Making Labor Pay
Recent battles in Wisconsin and San Jose show why we need universal pensions.
This article is from Dollars & Sense: Real World Economics, available at http://www.dollarsandsense.org
This article is from the September/October 2012 issue of Dollars & Sense magazine.
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The political economy of the recovery is making the United States even more unequal than it was during the bubble years. Incomes fell across the board during the crisis: median family income is 6.3% below what it was in 2001. But the top 1% garnered 93% of income growth in the first year of recovery. Housing, still the main source of wealth for middle-income families, remains depressed while stocks are close to pre-crash highs. Moreover, the drive for more tax cuts for the wealthy continues. And policy initiatives to cut Social Security, Medicare, and Medicaid would weaken the safety net even as it is most needed.
A spate of attacks on state and local public-sector pensions now threatens to make inequality even more entrenched and painful, and to undermine both short- and long-term economic growth.
The power of labor is dead center in this agenda. Despite a long-term decline in workers covered by union contracts, unions have over 16 million members: they are still the social force most capable of combating the assault on workers’ incomes and militating for greater equality. Crippling their political power therefore remains both a tactical and a strategic objective on the right. With only 6.9% of workers in the private sector covered by union contracts, versus 37% in the public sector, public-sector unions are bearing the brunt of the attacks. And public pensions are the battering ram.
Attacking Unions, Eroding Pensions
The trip wire for the assault on pensions was the combined fall in state and local revenues from the bursting of the housing bubble, and the steep losses suffered by pension funds during the resulting stock market slide of 2007-2009: by 2010 there were widely acknowledged public pension funding shortfalls totaling nearly $800 billion
While pension funds are slowly making back market losses, conservative advocates like Andrew Biggs at the American Enterprise Institute are arguing for new measures of shortfalls that would bring them to over $4 trillion, and using this $4 trillion figure to call for a national movement to slash both public-sector pensions and union rights. The implicit threat is that taxpayers will have to pay these trillions now and into the future, even though they themselves may not have pensions. The stated policy objective is to convince taxpayers and politicians that defined benefit pensions are too expensive in the public sector and should be replaced with defined contribution plans.
Defined benefit pensions are a form of deferred compensation—pay for work performed; they provide guaranteed lifetime payments in retirement. Defined-contribution plans give workers tax breaks for individual savings; workers invest these savings and then pray they don’t run out. Over the past three decades, defined benefit pensions have been nearly eradicated in the private sector for non-union workers; their abandonment in the public sector would effectively end defined benefit pensions as a norm for retirement security and shift the burden of retirement savings almost entirely to individuals.
Abandoning public defined benefit pensions would also erode the more than $3 trillion in investment capital controlled and invested by public-sector funds—aggregated capital that gives the funds both a critical role in long-term economic investment and an important shareholder voice in reforming corporate governance and pushing for re-regulation of the financial sector.
While unions remain a powerful voice in defending universal programs like Social Security, declining union density makes defending benefits like defined benefit pensions that are mainly enjoyed by union workers more difficult. Union benefits no longer spill over into the non-union sector as they did when non-union employers had to complete with union employers for workers. While 70% of private-sector union workers and almost all public-sector workers still have access to defined benefit pensions, only 14% of private-sector non-union workers do, opening the way for a divide-and-conquer strategy for conservative politicians to exploit.
Cutting Edge in Wisconsin
Wisconsin governor Scott Walker is the poster child for the dual attack on public-sector unions and pensions. Elected in late 2010 in a Republican sweep, Walker immediately pushed through over $140 million in tax cuts targeted to corporations and the wealthy, then turned around and blamed an alleged $137 million state budget deficit on public employee pensions and unions. In early February, he introduced legislation to eviscerate state workers’ bargaining rights, triggering the now-famous months-long occupation of the state capitol by hundreds of thousands of outraged union and non-union workers.
The facts were with the demonstrators: there were no shortfalls in pension funding for taxpayers to make up, and unions had already offered higher worker contributions to help pay for benefits.
