About 100,000 retired Minnesota public employees this year are getting the smallest percentage increase in their pensions since 1980.
But it’s hard to feel sorry when they’ve done very well over the past eight years, with a cumulative increase in benefits of 94 percent, compared to inflation growth of under 25 percent in the period. In addition, their benefits are subject to less risk than most of us face with our retirement plans.
Citizens rightfully should ask if the unique way public employee benefits are adjusted meets some broad public purpose of efficiency or fairness. It seems clear they don’t. And as state government grapples with its worst deficit in 20 years, it would be wise to take another look at these lopsided retirement plans.
Pension plans come in two basic forms. A defined benefit plan provides guaranteed, post-retirement payments based on a formula that usually involves years of service, rank and earnings. Social Security is essentially a defined benefit plan, as are most older company pensions.
The second form is the defined contribution plan, in which the employer pays a stipulated amount or percentage of earnings into an investment plan on behalf of the employee. The amount that any eventual retiree can draw out depends on how much was paid in and on the performance of the investment. The most familiar examples are the 401(k) and 403(b) plans.
The Minnesota public employees’ pension combines the best features of both, at least from the point of view of retirees. For taxpayers, however, it’s like being on the wrong side of the “heads I win, tails you lose” coin toss game.
For many government employees in Minnesota, the underlying plan is basically one with defined benefits. Work a certain number of years and you qualify for retirement at a certain percentage of your earnings. The government also guarantees an annual adjustment for inflation, up to 2.5 percent. This is not much different from what autoworkers or federal civil service workers are offered.
But there’s a kicker. The state, and some local governments, pays a portion of their payrolls into a fund invested by the State Board of Investment. If the investment returns are high, plan managers can increase pensions proportionately for everyone.
However, if the market is bad and investment returns are low, retirees do not run any risk of pension reduction. Governments — and by extension taxpayers — are liable for any deficiency.
Heads I win, tails you lose.
Let me make clear that this is not an anti-public employee rant. Most employers pay workers with a combination of cash and non-cash compensation, such as pensions. If an employer reduces the attractiveness of a pension plan, it may have to increase cash wages. So the fact that many public employees in Minnesota benefit from a pension scheme in which there’s little risk doesn’t necessarily mean that they are overcompensated.
But the fact that this particular hybrid of defined benefit and defined contribution plans exists poses some interesting economic questions. Is the arrangement economically efficient? Does it get the state a better mix of labor quality and quantity than more conventional plans or, for instance, better cash compensation?
Moreover, why did such a plan come into existence when it is not used by the federal government and is not common in the private sector? Its existence suggests that there is something special about state and local government work that must be rewarded.
The primary difference between conventional defined benefit and defined contribution plans lies in who bears what risks. In traditional defined benefit plans, retirees, such as current Social Security recipients, do not have to worry about financial market performance. It makes no difference if stock and bond markets are up or down, the payment will come every month.
In the private sector, defined benefit retirees still have to worry about whether the business that employed them retains the financial capacity to meet its pension commitments.
History is replete with companies from Kaiser-Frazier and Studebaker to contemporary steel producers entering bankruptcy with only a fraction of the assets necessary to meet pension obligations. The federal Pension Benefit Guaranty Corp., modeled on the FDIC, was created to address this problem. It puts the taxpayer on the hook for most, but not all, defined benefit entitlements. During its last fiscal year, it took control of 157 pension plans, up from 101 the previous year.
Workers covered by defined contribution plans take on the risk of variable investment returns. But they also possess control of that risk with choices among investment funds. Depending on vesting requirements, defined contribution plans usually are more portable. Individuals thus aren’t locked into working for a single employer just to get a pension.
Economists generally believe that such plans make labor markets more liquid and more efficient.
None of this, however, explains the peculiar guaranteed benefits for Minnesota public employees.
© 2002 Edward Lotterman
Chanarambie Consulting, Inc.