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.

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.


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.


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

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.