When the Republican legislature nevertheless passed legislation eviscerating public-sector bargaining rights and unilaterally raising worker pension contributions, unions launched a yearlong effort to recall the governor.
In the 1930s, Wisconsin had been the birthplace of AFSCME, the nation’s largest public-sector union; in the 1950s, it had passed the first state legislation authorizing public-sector bargaining. Yet public pensions remained a wedge issue throughout the campaign.
Wisconsin was once a private-sector union manufacturing stronghold as well, but more recently workers there have been battered with job and benefit losses. As one activist put it, the Walker campaign’s uninterrupted message was “cut taxes, create jobs, don’t pay for other peoples’ pensions.” Union workers were almost as vulnerable to the argument as non-union workers: 38% of union households in the state had at least one member who voted to keep Walker in office, handing him a 53% to 47% victory.
Scapegoating in San Jose
Accounting for Liabilities, or Blowing Them Up?
San Jose’s choices to magnify its pension problems echo national efforts by conservative advocates to change accounting and reporting of unfunded public-sector pension liabilities in order to increase the appearance of shortfalls and spur a transition from defined benefit to defined contribution pensions.
Unlike corporations, most governments don’t go out of business; public-sector pension funds can count on a future stream of contributions from new entrants to maintain funding. As a result, most public-sector pension boards use the long-term average of their funds’ actual investment returns—between 7.25% and 8.25% for many funds today—to estimate the rate of future returns. Private pension fund managers use a more conservative rate based on high-grade corporate bonds—recently, approximately 5.5%.
In either case, the projected rate of return is known as the “discount rate”—so called because pension boards count backwards from the amounts they will need to pay benefits, and then discount, or reduce, those amounts by the rate of return they expect on their investments in order to arrive at the amounts they need to invest to fund future benefits. Understanding the concept of a discount rate is important because much of the current war over public-sector pensions is being fought over whether public-sector funds should continue to use a discount rate based on their historical returns, or should use a lower discount rate, similar to the rate used by private-sector pension funds, or even lower. The lower the discount rate, the worse the funded status of public-sector pensions will appear to be, and the more political pressure will be generated to reduce or eliminate defined benefit pensions.
Instead of using past rates of return, advocates such as the AEI’s Andrew Biggs argue that public pension funds should use a much lower “riskless rate” based on 30-year treasury bonds—currently at 2.75%—as the discount rate. The argument is that because public-sector pension benefits are usually guaranteed, the rate of return used to assess funding should also be “riskless.” Because public-sector pension funds invest in mixed portfolios of stocks and bonds that yield higher returns than treasuries, a “riskless” discount rate makes public-sector funds look much less well funded than they really are. This is especially true today when the economic crisis and monetary policy have driven interest rates into negative territory. Using a riskless rate, state pension liabilities jump from less than $800 billion to well over $4 trillion nationally. Even fully funded Wisconsin suddenly appears underfunded.
The Government Accounting Standards Board (GASB) has recently revised its standards to allow public-sector pension funds to use discount rates based on actual rates of investment returns for the “funded” portion of their pension portfolios, but to require the use of discount rates based on high-grade municipal bonds to account for the “unfunded” portions. This achieves a reporting result between current practice and a market-based bond rate.
GASB stresses that its standards are only for reporting on the status of public-sector pension funds. They don’t dictate the size or timing of contributions or the actual investment strategies.
Advocates of a riskless rate may be counting on few people understanding the distinction between reporting and funding requirements. The Boston-based Center for Retirement Research calculates that state and local pensions were 76% funded in 2010, but that applying a riskless rate would have yielded a 51% funded status. It cautions that even the new GASB standard would have resulted in a 57% figure for 2010, and could, when it goes into effect in 2014, create unnecessary confusion about differences between reporting and funding requirements, leading politicians to conclude there is a worsening crisis, when in fact pensions are on a more secure footing. More recently, Moody’s Investor Service has announced that, among other accounting changes, it is considering using a high-grade corporate bond rate, a discount rate similar to that used by private pension fund managers, to evaluate public-sector pensions when it rates state and local governments. Moody’s proposed changes would triple estimates of unfunded liabilities of public-sector pension plans. Since states rely on Moody’s for a seal of approval when they borrow in the bond market, if adopted, Moody’s proposed discount rate, though only one factor in its evaluation, could put even more concrete pressure on state and local pensions. On top of fueling arguments that public-sector defined benefit pensions are unaffordable, the proposed changes would increase credit costs for states and cities whose rates were lowered. This would add to budget problems just as states and localities are struggling hardest to fund pensions and maintain services. Moody’s materials suggest that it views workers’ pensions as a rival to bondholders’ interests in obtaining more from a shrinking pool of public resources.
