Analysis of the 2004-05 Budget Bill Legislative Analyst's Office February 2004

Alternative Retirement Benefit Programs

Background

State Currently Has "Defined Benefit" Plans

Six Retirement Plans. The Public Employees' Retirement System (PERS) administers the principal retirement plans for state employees. Employees are divided among six retirement classifications based on type of work. Figure 1 shows these classifications and the standard retirement benefit for each plan. Correctional officers, firefighters, and highway patrol members have more generous retirement plans than most state employees who are in the Miscellaneous classification.

"Defined Benefits." The state's PERS plans are known as defined benefit programs. Upon retirement, employees receive a set amount of benefits based on a formula that includes age and salary at retirement and the number of years of service. These benefits are lifetime annuities, in that the retiree receives benefits until death. These retirement benefits are not "portable" for those who leave state service (except when they go to other public sector entities in California with reciprocity agreements with PERS). That is, retirement credits must stay with the state, unless an employee opts to "cash out" retirement contributions upon leaving state service. Only the member's contributions (and accumulated interest) can be cashed out. The state's contributions toward retirement are "lost" to an employee who cashes out.

State Year-to-Year Costs Have Fluctuated Dramatically

Employee and Employer Contributions. Employees contribute to their retirement through a specified percentage deduction from pretax salary. This amount is fixed and does not vary from one year to the next (unless changed by the collective bargaining process). As shown in Figure 1, employees in the more generous plans have higher contribution rates. The state makes up the difference in contributions required to pay for the guaranteed benefit. As a result, state contributions vary from year to year. The state's contribution rate is made up of two components: (1) the "normal cost," which reflects the annual cost of that year's service and (2) the "unfunded liability," which reflects any shortfall in funding from prior years. The total cost to the state can fluctuate significantly. Figure 2 shows how state employer contribution rates have changed since the 1990s for the different retirement classifications.

Poor Stock Market, Benefits Increase Source of Higher Rates. As shown in Figure 3, PERS estimates that 2004-05 state employer retirement contributions will be $2.6 billion ($1.4 billion General Fund)—just four years after being less than $200 million in 2000-01. This recent growth in state retirement costs is largely attributable to two factors: 

• Poor Performance of the Stock Market. When investment returns are less than assumed, rates go up. Significantly worse returns than expected for three consecutive years beginning in 2000-01 have resulted in rapidly increasing state costs.
• Enhanced Retirement Benefits. The enhanced retirement benefits resulting from the enactment of Chapter 555, Statutes of 1999 (SB 400, Ortiz), are also a significant factor in the higher rates. Chapter 555 increased benefits by lowering retirement ages, increasing the percent of salary paid in retirement, and basing benefits on the one-year period of highest salary instead of an average of three years. In addition, for highway patrol and correctional officers, Chapter 555 raised the cap on the portion of salary that can be received in retirement from 85 percent to 90 percent. Chapter 555 also closed the state's "Miscellaneous, Tier 2" system to new employees (unless specifically chosen by the employee). Based on PERS data, we estimate that these additional benefits add approximately $600 million to anticipated 2004-05 costs—almost one-quarter of the state's total payment.

Cycle Can Make Hard Fiscal Times Even Tougher. This cyclical nature of retirement costs can unfortunately track with state finances in a perverse way, as demonstrated in recent years. When the state had budget surpluses in the late 1990s, retirement contributions fell to very low levels. At that time, however, the state could have more easily covered the current, high retirement costs. As the state budget situation began to deteriorate in 2001-02, retirement contributions started on their upward spiral.

Governor's Retirement Proposal

Budget Proposal. The Governor's budget has three retirement-related proposals:

• A pension obligation bond to pay a portion of 2004-05 retirement contributions.
• A 1 percent increase in employee contributions from current state workers.
• Enrolling new employees in the retirement plans in effect prior to Chapter 555's benefits increase, including Tier 2 for new Miscellaneous employees.

