipalities and the state have to put aside to catch up on the current debt. The mechanism for this argument is the “normal cost” of a current employee’s pension — that is, the percentage of payroll that must be invested in order to fully fund pensions as if the past liability did not exist.

For teachers, the “normal cost” is now pegged at 11.82% of payroll, and since the teachers contribute 9.5% from their own paychecks, the city and state combined only have to put in another 2.32%. That’s what NEA-RI Executive Director Robert Walsh meant when he wrote in the Providence Journal that “for the vast majority of existing employees, the facts support no further changes” to the pension system. Get over the liability hump, in other words, and it’ll be clear sailing for public-sector retirees.

The question that hasn’t been asked, yet, is what Raimondo’s hybrid defined-contribution/defined-benefit plan will do to public costs when calculated in these terms. The answer is that it will actually increase them, as the following table shows.

RI State Pension Employee and
Employer Contribution Rates (% of Payroll)
Current Employees Defined Benefit
Current Employees Defined Contribution
Liability Amortization
Subtotal
Total
Employee
Employer
Normal Cost
Employee
Employer
Employee
Employer
Employee
Employer
State workers – current system
Prior assumptions
8.75
0.60
9.35
0
0
0
25.95
8.75
26.55
35.30
Assumptions in effect July 2012
8.75
2.64
11.39
0
0
0
33.70
8.75
36.34
45.09
After 2029 amortization
8.75
2.64
11.39
0
0
0
0
8.75
2.64
11.39
State workers – proposed system
2029 amortization
3.75
5.44
9.19
5
1
0
18.94
8.75
25.38
34.13
2035 amortization
3.75
5.44
9.19
5
1
0
14.91
8.75
21.35
30.10
After 2029 amortization
3.75
2.49
6.24
5
1
0
0
8.75
3.49
12.24
After 2035 amortization
3.75
2.49
6.24
5
1
0
0
8.75
3.49
12.24
Teachers – current system
Prior assumptions
9.50
0.50
10
0
0
0
25.71
9.50
26.21
35.71
Assumptions in effect July 2012
9.50
2.32
11.82
0
0
0
32.93
9.50
35.25
44.75
After amortization
9.50
2.32
11.82
0
0
0
0
9.50
2.32
11.82
Teachers – proposed system
2029 amortization
3.75
4.84
8.59
5
1
0
16.34
8.75
22.18
30.93
2035 amortization
3.75
4.84
8.59
5
1
0
13.27
8.75
19.11
27.86
After 2029 amortization
3.75
2.42
6.17
5
1
0
0
8.75
3.42
12.17
After 2035 amortization
3.75
2.42
6.17
5
1
0
0
8.75
3.42
12.17
Notes
1) Prior and current data from Employees’ Retirement System of Rhode
Island Actuarial Valuation Report as of June 30, 2010

2) Proposal data from “Actuarial Analysis of the Rhode Island Retirement
Security Act of 2011”
3) Amortization is currently scheduled for 2029; 2035 represents reamortization.
4) The proposed system continues the assumptions that will be in effect
as of July 2012.
5) Liability amortization includes current retirees’ pensions and the portion of current employees’ pensions not covered under normal costs.

Reformers should be wary of two facts that emerge from these eye-glazing numbers:

  1. Five percent of current retirees’ contributions will be entirely insulated from any problems that might arise with the defined-benefit component of the system — whether they be low investment returns, proof of unrealistic predictions, or a failure to meet recommended funding.
  2. Combining the defined-benefit and defined-contribution payments, the amount of money that state and local governments will spend on the retirements of current employees every year will increase — more than doubling until such time as grandfathered employees leave the system and continuing on at a higher rate even then.

This means that the savings of the overall pension reform rely entirely on changes to the existing system (e.g., COLAs and retirement age), because the hybrid will cost tens of millions of dollars more every year… even when the “pension crisis” is completely resolved and even if the assumptions prove accurate. And changes to the existing system are precisely the controversial elements that have battle lines being drawn.

With all the lines on the field and the questionable allegiances, taxpayers should be sure that somebody is defending their interests.

Hybrid Pies

As much as I love text and tables, they do require quite a bit of background consideration before their more interesting revelations are truly visible. So, herewith, some pie charts to illustrate my core point on the matter of General Treasurer Gina Raimondo’s hybrid pension proposal.

