A better way to reform pensions

Maryland should offer workers something they value more than retirement benefits: cash

July 26, 2011|By Thomas A. Firey

After much haggling, Maryland took a tentative step this spring toward strengthening its state employee pension system, which is estimated to be underfunded by at least $19 billion. By raising the amount state workers must pay toward their own pensions, cutting benefits for new employees and doubling their vesting period, and adding a more stringent requirement for the age and years of service required to receive full benefits, Maryland lawmakers expect to close about half of the pension deficit by 2023.

There are several reasons to dislike this fix. It assumes the state will faithfully make payments to the pension fund in the future, even though much of the money raised by the changes over the next two years will go to state coffers for "budget relief." Prospective state workers will not like that they must wait 10 years to become vested in the system — and would then receive smaller pensions than their older coworkers. Most unsatisfying, state workers likely feel that the increased paycheck deductions are little more than an income tax they must pay in order to receive their promised pensions.

The architects of the reform would respond to these complaints by saying that, as unpleasant as the changes are, they're necessary to make the system solvent.

What if Maryland could adopt a different reform that would significantly lower its pension cost but would give workers something they want more than the promised pension? This appears possible, given research by Stanford University postdoctoral fellow Maria Fitzpatrick.

Ms. Fitzpatrick studied a 1998 change to Illinois teachers' retirement plan that increased retirees' "pension allowance" for each year of service following the change's enactment. The state also gave teachers the option to increase their pensions for service years prior to 1998, in exchange for the teachers paying a relatively small one-time fee. For most teachers, the option was a huge bargain, which Illinois further sweetened by offering generous terms for the fee's payment and allowing teachers to exercise the option at any time. Yet despite strong, favorable publicity for the option, many teachers chose not to take it.

Using the Illinois data and careful econometrics, Ms. Fitzpatrick determined that the teachers, on average valued the new pension benefit at a mere 17 cents for each dollar it cost Illinois to provide it. In other words, many teachers preferred to keep some money in their pocket today, rather than receive a lot more money in retirement. Other studies of different public pensioners have found similar results.

The Illinois option revealed how much teachers valued their pensions "on the margin" — that is, how much they valued having a little more (or less) of something they already have. It suggests that many teachers would happily trade off some of their promised benefits in exchange for cash, even though the cash received would be much less than the eventual cost of the surrendered benefits. This is hardly an irrational decision; the teachers may simply prefer the security of cash today, especially when they face the costs of middle age (e.g., college loan repayment, children, mortgage) and they can save for retirement themselves instead of depending on politicians.

This suggests a promising opportunity for Maryland: Create a voluntary "buy back" program in which the state would pay cash to public workers who agree to forgo some of their pension benefits. If structured correctly, and if many Maryland workers have preferences similar to their Land of Lincoln counterparts, this program could significantly reduce state pension fund liabilities, while giving workers the cash they want. Even if Maryland needed to borrow money today to fund the payments, the long-term savings could make this well worthwhile.

We don't know if Maryland employees' preferences are similar to Illinois teachers'. But it would certainly be worthwhile to ask. Maryland might find that it could help out both taxpayers and state workers.

Thomas A. Firey is senior fellow for the Maryland Public Policy Institute. Citations for material referenced in this column can be found on his page of the institute's website, http://www.mdpolicy.org. An estimate of the unfunded pension liability facing Maryland counties is also on the website under "Project: Pensions." His email is tfirey@mdpolicy.org.

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