Reforming Pensions

I don’t usually write about labor issues or pensions specifically, but an interview I got with a clerical union representative a few months ago made me think about pensions and vesting. I’ve come to believe that, to improve labor productivity at US public agencies (including transit, but not just), it would be useful to reform pensions, keeping their current levels and defined-benefit nature, but changing them to vest annually. That is, a year of working for a public agency at salary X should entitle a worker to a retirement annuity equal to a fraction of X, depending on age and years of experience (the fraction should be higher at lower age, representing more time the pension fund has had to gain interest).

In contrast, state governments in the US today have a long-term vesting model. I talked to Tim Lasker, president of the local Office and Professional Employees International Union, representing MBTA clerical workers. I intended to ask about salary competitiveness and retention, but Lasker told me that the pension system represents a “golden handcuffs.” People who are on the job for 25 years have fully-vested pensions, but people who leave earlier leave a chunk of money on the table by going. As a result, people with 15 or so years of experience don’t leave.

Jamal Johnson, a labor relations analyst working for the state government of Pennsylvania, said that in Pennsylvania pensions take up to 30 years to fully vest, and take 10 years to even partially vest, so workers who leave earlier get nothing.

The result is that there isn’t much turnover among employees with defined-benefit pensions. This is not a good thing. Lasker told me there is a lot of burnout, and a lot of people who just show up to work but aren’t productive, and are just punching the clock every day until they vest. They’re not lazy, and probably would quit in frustration and leave to a place where they could be more productive if it didn’t come at an enormous cost. Among the people who don’t have defined-benefit pensions, such as assistant secretaries and M.B.A. hires, there is much more turnover – too much, per Lasker, with people typically staying 1-2 years.

In the private sector, the best practice seems to be letting stock options vest after a number of years, as in the tech industry. But this is in an environment with performance bonuses – the idea is that giving workers shares in the company that only vest in a few years will incentivize them to work toward the company’s bottom line. The pensions are defined-contributions, which means the company and employee set aside money for a savings account that the government undertaxes, rather than providing a real pension.

Calls for pension reform in the public sector have tried to look to private-sector models, hence calls on the right (e.g. by Nicole Gelinas) to give public employees tax-deferred defined-contribution pseudo-pensions rather than actual pensions. Unless the point is to surreptitiously cut pension obligations, there is little point in this. The difference between a defined-contribution and a defined-benefit pension is ultimately who bears the risk of the worker living longer than expected. Under defined-contribution, it’s the worker, who then has to save much more money to avoid being penniless at 90. Under defined-benefit, it’s the company, which can average the amount across a large number of employees. In effect, defined-benefit pensions work as free life insurance.

The problem with the defined-benefit model today is purely that it assumes people work for the same agency their entire life, and thus pensions take decades to vest. This might have made sense in the middle of the 20th century, but it doesn’t today. People burn out, at which point it’s mutually beneficial for both sides to have them look for a new job and for the agency to look for a new worker. With burned out employees, the effect of the golden handcuffs on loyalty is not positive: people who are just punching in and out have no reason to be especially loyal to an employer that they hate. And the effect on morale is destructive: Lasker did not tell me this, but I suspect that with so much resentment among middle management, new hires are inducted into a culture in which good work is not valued. Lasker blamed mismanagement, and it is likely that this mismanagement percolates down the food chain.

There’s also limited risk of revolving door with transit agencies. In regulatory agencies, limiting employee exchange with the private sector is desirable, because otherwise workers have an incentive to shirk their duties in exchange for later high-paying jobs at the private companies they’re supposed to regulate. Tax collection agencies, safety agencies (including the FRA), and antitrust regulators are all at risk of regulatory capture. But transit agencies exhibit little such risk, since they do operations in-house. Capital programs are more vulnerable, but there, the people who are most affected by the revolving door are at the very top, and they’re not relying on a union pension. So the biggest risk coming from encouraging turnover at other public agencies is limited when it comes to transit agencies.

With this in mind, it’s useful to come up with a model in which pensions work like defined-contribution pseudo-pensions – that is, a sum of money the employer gives the worker that’s earmarked for a tax-deferred savings account. However, to reduce the aforementioned risk of running out of money in old age, it should be defined-benefit. I’m not aware of an existing model that achieves this, but it doesn’t mean such a scheme is impossible: the numerical parameters of this scheme (retirement age, rate of return, etc.) are already set in union agreements. All that’s required is to break down the pension into fractional amounts, accumulated every year of work, and cut the overall levels slightly so as to account for people who leave before their money is vested.