The first chart shows state workers’ arrangement currently in place for fiscal year 2012.  Of total state worker payroll, each employee will contribute 8.75% of his or her salary to the defined benefit plan (the light-blue wedge), and the state will add in another 2.64% of payroll (the dark blue wedge).  The larger part of the state’s pension expenditure, accounting for 33.7% of payroll, is the brown wedge, which will go toward amortization of the unfunded liability.  In total, 45.09% of state worker payroll goes toward pensions.


Under the new pension system that General Treasurer Gina Raimondo and Governor Lincoln Chafee have proposed, state workers will put 3.75% of their salaries into the defined benefit plan (light blue) and 5% toward a defined contribution plan (leaving their total contribution the same). These amounts will be supplemented with 5.44% of payroll from the state toward the defined benefit program (dark blue) and 1% toward the defined contribution program (dark green).  The amount to be put toward the unfunded liability (brown) is 14.91%, bringing the overall cost of pensions to 30.1% of payroll.

The current arrangement in place for fiscal year 2012 for teachers calls for each employee will contribute 9.5% of his or her salary to the defined benefit plan (the light-blue wedge), to which the state and local governments combined add another 2.32% of payroll (the dark blue wedge).  Again, the larger part of the state’s pension expenditure, accounting for 32.93% of payroll, is the brown wedge, which will go toward amortization of the unfunded liability. In total, 44.75% of teacher payroll goes toward pensions.

Under the proposed pension system, teachers, will put 3.75% of their salaries into the defined benefit plan (light blue) and 5% toward a defined contribution plan (reducing their total contribution by 0.75% of salary). These amounts will be supplemented with 4.84% of payroll from the state toward the defined benefit program (dark blue) and 1% toward the defined contribution program (dark green).  The amount to be put toward the unfunded liability (brown) is 13.27%, bringing the overall cost of pensions to 27.86% of payroll.

Negotiating Points in the Pension Proposal

Underlying the policy complexities of the pension issue is the background give and take of financial interests and political careers. General Treasurer Gina Raimondo, for example, is free to propose pretty much anything and let the General Assembly take the heat for actual changes. As long as she stays off the unions’ “not with a 10-foot pole” list, she can run for higher office as the stern-chinned pragmatist.

Similarly, Governor Lincoln Chafee can seek to burnish his “fiscal conservative” bona fides by publicly endorsing a plan more generally seen as Raimondo’s handiwork. For their part, legislative leaders can play off the treasurer’s supposedly objective calculations and the governor’s veto power. What the public is seeing and what elected officials are planning can be two very different policies.

An October 10 Providence Journal op-ed by National Education Association Rhode Island Executive Director Robert Walsh fits neatly into that interpretation:

The only equitable option presented to the pension advisory group was to make current retirees subject to the “Plan B Cost-of-Living Adjustment.” The Plan B COLA, already in place for current teachers and state employees, bases the COLA on the lesser of the rise in the Consumer Price Index or 3 percent, and it is further capped at the first $35,000 in pension earnings, which is also indexed to inflation. (The CPI is also used to calculate Social Security increases.) When combined with a more modest 25-year reamortization of the pension fund, the Plan B COLA option for retirees solves a significant part of the pension dilemma, unless the courts rule otherwise.

General Treasurer Gina Raimondo, to her credit, has allayed some fears already by strongly stating that no earned benefits would be cut, and that the debate regarding retirees would focus on the COLA. She has also wisely shown more openness to reamortization as part of a comprehensive solution to the pension issue.

Obviously, Treasurer Raimondo’s proposal (onto which the union-backed Governor Lincoln Chafee has signed) goes a bit farther than that, mainly in that it completely suspends COLAs pending the pension system’s healthy recovery, it introduces a hybrid defined-benefit/defined-contribution plan, and it adjusts the retirement age upwards to Social Security standards.  (Keep in mind, by the way, that various categories of employees — teachers, public safety, and so on — receive differing treatment.)

Several components of the proposal are subject to basic mathematical negotiation, meaning that the sides will trade dollar amounts in order to secure principles that they want to protect. It’s useful, therefore, to consider COLAs, retirement age, and amortization in this context.

