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State Pension System Needs Broad Overhaul

January 13, 2004

By E. J. McMahon

Municipalities throughout New York State are getting clobbered with higher costs for their employees' retirement plans.

The pension bills for Nassau and Suffolk counties have risen a combined $188 million in just two years - more than double the much-bewailed increase in their Medicaid costs during the same period. And it's even worse in some other parts of the state. Such costs in New York City have risen $1.1 billion.

Why are pension costs rising so steeply and suddenly? The 2001-02 bear market, which erased $16 billion in New York State pension-fund assets within two years, clearly was the precipitating factor. Costly pension benefit sweeteners enacted by Albany made matters even worse. But the fundamental problem is the structure of the pension system itself - which is tailor-made to demand more cash when New York taxpayers can least afford it.

In the short term, nothing can be done to reverse the recent run-up in pension costs, because the state constitution forbids any change in benefits for current employees. But, in the long term, New York's public employee retirement plans can be made more predictable and affordable - without depriving workers of the benefits they need.

The answer lies in switching from government's expensive and outdated pension guarantee to the sort of individual, savings-based approach that dominates private-sector retirement planning.

New York government workers currently are entitled to a guaranteed defined-benefit pension based on career longevity and highest average pay. These payments are financed out of common pension trust funds, invested mainly in stocks and bonds, and replenished mainly by employer contributions. When the pension fund's investments earn a larger-than- projected return, the required employer contribution to the fund decreases. This is what happened during the record stock market boom of the 1990s, when the taxpayers' share ultimately dropped down to practically nothing.

But, as state Comptroller Alan Hevesi recently observed, "it is unrealistic to expect to provide a pension without any cost." When the rate of return falls short of projections, employer contributions must increase to make up the difference. Since stock markets often decline during recessions, defined-benefit plans require governments to spend more money on pensions when unemployment is up and revenues are down - in short, at the worst possible time. That's what's happening in New York State now.

The alternative approach - known as a defined-contribution plan - consists of individual accounts supported by employer contributions, usually matched at least in part by the employees' own pre-tax savings. The money in each worker's account is managed by private firms and invested in a combination of stocks and bonds.

The size of the ultimate retirement benefit generated by a defined-contribution plan, such as a 401(k) account, depends on the amount of savings and investment returns a worker can accumulate.

For decades now, a defined-contribution plan has been the retirement vehicle of choice for most employees of public higher education systems throughout the country, including the State University and the City University of New York. A 401(k) plan has been in effect since 1997 for all new state employees in Michigan. The vast majority of private-sector workers depend on defined-contribution retirement plans.

As outlined in a recent Manhattan Institute report, a defined-contribution plan in New York would effectively cap taxpayers' costs at 7 percent of employee pay, which is just over half the contribution rate for current civilian workers in the state and local system. Existing employees would stay in the old system, but costs would drop quickly over the next 10 years due to natural turnover as new employees are hired under the new retirement system. While it's impossible to make a long-term projection of defined-benefit contributions, a defined-contribution plan would ultimately represent nearly $1 billion in savings for the state and local governments, compared to projected 2004 pension contribution levels.

A defined-contribution retirement plan would offer new advantages to workers as well. Benefits for public employees would finally be portable from job to job, between different levels of government and across different jurisdictions, from public to private sector or vice versa.

By acting now to reform government pensions in a way that protects the interests of both employers and employees - which would require new state legislation - farsighted public officials can make real progress in bringing these costs permanently under control before another generation of New Yorkers must wrestle with the consequences.

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