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Defusing the Pension Bomb


Defusing the Pension Bomb

December 19, 2003
Urban PolicyNYC

DESPITE the improving national and regional economy, New York City's budget remains stuck in a hole. With operating expenses momentarily in check, the city's continuing fiscal imbalance stems mainly from big projected increases in the cost of Medicaid, debt service, employee health benefits - and, seemingly out of nowhere, pension contributions.

Since 2001, municipal pension costs have more than doubled, growing by over $1.3 billion - enough to consume the lion's share of this year's record property-tax increase.

And it's not over yet. The city expects pension contributions to jump from $2.5 billion in fiscal 2004 to $4.3 billion by 2007.

Gotham's predicament is not unique. Counties, cities and towns across New York, as well as the state government itself, are grappling with similar pension-cost explosions.

The problem is not simply a function of the 2001-02 stock- market slump or the big benefit hikes enacted by the Legislature and governor just before the market crashed (although both helped precipitate the crisis). The ultimate cause is the outmoded and inherently volatile pension structure itself, which obscures costs and wreaks havoc on long-term financial planning.

Because the state Constitution doesn't allow pension benefits to be "diminished or impaired" for current public employees, nothing can be done to reverse the run-up in pension costs. This system will remain a ticking time-bomb - ready to explode again with the next market down-cycle - if it's not reformed.

How to permanently defuse the pension bomb - and to ensure lasting stability and transparency for the pension system? Replace New York's old-fashioned defined-benefit pension with the sort of defined-contribution plan that's come to dominate private-sector retirement planning.

Defined-benefit (DB) plans give workers a guaranteed retirement benefit based on their career longevity and peak income while working for government. But to make good on this, the pension fund's investments must perform strongly.

When investment returns sink, as state and city pension funds did starting in 2001, employer contribution must rise to pick up the slack. Conversely, when the rate of return rises above projections, employers may temporarily get to contribute less.

Since stock markets often decline during recessions, DB plans force governments to spend more money on pensions when unemployment is up and revenues are down - exactly when they can least afford it.

This pattern has particularly dire implications for New York City and state, which depend heavily on tax revenues from the stock market. It makes it even harder to weather downturns without raising their already high taxes, which in turn depresses the local economy and harms the business climate.

Defined-contribution (DC) retirement plans consist of individual accounts supported by employer contributions, usually matched in part by the employees' own savings. Funds in the accounts are managed by private firms and invested in a combination of stocks and bonds.

One key difference is timing: Under a DB system, the employer promises to finance a future retirement benefit for a group of current and former workers. Under a DC system, the employer promises to make current contributions to the retirement accounts of each employee.

The size of the ultimate retirement benefit generated by a DC plan depends on the amount of savings and investment returns the worker accumulates over the course of his or her working life. Both the risk of unanticipated investment losses and the potential upside of unanticipated investment gains shift from the employer to the employee.

The most common example of a defined-contribution plan is the 401(k), which has become the backbone of retirement planning in the private sector, where DB plans are dying out.

A DC plan is now being phased in as the sole pension for state government employees in one major state (Michigan) and as an option in another (Florida). And for decades now, a DC plan also has been the retirement vehicle of choice for most employees of public higher-education systems throughout the country, including both SUNY and CUNY.

A defined contribution plan would gradually ensure that pension costs remain well below today's high levels, relative to payroll. At the same time, a personalized, savings-based pension would provide city and state employees with benefits that are flexible, portable - and comparable to those offered by most private-sector retirement plans.

Even in times of retrenchment, the city and state need to hire thousands of new employees every year just to maintain current service levels. At the moment, these new employees are becoming permanent members of a costly and inequitable pension system - adding to the future obligations of a costly and inequitable system.

The sooner New York switches to a new pension plan, the sooner taxpayers and employees alike can begin to reap the many advantages of individual retirement accounts.