The “Plan B” COLA calculation to which Walsh refers follows the Consumer Price Index and is capped at 3%; it also applies only to $35,000 of the pension benefit (although that number adjusts upwards every year by CPI-to-3%, as well).  Raimondo’s proposal replaces the CPI with the pension’s annual net return (over a five-year average), with the cap at a 4% increase.  In terms of the actuarial calculations, the upshot is that this move reduces the predicted annual COLA from 2.35% to 2%.  The sticking point is that the new proposal would withhold COLAs in any year that the system is less than 80% funded, which could mean a decade or more of no increases.

That aspect of the proposal, along with the increase in retirement age, are likely to be hotly contested.  And since Raimondo has crossed the Rubicon of reamortization (thus extending the number of annual state budgets until the plan is fully funded, reducing the hit each year, but also reducing investment returns), it will appear more reasonable to extend the amortization period even farther in order to “buy back” reduced benefits.  So, for example, advocates for retirees might accept the later retirement age but insist that the COLA pinch be eased, with the difference in costs made up with a few more years of amortization.

But this is all a numbers game.  The interesting wild card is the hybrid plan, which reformers rightfully like as a means of shifting market risk away from taxpayers and toward retirees, but which contains details that ought to make them wary.  Given the complexity of that topic, I’ll take it up in a separate post.

Gio Cicione on Newsmakers (Ch-12 & Ch-11) this past Sunday

Our senior policy advisor, Gio Cicione, appeared this past Sunday, 9/25, on Channel-12. Tim White and co. reviewed our Center’r recent Policy Brief on the legal authority to adjust state pensions as well as our recommendation that the General Assembly clarify the law with legislation that states this intent due to a critical “public purpose”. Check back soon for a link to the video.

LawBooks-full

Legal Authority to Adjust State Pension Plans

To read the full version, with citations, click here for PDF …

Exorbitant retirement benefits are threatening the ability of Rhode Island and its municipalities to deliver essential government services and, in one of the most extreme cases in the nation, one of Rhode Island’s municipalities has been driven into bankruptcy because of an inability to resolve pension debt issues through negotiation.

A recent decision by Rhode Island Superior Court Justice Taft-Carter has called into question whether the state and its municipalities have the flexibility to unilaterally adjust pension benefits. Our Center believes that Rhode Island does have broad legal flexibility to adjust existing pension benefits in order to stave off bankruptcy or avoid dramatic reductions in essential services. This policy brief considers the legal background of that question and suggests proactive steps which the legislature can take in order to guide future courts as they consider the constitutionality of proposed reforms.

Most estimates place Rhode Island’s state level unfunded liability at approximately $6,800,000,000 ; a figure on scale with the state annual budget and roughly twice what the state collects in revenues in a year. Of great concern is that such estimates assume investment returns in the pension funds of 7.5 percent while many states are considering using estimates pegged to the money they pay for bond issues – potentially closer to 5 percent. If Rhode Island was to follow that more prudent approach, the unfunded liability would likely exceed twice the current estimates.

More importantly, a practical discount rate would more accurately reflect the expectations of beneficiaries as to the risk of their retirement plans. State and municipal retirees have long been led to believe that pensions were guaranteed by the government. In fact, pensions have always been some combination of promise and ‘gratuity,’ with payouts left to the discretion of politicians and future taxpayers.

And while a lower discount rate would expand the unfunded liability on paper, perhaps it is better to recognize that, for retirees, a conservative estimate of returns is more properly in line with their tolerance for risk.

Unfortunately, for current pensioners, those less conservative estimates of 7.5% returns or higher have been used for decades in Rhode Island and, while we can take the more prudent approach going forward, we must accept that for current participants in our retirement system, the money they were promised is simply not there.

Like the state, municipalities suffer under the burdens of their own liabilities and, with well over one-hundred separate plans, Rhode Island fails to realize savings related to economies of scale and more experienced oversight: Already some of our pensioners are suffering the consequences.

With the City of Central Falls in bankruptcy, its retirees are facing potential cuts to their pension checks of more than half what they had been receiving; a dramatic reduction to a fixed income that many cannot reasonably expect to afford. Poor planning, non-existent oversight, and bad political choices will, in a very real sense, be driving some of these pensioners into poverty.

As the Wall Street Journal’s David Wessel says, “Bankruptcy is a last resort. To avoid it, state and local governments need an alternative that is less unappealing. They don’t have one yet.” With 38 other cities and towns in Rhode Island facing the impacts of the same crisis, Governor Chafee recently called for alternate suggestions to the futility of trying to tax our way out of this deep hole.