Combining the impact of additional employee contributions, state contribution savings from pre-Chapter 555 plans, and pension obligation bond proceeds and debt payments, the Governor's budget estimates the General Fund retirement cost savings shown in Figure 4 through 2009-10.

Pension Obligation Bond

We recommend that the Legislature reject a pension obligation bond to pay 2004-05 state retirement contributions. Courts have thus far prevented the state from issuing such bonds. Irrespective of legal issues, incurring two decades worth of debt to avoid an annual operating expense is poor fiscal policy.

The Governor's retirement proposal includes a pension obligation bond to pay a portion of the state's 2004-05 retirement contributions to PERS. This would benefit the General Fund by an estimated $929 million in the budget year and $20 million in 2005-06 (to cover some debt-service costs). The bonds would be paid off from the General Fund, with an estimated four years of interest-only payments between $55 million and $60 million, followed by interest and principal payments of roughly $100 million annually for 15 years (see Figure 4).

Lack of Voter Approval Makes Court Certification Unclear. The 2003-04 budget package included a similar pension obligation bond proposal (although it totaled $1.9 billion). In last year's Analysis (please see pages F-14 through F-16), we noted that pension obligation bonds had not previously been used to pay a government's annual retirement contributions—an ongoing operating expense. Rather, local governments had used these bonds to pay off unfunded liabilities—a preexisting obligation. For local government bonds, courts had concluded that these general obligation bonds were exempt from voter approval requirements since no new debt was incurred. During the fall, a Superior Court decision invalidated the state's 2003-04 pension obligation bond proposal because it lacked voter approval. The state is currently appealing this decision.

Despite the fact that the administration is concurrently proposing retirement changes, the pension obligation bond proposed for 2004-05 appears nearly identical to the one invalidated by the Superior Court. The bonds are proposed to be sold without voter approval, which is the grounds on which the court disqualified the current-year bonds. Thus, it is unclear to us whether the court would validate this new proposal.

Incurring Debt for Operating Costs Is Ill-Advised. Even if the state could legally implement the Governor's proposal, we believe that incurring two decades worth of debt to avoid a 2004-05 operating expense is poor fiscal policy. Current operating expenses should be paid with current revenues. Paying off the bonds for the one-time benefit in 2004-05 would leave fewer funds for state priorities in the future.

Recommend Rejecting Pension Bond. For these reasons, we recommend that the Legislature reject the pension obligation bond proposal to pay 2004-05 state retirement contributions.

Higher Contributions From Current Employees

Gaining higher retirement contributions from current employees is an idea worth pursuing in collective bargaining. The Legislature should be aware, however, of what this provision might cost the state in return.

The budget proposes increasing contributions into the retirement system from current employees. For most employees, the proposal would raise pretax deductions from 5 percent to 6 percent of salary. The employee contribution for correctional officers, state firefighters, and highway patrol officers would increase from 8 percent to 9 percent.

Additional Contributions Would Require Agreement of Unions. State collective bargaining contracts specify employee retirement contribution provisions. Consequently, this proposal would require the agreement of state employee unions through collective bargaining. The proposal assumes that new contracts will include these provisions beginning one year after current contracts expire. Since most bargaining units have contracts that do not expire until the end of 2004-05 or later, the administration estimates that higher employee contributions would be phased in. As a result, budget estimates show additional contributions starting at $14 million in 2004-05, growing to $44 million by 2007-08, and declining thereafter (as more new employees are hired into the pre-Chapter 555 plans).

Employees Help Pay for Higher Benefits. This proposal could be viewed as having current state employees share in the additional annual cost of the retirement benefits increase adopted in Chapter 555. We think this makes sense, particularly given the overall level of retirement benefits currently provided to state employees. (See box for a comparison of California benefits to selected other states.) 