The big drawback of this plan is that there’s no real political appetite in the United States for any benefit-neutral pension reform. The unions might be interested, but without small cuts to offset people who leave early, a small additional increase in spending is required; the effect on productivity should be more than high enough to justify it, but the current zeitgeist in rich American cities treats pensions as outdated for ideological reasons. These same reformers who, as a rule, are outsiders to the union and think in terms of defined-contribution pensions, aren’t especially interested in making defined-benefit pensions work. If they think in terms of attracting and retaining talent, they think in terms of higher base wages.

29 comments

  1. Jacob

    My sense of the big challenge with defined benefit pension is that the employee becomes a lifelong creditor to the employer. This makes it very tempting both for the employer and for their other creditors to try and renege on their obligation. In the public sector this usually happens stealthily by underfunding and overly optimistic returns expectations. In the private sector, the problems crop up during bankruptcy.

    This is not to say that the vesting schedule isn’t a problem but when people talk about pension reform in the United States the problem they are usually trying to address is the funding mechanism rather than the labor incentives.

    • Alon Levy

      Larry Littlefield explained a few years ago that in the public sector bankruptcies were a problem in the 1970s, so the feds passed new rules requiring companies to fully fund their pensions. I think this is what led to defined-contribution pensions: every month the company gives a lump sum to the worker labeled “salary” and another lump sum labeled “pension” and the latter lump sum gets treated differently for tax reasons. So if the company goes bankrupt, workers don’t lose their pensions. In the public sector, this process didn’t happen, so agencies pay pensions to current retirees, not current workers. My contention is that fully funding pensions is compatible with a defined-benefit process.

      • Jacob

        I agree that fully funding pensions is compatible with defined benefit (other countries do it!) but defined-benefit pensions are by their nature much easier to loot (or to destroy by mismanagement). In the private sector, the PBGC backstops pensions, but it is tens of billions of dollars in the hole. In the public sector, CalPERS has a staggeringly large actuarial gap.

        This is completely orthogonal to your proposal of course — there’s no reason a looted pension can’t still have better incentives for employees — but you also have to model how things got this way. If management underprices the cost to them of increasing pensions, then they become an artificially cheap bargaining chip in negotiations. I’d love to know more about how the vesting structure got the way it did because I have a feeling there’s a similar explanation there (underfunding pensions screws future taxpayers, back-loaded vesting structures screw future employees?)

        So what I’m wondering is if there are ways to change the way these contracts get negotiated that factor in the desires of the people not yet at the table because they’re as yet unborn/unhired. On the government side, legislating that pensions be fully funded is the obvious goo-goo solution (though its effectiveness seems limited) but I don’t know of any proposals on the union side.

        • Connor Harris

          DB pensions are much easier to loot and also more vulnerable if the local economy crashes, as has happened in plenty of Rust Belt cities. I suppose this could be hedged against via a nationwide pension fund that all municipalities pay into, but I have no idea how such a fund could be implemented, and I suspect the political difficulties are insuperable (enforcement of payments would be tough, for one, and local politicians would be loath to give up one of their big levers of influence).

          • Alon Levy

            DB pensions are only more vulnerable if the money has to be invested locally. Or are you saying that there is political pressure on a local pension fund to mostly invest locally rather than hedge? Because at least in Canada, the funds aren’t just invested locally: the Quebec pension system has a 30% stake in Keolis.

          • Connor Harris

            Are there many local pension funds whose investment profits completely cover their expenses? I thought that most of them also rely on local tax revenues, which a regional economic crash would threaten.

  2. Nathan Williams

    Just so it’s clear, the MBTA’s 25-year vesting is a 100% vesting cliff: at 24 years and 11 months you have no pension at all if you leave, although you do get payroll contributions back as a lump sum. The PA state pension you mention that vests incrementally from 10 years on seems like a great idea by contrast.

  3. Daniel Hartig

    Pensions are silent killer of municipal budgets. The only thing that should be done with pensions is to reduce them. While the vesting after a year (or after 2 or 5 years, more realistically) may be good to increase turnover and thus productivity, another good way to increase turnover and productivity is to fire unproductive workers. This is also a private company best practice. In this case, employees with few years and a vested pension would not work.

    What we really need is to alter the ratio between pay for current workers and pay for pensioners. In some local government budgets, the retirees are paid more than the workers! This is not economically feasible. Cut pensions by 50%, increase pay by 25% and make people figure out how to save money themselves.

    • Alon Levy

      You can fire workers and let them keep their partial pensions, same way they keep their 401k accounts in the private sector. If anything, I’d argue that keeping the pensions makes it easier to let go of unproductive workers, because it’s less punitive (you don’t zero out their entire retirement savings).