There is growing bi-partisan recognition that exorbitant retirement benefits granted to civil service unions are threatening the ability of states and cities to provide essential services without implementing job-destroying tax increases. Indeed, even former San Francisco Mayor and California State Assembly Speaker Willie Brown (D), a staunch public union supporter, recognizes that lucrative defined benefit pension plans are unsustainable. John Fund of the Wall Street Journal writes about a column Willie Brown authored for the San Francisco Chronicle in which Brown lamented that civil service was out of control.

“The deal used to be that civil servants were paid less than private sector workers in exchange for an understanding that they had job security for life. But we politicians – pushed by our friends in labor – gradually expanded pay and benefits … while keeping the job protections and layering on incredibly generous retirement packages.”

Brown later told Fund, “When I was Speaker I was in charge of passing spending. When I became mayor I was in charge of paying for that spending. It was a wake-up call.”

Fortunately, despite the concerns raised by a recent Rhode Island Superior Court decision in the matter of Council 94 v. Carcieri , a more appealing remedy than bankruptcy exists. It is contained in two U.S. Supreme Court cases, Energy Reserves Group v. Kansas Power & Light and United States Trust Company of New York v. New Jersey .

States and (with state authority) municipalities, can unilaterally reduce excess retirement benefits under circumstances now widely prevailing. There is a widespread misunderstanding in many states that the U.S. Constitution prohibits these adjustments but there is no such prohibition. The Council 94 v. Carcieri decision has been misinterpreted as suggesting that Rhode Island has some unique version of that prohibition but that is not what the decision says.

In short, the Council 94 v. Carcieri decision simply states that some Rhode Island pensioners have certain contract rights. That is far from saying that those contract rights cannot be revoked when the state faces a pressing need.

A report published earlier this year by The Pew Center on the States confirmed that legislators’ belief that retirement benefits cannot be modified is only an assumption. “It is uncertain in many states what the constitutional protections are because they haven’t been tested or at least thoroughly tested in the courts,” says Ron Snell, director of state services at the National Conference of State Legislatures. “But state legislators have assumed the protections to be quite strong.”

This assumption that there is constitutional prohibition against benefit modification is a misunderstanding. Case precedent is clear that, under circumstances currently prevailing in many places, retirement benefits may be reduced. The U.S. Supreme Court’s interpretation of the U.S. Constitution lays out the rules by which states may modify their contractual obligations.

The facts required by the clear language of the governing cases are directly applicable to the situation in RI. These cases give us clear guidance.

There are scores of state and lower federal court cases holding against attempts to modify vested pension benefits. Upon examination, few, if any, of these cases were brought on the grounds set forth as applicable by the U.S. Supreme Court. Accordingly, these state and lower court cases are irrelevant to the current circumstances. They were special, very narrow cases that did not spring from legislative action to remedy a broad and general social or economic problem. The governing law may be summarized as follows:

• A state may impair a contractual right if it has a significant and legitimate public purpose such as remedying a broad and general social or economic problem, such as elimination of unforeseen windfall profits.

• A state may do so as an exercise of its police power.

• A contractual impairment may be constitutional if it is reasonable and necessary to serve an important public purpose.

When a state reduces an obligation, the courts will inquire as to whether the adjustment of “the rights and responsibilities of contracting parties is based upon reasonable conditions and is of a character appropriate to the public purpose justifying the legislation’s adoption. Courts properly defer to legislative judgment as to the necessity and reasonableness of a particular measure.”

When a state impairs its own contractual obligations (as is the case with retirement benefits promises) the courts and certain other material factors come into play. The courts will hold the state to a somewhat higher standard of scrutiny as to the policy’s necessity and reasonableness. Therefore, a prospering state with a well-funded retirement plan could not arbitrarily cut promised benefits. But a state struggling to the point of eliminating essential services or a municipality facing insolvency certainly may, under the law, modify existing retirement benefits. Furthermore, it is entirely settled law that one legislature may not abridge the powers of a succeeding legislature and cannot bargain away the police power of a state.

So, in addition to the realistic reading of the contracts clause itself, and as recognized by the Supreme Court, an independent doctrine holds that the Constitution’s contract clause does not require a state to adhere to a contract that surrenders an essential attribute of sovereignty. The classic doctrine that one legislature can neither abridge the powers of a succeeding legislature nor bargain away its police power permits states to reduce their public employee pension obligations under the circumstances now besetting many states.

