Friday, November 28, 2014

Pensions for State of Illinois Employees - Again

The piece linked below is now almost a week old.  So it no longer counts as news. But it's been on my mind and now that Thanksgiving has past, I thought I'd write a bit on the topic.  One has to wonder whether defined benefit versus defined contribution is the real issue.  My guess is that it's not.  To me, the real issue is how generous the benefits are.  This discussion about defined benefit versus 401(k) plans masks this issue.

In the plan that I retired under, 8% of my salary was withheld for pension.  I didn't pay state income tax on that amount.  (I also didn't contribute to Social Security.  My retirement income is in lieu of Social Security.)  In theory, the state matched my contribution dollar for dollar.  So each year 16% of my salary was going to fund my pension.  Plus there was interest earned on already accumulated funds.

But since I was in a defined benefit plan, the above was all an accounting fiction.  The annuity I'm currently receiving doesn't depend on contributions and accumulated interest.  It depends on a formula based on years of service, average salary over the last four years of service, plus the COLA increases received since retirement. This formula does not depend, for example, on age at retirement.  If you are 10 years younger than somebody else, but have the same years of service (because you started earlier on the job) and the same last four years of salary income, then your annuity per month will be identical, but your expected annuity earnings over the time of retirement will be much greater, because you should expect to receive that annuity for a much greater duration.

Given that I retired at age 55 (the earliest possible age) I'm maximizing on the duration of retirement variable.  When I did a quick and dirty calculation to compare expected contributions to expected benefits, I got a ratio of something like 1 to 3.  (This calculation didn't include any risk adjustment.  If inflation returns big time and outstrips the COLA adjustments, then those later year benefits would have to be discounted accordingly.  Since I retired four years ago, the COLA 3% per year has exceeded the inflation rate, so my actual benefit per year has risen in real terms.)  But even if I were 65 when I retired, the definted benefits would be generous, with a ratio of contributions to benefits of something like 1.7  (Note that I worked 30 years and got an extra year of service credit for unused sick leave when I was being a prof full time - the first 15 years of work.)

Why is the defined benefit so generous for me?  One reason is how my wages grew since I started in the job.  There was roughly a seven-fold increase in pay, a not quite 7% annualized rate of increase. Early on this was because inflation was running higher than that.  Later it was because of job switching, with each job switch accompanied by a nice pay increase, while salary increases within job were rather modest.  For someone with fewer job switches the formula would be still less generous.  But would it produce a contributions to expected payout ratio that is on par or would it still be generous?  I don't know but my guess is that it still would be generous, which is why the unions resist so much a move to the defined contribution sort of pension.

In a perfectly competitive labor market, if pension benefits go down then wages paid must go up.  Otherwise the jobs will look less attractive and the people who are candidates to fill the jobs will choose to work elsewhere.  For those state employees where the labor market is perfectly competitive, such as the market for new assistant professors, should this change in pension provision go into effect, they will have to earn a salary premium as compared to working elsewhere.  Otherwise, we'll be unable to recruit them.

Of course, the labor market for many state employees is not perfectly competitive.  Most state employees, particularly those who are long timers, are earning considerably more in their current jobs than they could earn elsewhere.  That differential is an economic rent, which accrues to the employees.  One way for the state to save money on such employees is to cut their wages.  In effect, that is what the move to a defined contribution retirement plan would be doing, while at the same time keeping the nominal wage paid unchanged, so to the naive a claim could be made that it is neutral on compensation.  But that would not really be true.

There is one further issue between defined benefit and defined contribution plans if they were otherwise constructed on par.  This is on whether an individual with a a pot of money from a defined contribution plan can annuitize that in a reasonable way (convert it to fixed monthly payments that will exhaust either after a known time horizon has past or at end of life).  The ease of doing this is greater the larger the size of the pot of money.  Those with modestly sized retirement accounts will not fare as well and if they can only select fixed duration alternatives they will end up bearing the risk that they outlive their retirement savings.  Really, they should not bear this sort of risk.  The state should because it is much better able to diversify the risk.  This last is a reason to stay with defined benefit plans, really the reason.

But this reason is not how people are thinking about it.  They are thinking about it from how generous the plans are.  I expect a lot more hyperbole on the issue before (or if) we ever get to a resolution.

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