      • Daniel Hartig

        It doesn’t have to be a high firing level, it just has to be a greater than zero firing level, so people understand that they can get fired. Coming from the Navy, where you can’t get fired (except for criminal activity, basically), it is very common to see people with that ‘you can’t fire me so why should I care’ attitude. If I fired one person per year from my division of 40 (and we lose and gain ~10 per year to transfers anyways), this would definitely _increase_ morale. Nothing is more corrosive to morale than seeing someone do nothing and get paid the same as you.

  4. Bjorn

    I recall seeing that some 401k plans have an annuity disbursement option. When the beneficiary retires, they have the option of using their 401k to purchase an annuity through a third party if they want. This way, the employer avoids future liabilities, the new retiree knows how much income they will get every year, and the mathematics are handled by a company that does this as a core competency.

    Last year for a few months over the spring and summer I was technically classified as a state of Iowa merit employee instead of as a student employee because I averaged too many working hours per semester (I was only in school part-time to get residency status and the lower tuition that entails). I was given the choice between contributing to either the state retirement system or to a TIAA 401k (I think it was a 401k-like product). When last semester started, I was once again considered to be a student employee and my state retirement contributions returned in a lump sum. (Iowa’s vesting period is seven years.)

  5. threestationsquare

    Your core point that large vesting cliffs of any kind have mostly negative incentive effects seems correct. I would guess, however, that they exist as a way to cut the cost of pensions without cutting benefits for the most entrenched and influential union members.
    Why do you believe that the cost of getting rid of them would be small?
    A couple other details that seem off:
    1) People with defined-contribution pensions like 401ks are free to put the money in an annuity to get a defined-benefit style outcome avoiding longevity risk. They’re then exposed to counterparty risk if their annuity provider collapses, but of course defined-benefit pensions also carry some risk the employer will renege. Few people take this option when given the choice because annuities offer poor average returns compared to the market and eliminate the possibility of leaving significant inheritance to children or charity. (If public employers offered defined-contribution pensions that cost them the same as their defined-benefit pensions, I expect most people would choose the defined-contribution option, but then the employer wouldn’t get to pretend its costs are lower than they are.)
    2) Most tech companies have moved to granting equity compensation as (sometimes restricted) stock rather than stock options. Regardless of which they use, vesting is generally gradual, with roughly equal amounts each year (often monthly; sometimes there’s a one-year vesting cliff but I’ve never heard of multi-year cliffs). Equity compensation is at any rate unrelated to pensions.

    • Alon Levy

      A union president told me on the record that morale is low and there are people who are just punching in and out every day waiting to vest. So I don’t think the unions are wedded to steep cliffs.

      And as for point 1, “eliminating the possibility of inheritance” is the other side of risk, and usually people are risk-averse. I think what you’re actually saying is that annuities provide so low returns that workers take the risk of running out. But that is in effect the cost of insurance: you lose money on average having insurance while your provider profits, and your gain from having insurance is reduced risk. What I’m proposing for large public-sector outfits is to effectively be self-insured on the annuities, in the same manner large employers in the US (tend to?) self-insure on health care.

      • threestationsquare

        I don’t think requiring each public employer to maintain their own actuaries, manage their own investments, etc is likely to lower the overhead insurance cost of annuities; probably they’d contract it out to one of the same insurance companies who will happily sell annuities to individual employees anyway. Some people are risk-averse enough that they choose to put their 401ks into annuities (either continuously or when they turn 65), but AFAIK this is not terribly popular; I suspect it would be more popular if people didn’t mostly get a baseline annuity from Social Security regardless (which you can “buy” more of by deferring until age 70, spending 401k balance until then).

          • SC

            Isn’t a giant bundled annuity fund essentially what existing a state-run pension plan like Calpers already is?

          • threestationsquare

            That gets rid of some of the investment-management overhead (though most states would still have less AUM than Vanguard) but not the actuarial overhead. (What if it turns out teachers live longer than average?) Still not seeing why you’d expect a state to be better at this than an insurance company (which also have big investment pools). Indeed, if a state (or other employer) claims to be able to offer significantly better annuity rates than insurance companies my first guess is that they are mistaken. Calpers and similar systems seem to have problems with making overly-optimistic projections of investment returns and then needing the state general fund to bail them out.

          • adirondacker12800

            Teachers have had pension plans forever, the actuaries know how much longer they live compared to the general population. Or shorter. I suspect it’s longer.