The law does not permit a state to impair its contractual obligations arbitrarily or with impunity. The courts will look into whether a proposed impairment is reasonable and necessary to “serve an important public purpose”. Modifying existing pension benefits because the cost of providing them threatens a state or municipality’s ability to provide essential services or precipitating insolvency certainly rises to the standard of “remedying a broad and general social or economic problem.”

According to several well accepted doctrines and the clear holdings of the United States Supreme Court, if a state or, with a state’s authority, a municipality finds itself confronting a severe fiscal challenge based on exorbitant retirement pension obligations it is well within its inherent police powers to reduce its obligations to a reasonable level.

The courts will not rubber-stamp an arbitrary decision. Yet it is difficult to imagine a court finding that a reduction of such benefits to private sector levels for retirees of comparable circumstances to be ‘unreasonable,’ especially when the cost of providing those benefits threatens the ability to provide essential services.

Current evidence of reasonableness and necessity of such reductions includes:

1. extensive studies by respected nonpartisan institutes;

2. reports from respected media sources from across the political spectrum;

3. critiques by elected officials nationwide, both liberal and conservative, Democrat and Republican, of unjustifiably extravagant retirement benefits;

4. the documented growing inability of states and municipalities burdened by the cost of these retirement benefits to provide essential government services or maintain solvency.

Taken together, these factors are highly persuasive that it is reasonable and necessary to adjust certain states’ and municipalities’ pension obligations to the median level of private sector comparable positions. The power to unilaterally, though reasonably, reduce benefits provides a great deal more latitude for officials than many knew they had.

By taking this power into account, the Governor, the Treasurer, and the Rhode Island legislators who are considering solutions for addressing our pension crisis will find themselves positioned with many new options that they may not have realized were available.

Recognizing that, public officials simply may choose to reduce benefits of public workers to demonstrably reasonable levels. A good faith demonstration is all a state needs to reduce retirement benefits. This is simply done by showing they are implementing a remedy to a general economic problem and that such reductions are necessary and reasonable.

One approach, and one that has the added benefit of giving future courts a well-defined outline of legislative intent, would be to introduce and pass legislation laying out clearly and without hesitation the dramatic economic crisis now faced by the state. Such an Act would describe the need to assess the liabilities of the state and municipal pension funds with reference to rates of return reasonably in line with pensioners’ expectations of risk, would describe the limitation on additional sources of revenue to find the massive deficit, and would reference the dramatic reductions in essential services that are unavoidable if we fail to address the unfunded pension liability.

Therefore, the Rhode Island Center for Freedom and Prosperity recommends that the Rhode Island legislature acknowledge, through amendments to the laws governing Rhode Island’s state and local pension systems, that:

a. Pension benefits are promises limited by the ability of the system to pay, and are not binding contracts with pensioners;

b. A reasonable rate of return for pension investments should be equivalent to that of high-quality corporate bonds, as this is more in line with pensioner’s expectations as to the security of their retirement funds;

c. The unfunded liability of the state should be calculated using these more conservative rates and should be reduced to zero over a clearly defined period of time by modifications to existing pension plans that fairly reflect the economic circumstances we face as a state today and the detrimental impact on essential state services that this liability creates.

We further recommend that an extensive public record of such findings be established and preserved in order to leave no questions as to legislative intent and the factual basis for any proposed reforms. By taking this added step the executive branch and the general assembly will have made the job of the courts in ratifying such reforms all the easier, hopefully avoiding further costly legal battles, and providing pensioners with the clarity and predictability that they deserve.

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About The Author

Giovanni D. Cicione Esq. is the Senor Policy Advisor to the Rhode Island Center for Freedom and Prosperity, a non-partisan and non-profit public policy group that advocates for free enterprise solutions to societal problems and for the protection of personal freedom. He received his Juris Doctor from Boston University Law School, a bachelors degree in Philosophy from George Mason University, and is a member of the Bar of the State of Rhode Island and of the Commonwealth of Massachusetts.

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State Pension Reform – RI has a way to go to catch up with other states

In 2010 and 2011 (39) US states enacted some form of public pension reform. Rhode Island is one of those states, but we acted in only one of the measured categories in this report.