Pension Woes Have Cities, States Eyeing 401(k) Style Plans

In June 2012, San Diego voters by a margin of 2-to-1 approved a ballot measure that eliminated guaranteed pensions for most future city employees and replaced them with individual retirement accounts -- 401(k)s -- similar to those used in the private sector.

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Police officers were the only public employees exempted from the shift, the centerpiece of a reform effort designed to close San Diego’s $2 billion gap in unfunded pension liabilities.

Former San Diego City Councilman Carl DeMaio, who spearheaded the effort and helped craft the reform legislation, said the city had no blueprint to follow because so few other U.S. cities have attempted the shift.

“We looked around but no one was really doing it, so we had to build it ourselves,” said DeMaio, a Republican who is now running for Congress in California’s 52nd District.

With San Diego on the “brink of bankruptcy,” DeMaio and other like-minded elected officials decided to initiate a reform plan that “put government employees in a retirement program that was no better and no worse than the retirement benefits most taxpayers receive,” DeMaio recalled.

“Our pension initiative said basically, ‘enough’s enough,’” he said.

San Diego is at the forefront of a controversial push by municipal and state governments to replace traditional public employee pensions with 401(k) plans that depend on the fortunes of the stock markets rather than the continued largesse of taxpayers.

“Politicians are able to make promises today that they hope they can pay for tomorrow, hoping tomorrow never comes. But tomorrow is here.”

Matthew Brouillette, Commonwealth Foundation

Recent studies by the Pew Charitable Trust revealed that the 61 largest U.S. cities were a combined $217 billion short on their pension obligations and the 50 U.S. states were a combined $1.3 trillion short on pension promises made to state employees.

Part of a Larger Reform Effort

Shifting away from guaranteed pensions, known as defined benefit plans, to 401(k)-style plans, called defined contribution programs, is part of a larger effort by cash-strapped governments to scale back on pension costs by, among other things, reducing cost of living adjustments (COLAs) and raising eligibility ages for retirement benefits.

To date the city council in San Diego and state legislatures in Rhode Island, Louisiana, Alaska and Michigan are among handful of government bodies to actually enact the shift to 401(k)-style programs, while numerous other state, county and municipal governments continue to mull the conversion.

Not surprisingly, the efforts that have succeeded have been opposed by public employee unions, which have vigorously fought the reforms in the courts.

The central argument against 401(k)-style programs for government workers is that they don’t guarantee a steady retirement income, especially if stock markets tumble as they did after the financial crisis of 2008. A 2012 study by the Center for Retirement Research at Boston College recently found that the typical household nearing retirement had about $125,000 in 401(k) savings, which translates to a monthly payment of $575.

Consequently, if government workers are shifted to 401(k)-style programs but those programs come up short in providing for the workers once they retire those workers will be forced to turn to the government for benefits, costing taxpayers more in the long run.

Moreover, the argument in favor of guaranteed pensions for public employees has traditionally held that the public sector generally pays less than the private sector so government workers should be guaranteed a comfortable retirement.

Gregg Adam, a labor lawyer who has represented police and firemen in San Jose and San Francisco, agrees that the vast public pension system as it is currently structured “is not without its challenges.” But he disputes the need for wholesale changes.

“A lot of people want to view the argument through the frame of the last five years,” he said. It’s no coincidence, he added, that declarations of a “pension crisis” coincided with tremendous losses to millions of private sector workers’ 401(k)s.

Fallout From 2008 Financial Crisis

Simply put, the fallout from the financial crisis has had a big impact on how many Americans now view public pensions. For instance, many Americans now favor smaller government, and with more government bodies facing growing budget deficits there have been widespread layoffs in the public sector.

Since the end of the 2009 recession, total public employment has declined while the rest of the economy has recovered. A 2012 study by the Economic Policy Institute showed that from February 2010 to January 2012, while the U.S. was adding more than 3.2 million nonfarm jobs, state and local government employment fell by 438,000.

“Indeed, in 2011 state and local governments experienced their worst job decline on record,” the EPI reported.

Adam said the layoffs have cut into public pension programs because there are now fewer workers contributing to the systems. And public payrolls may not be rising any time soon.

“We may have reached a tipping point on that,” said Adam. “The expectation is that public entities will do more with less.”

While he agrees that the public pension system needs to be tweaked, Adam is concerned that a large-scale shift to 401(k)s could bring “larger societal problems” if those programs prove insufficient in covering the needs of retirees.

In Rhode Island, where the state legislature in 2011 approved sweeping pension reforms including a hybrid-401(k) system for state employees, opponents have focused not only on the risks, but on what they describe as excessive fees earmarked for Wall Street-types such as hedge fund managers.

The state’s largest public employee union, Council 94, American Federal of State, County and Municipal Employees, funded and released in October a blistering report entitled “Rhode Island Public Pension Reform: Wall Street’s License to Steal.” The message was clear: taxpayer dollars and employee contributions that should be covering pension costs will instead be funneled to Wall Street.

A Highly Politicized Battle

Rhode Island State Treasurer Gina Raimondo, who led the state’s pension reform effort, has dismissed the report as “politically motivated” by opponents of reform.

The fight in Rhode Island is a reflection of how politicized the battle over pension reform has become.

Matthew Brouillette, president of the Commonwealth Foundation, a free market think tank, said shifting to 401(k)-style programs would reduce the influence of politics on how benefits are paid out.

“Pension benefits have been used as a political football,” said Brouillette. “Politicians are able to make promises today that they hope they can pay for tomorrow, hoping tomorrow never comes. But tomorrow is here.”

With 401(k)s, future payments aren’t guaranteed, consequently politicians can’t offer generous pension benefits to public employee unions as incentives to attract votes, knowing their promises will be backed by taxpayer dollars. “There are no future promises on earnings. The employee is responsible for his retirement as opposed to future generations of taxpayers,” said Brouillette.

Brouillette said corrupt deals between union bosses and politicians have left teachers, cops and firemen “caught in the middle” and “demonized” because public opinion has turned against the generous benefit packages they’ve been granted via backroom deals.

While acknowledging the risks inherent to 401(k)s, Brouillette noted that both 401(k) plans and defined benefit systems are vulnerable to the whims of the market because both plans are invested in stock funds.

“The difference, of course, is that with defined benefit plans (guaranteed pensions) the taxpayers are on the hook for shortfalls,” he said.

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