Idea Worth Pursuing. While we think the idea is worth pursuing, it is unclear at this time what concessions the administration would have to make in order for unions to agree to an additional employee contribution. As a practical matter, the administration's savings estimate from this provision is overstated in that it does not take into account these likely added costs. Thus, when reviewing negotiated contracts for approval, the Legislature will have to consider the merits and costs of the total package to determine if the higher employee contributions are "worth it."

Additional Contributions Would Not Reduce State Employee Rates Until 2006-07. We reviewed the administration's estimates for its proposal. The assumptions regarding the phasing-in of bargaining units and salary and attrition rates seem appropriate. Thus, the amount of higher employee contributions estimated by the administration appears reasonable. Absent a change in actuarial methods by PERS, however, the timing of estimated savings is overly optimistic in the short term. Annual state contribution rates to PERS are based on the status of the retirement plans in place as of June 30 two fiscal years prior. As a result, even with higher employee contributions beginning in 2004-05, PERS would not adjust state rates to account for this additional income until 2006-07. Thus, all state savings from the higher employee contributions would accrue two years later than assumed by the administration. For the budget year, this means a cost of $14 million General Fund. Over a 20-year period, this results in only a minor, downward adjustment in the administration's estimate of General Fund savings.

The administration notes that PERS could choose to take these additional employee contributions into account immediately, thereby offsetting state contributions in the budget year. The PERS board has not indicated to date whether it would do so. If PERS did not, the administration reports that it would propose a greater amount for the pension obligation bond to cover the delayed savings.

Pre-Chapter 555 Benefits for New Employees

The administration proposes negotiating pre-Chapter 555 retirement benefits for new employees. The state, however, could adopt this proposal on its own immediately, without waiting several years for full implementation. This would maximize possible savings.

The Governor's budget proposes additional steps to start containing state retirement costs now. Under the proposal, the defined benefit plans in place prior to Chapter 555 would apply to new employees. For most employees, this would be the "1.25 percent at 65" retirement formula under the Miscellaneous, Tier 2 plan. (The Tier 2 plan also includes no employee retirement contribution.) Correctional officers and state firefighters would receive "2.5 percent at 55" while highway patrol officers would get "2 percent at 50." The administration proposal retains the one-year final compensation basis for benefits instead of returning to the pre-Chapter 555 three-year period.

This proposed change would result in annual state employer retirement contributions for new employees that are smaller than they otherwise would have been. As the state hires more and more new employees, these savings would continue to grow. The administration estimates annual savings of just $6.4 million in 2004-05, but growing to more than $450 million annually by the end of a 20-year period.

Negotiation Not Necessary, State Could Adopt Proposal on Its Own. The administration has assumed that this provision would be negotiated in collective bargaining agreements (in a similar manner as the higher employee contribution discussed above). This delay, however, is not necessary. The state made Tier 2 mandatory for new employees beginning in 1991-92 through trailer bill legislation accompanying the budget act. The state could similarly adopt this part of the administration's proposal to begin in the budget year for all new employees. This would increase savings in the short term.

Savings Estimates Overstated. Based on our review of this proposal, the new employee hiring required to meet the administration's estimated savings is too aggressive. The state's ongoing hiring freeze and the assumed phasing-in of new agreements would limit the number of new state employees that would receive pre-Chapter 555 benefits. We estimate these factors would reduce the estimated annual savings by about half in the short term.

Additional Options for Controlling Future Retirement Costs

We recommend that the Legislature seriously consider the proposal to enroll new employees in pre-Chapter 555 retirement plans. We also recommend that the Legislature consider additional alternatives such as Tier 2 and defined contribution plans for all new employees. These alternatives would result in more state savings and provide other state benefits compared to the administration's proposal.

The pressure that rising retirement costs have recently put on the state budget highlights the ongoing liability the state has for its retirement system. Given the continuing prospect of making $2 billion-plus retirement payments, we recommend that the Legislature seriously consider the Governor's proposal to enroll new employees in the retirement plans in place prior to Chapter 555. We recommend, however, that the Legislature consider additional alternatives as well, such as (1) Tier 2 retirement plans for all classifications and (2) defined contribution plans. As shown in Figure 6, these alternatives could achieve more state savings than the administration's proposal while offering other advantages, as we discuss below.