          • Daniel Hartig

            In my opinion, CALPERS is a good model to follow, with the single exception of its fraudulent accounting based on expectation of unreasonable investment returns. I have heard in the past that the system is designed to operate on an expected 5% return, and that CALPERS did not change this at all for the Recession. In any case, a statewide system with non-fraudulent accounting would be a good system.

          • Henry Fung

            CalPERS real problem was SB 400 which jacked up pensions in 2000. It would have been perfectly sustainable otherwise and in fact was running a surplus, which caused the state to increase the payouts instead of reinvesting for a rainy day.

  6. SC

    From an actuarial viewpoint, actuaries will have a field day trying to figure out how to make work a pension plan that is both defined-benefit and defined-contribution with individual accounts. Mathematically, it might not be possible to create an individual defined-contribution account that disburses a pension payment defined independently from the amount of funds in the account. Additionally, legally, it currently appears that in the US, pension plans that are defined-benefit and defined-contribution cannot exist, because a defined-benefit pension is specifically defined as a pension plan that is not a defined-contribution plan (https://www.law.cornell.edu/uscode/text/26/414#j).

    Your other proposal to create a defined-benefit pension that fully vests annually does not seem to work, either, because that implies that the annual amount that vests will be available to be disbursed immediately on an annual basis, which implies an individual account to administer the funds and a disbursement that is defined by the annual amount contributed. The defined-benefit plan that comes closest to annually vesting appears to be a defined-benefit plan where the partial vesting percentage bumps up on an annual basis (i.e. an employee who completes one year of service will receive 4% of their potential full pension payment upon retirement; a two-year employee receives 8%; a 3-year employee receives 12%; etc.) However, such a plan can easily become administratively heavy, as many more people are eligible for small payments, to the point where the administrative costs might not be worth the benefit.

    I think there’s not much of an appetite for defined-benefit pension reform precisely because of the unions – the unions use the long vesting periods to encourage union members to stay within the union and continue to pay union dues. Perversely, the unions have much incentive and little disincentive to negotiate for larger pension benefits; once retirees gets their pots of gold at retirement, the unions have little use for the retirees because they are no longer active workers, so what does it matter that retirees get an unsustainable sum to the unions which don’t pay for the benefits? On the flip side, unions are incentivized to negotiate for larger pension benefits, in that this attracts more workers to join the union and pay union dues. Meanwhile, the risk that large pension benefits drive up pension costs to the point that the pension and the original employer become insolvent is negated in the public sector by the fact that the public sector, upon insolvency, can’t really declare bankruptcy and wind down their business like the private sector can. Thus, it’s much easier to try to fix the pension funding mechanism when public sector pension plans flirt with insolvency than to wind down the pension plan and the agency that sponsors that plan.

    • threestationsquare

      A defined-contribution plan that just puts each year’s contributions into annuities (which subsequently provide a defined benefit) is perfectly feasible and not particularly administratively heavy. But I suspect it would make the unsustainable nature of the situation clear up front, with either the necessary contributions being unacceptably large or the annuity payments being unacceptably small.

      • SC

        Sure, a defined-contribution plan that puts each year’s contributions into defined-benefit annuities is feasible. But would it be set up where each year one buys a separate annuity? Depending on the length of one’s career, that’s 25-40 separate small annuities to manage, and who wants to manage that? You can cash out some annunities to combine them, but then that’s a bunch of administrative fees for the beneficiary to pay; another option is to bundle all those annunities into an account for a financial advisor to manage, but that’s another layer of administration that the beneficiary again pays for.

        I agree with your previous comment that the value in putting defined-contribution funds into defined-benefit annuities is just not there for most people. To institutionalize a defined-contribution-into-annuity pension plan by offering it as a public sector benefit possibly could reduce the competitiveness of public sector hiring even more.

    • Alon Levy

      The last link gives two arguments against: opacity, and turnover. The turnover situation depends on the job category; Lasker is the president of an office worker union, and there it’s more normal for people to change employers and even job descriptions to gain skills than in traditional unionized jobs like bus driving or teaching or firefighting.

      Opacity is, I think, the difference between what I’m proposing and cash balance. Cash balance tries to have some defined-contribution layer; I’m trying to make it pure defined benefit, but not based just on last-year salary.

  7. Ian Mitchell

    I fail to see what value pensions provide the employee- it seems like it gives everyone fewer choices to prioritize an arrangement only some prefer.

    Would it not be a better move to simple pay employees better in cash, and let them spend their money on an annuity if they want to never run out if they live ’til 90, or on art, wine, cheese, plastic surgery, or pogs, if that’s what they prefer instead?

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.