Tier 2 Benefits

Higher Take-Home Pay. Tier 2 pays approximately two-thirds the benefits of Tier 1, and at a higher retirement age. Tier 2, however, also includes no employee retirement contribution. Therefore, take-home pay for a Tier 2 employee is higher than that for a Tier 1 employee with the same position and salary. This has the effect of redistributing lifetime income towards the front end-to be used at employees' discretion-and away from the back end-designated for retirement.

Lower State Costs. In addition, state costs for Tier 2 are also less on a per-employee basis. This is because the benefit to be paid upon retirement, and therefore the total estimated cost, is less than for a Tier 1 employee. For 2004-05, PERS estimates a difference of 4.6 percent of salary between state Tier 1 and Tier 2 contributions. This is significant: for a $40,000 position, a department would pay $1,840 less in retirement costs for a Tier 2 employee in 2004-05. On a statewide basis, existing Tier 2 employees (about 18,000) will save the state $34 million in costs in the budget year.

Option for Tier 2 for All New Employees. The administration proposes enrolling new Miscellaneous state employees in Tier 2. The state could also institute Tier 2 retirement benefit programs for all retirement classifications. In this instance, the Legislature would want to adjust Tier 2 benefits proportionally to reflect the different benefits received by various classifications. (For instance, safety-related employees could receive enhanced Tier 2 benefits.) As noted above, with a lower or eliminated employee contribution, employees would receive increased take-home pay.

Potential Savings of 10 Percent Over Governor's Proposal. Based on the existing difference between Tier 1 and Tier 2 for the Miscellaneous plan, we estimate that Tier 2 plans for all retirement classifications could achieve upwards of 10 percent more savings annually in the long term than the Governor's proposal.

Defined Contribution Retirement Program

Defined Contribution Plan Limits Future Liability. As discussed above, defined benefit plans create a great deal of fiscal uncertainty for the state as it is on the hook for all rate changes at the margin. To limit their uncertainty, many private sector companies have switched to "defined contribution" retirement programs. In addition, some states such as Ohio, Michigan, Oregon, and Washington have either switched to defined contribution plans or offer such a plan to their employees. Under these plans, companies or governments contribute a certain amount to employees' retirement accounts. Typically, a business contributes a specified percent of salary, matches employee pretax contributions up to a specified percent of salary, or both. As a result, a company or government has no continuing obligation for retirement pensions after contributing the specified amount to employee accounts. With defined contribution plans, there is more uncertainty for the employee in that there is no guaranteed level of benefits upon retirement. These benefits depend instead on stock market performance and overall investment returns.

Portability. In addition, retirement funds under a defined contribution plan are portable for employees who leave the company. Unlike defined benefit retirement plans, both company and employee contributions can be cashed out. Individuals can also "roll over" retirement funds to new employers.

Flexibility in Annual Costs. With a defined contribution plan, the state would be able to set employee and state contributions at any level desired. These decisions could be left to collective bargaining as well. A typical contribution by employers for such retirement plans is 5 percent of salary.

Predictable Expenses. The dollar amount required by whatever rate is set for an employer's defined contribution is the only cost incurred. There is no risk of an unfunded liability to pay off in future years. That is, there are no expenses that cause future retirement rates to go up. Each year has a set identifiable cost, lending greater predictability to state finances.

Potential Savings of One-Third Over Governor's Proposal. Any state savings from a defined contribution plan would depend on the chosen level of the state's contribution. For instance, based on the existing difference between the Tier 1 normal cost and a five percent state contribution, we estimate that defined contribution retirement plans for all new employees could achieve upwards of one-third more savings annually than the Governor's proposal in the longer term.