The same day as the failed Wisconsin recall, voters in largely Democratic San Jose, California, approved drastic cuts to city workers’ pay and pensions with an equally shocking 69% yes vote.
A wealthy community in the heart of Silicon Valley, where the average annual wage is $95,472, San Jose began an ill-timed “Decade of Investment” at the height of the dot-com bubble. Severely limited both in the property tax revenues it could collect, by California’s long-standing Proposition 13, and in raising other taxes to compensate, San Jose was buffeted over the next ten years by two recessions, high unemployment, sharp drops in revenue from sales taxes, and repeated budget shortfalls. While city leaders managed to more than double capital expenditures during this decade, spending on services increased less than 1.5% per year (not adjusted for inflation). By 2011, San Jose had endured cumulative workforce reductions of 20% and repeated cuts in services, including closings of 22 community centers.
Having paid for virtually its entire FY 2011-2012 budget shortfall with cuts to payroll, with its FY 2012-2013 budget finally projected to be in balance, the city promptly set about restoring services by slashing pensions.
Like most pension funds, San Jose’s were heavily invested in the stock market and suffered large losses from 2007 through 2009, bringing the funds from roughly 90% funded to 75% funded. Although the drop in funding necessitated increased contributions by the city to compensate, the size of the contributions could have been kept reasonable by spreading them out over a longer period of time and bargaining with city unions for appropriate adjustments to benefits and employee contributions.
Instead, San Jose Mayor Chuck Reed magnified pension funding problems to scapegoat workers for revenue shortfalls. Over an 18-month period that coincided with the turmoil in Wisconsin, Reed repeatedly described the city’s pension costs as a “cancerous growth” and talked about imminent disaster if benefits weren’t cut.
Reed’s “Exhibit A” was a figure—eventually exposed by NBC reporters as having been pulled “off the top of the head” of a city retirement official —purporting to show that city pension contributions would more than double over four years, reaching $650 million annually by FY 2015-2016. Forced to do math, the city cut its estimate to $430 million, but still failed to factor in savings from negotiated pay cuts of 10% to 12% and workforce reductions.
The city’s final figure—published a year into Reed’s campaign, well after the $650 million figure was burned into peoples’ brains—was $320 million, less than half the city’s original claim. Even this figure included the costs of a voluntary undertaking by the city to pre-fund retiree health care benefits, as well as changed assumptions about future investment returns that increased the size of city pension contributions to be made in the short term – decisions that AFSCME researcher Dan Doonan publicly described as “comically bad timing” for a city recovering from the most severe economic downturn since the Great Depression.
Numbers Games
The pension fight in San Jose highlights the role seemingly arcane actuarial assumptions play in calculating pension shortfalls, and how such assumptions can provide ammunition for public pension battles.
Pension boards invest contributions made by employers and workers and use the returns on these investments to pay for benefits to retirees. They regularly assess the adequacy of returns in relation to benefits that will have to be paid. If pension boards anticipate lower returns over an extended period, they may decide to increase contributions to compensate.
If increased contributions are required, pension boards have several options for minimizing disruptions. They can average gains and losses over a five-year period—a practice called “smoothing.” They can lengthen the number of years—or amortization period—over which payments are spread. Lengthening the amortization period is similar to what homeowners do when they choose between a thirty-year mortgage, which spreads payments out over a longer period to keep each payment lower, and a fifteen-year mortgage, which saves money over the long-term, but increases the size of required monthly payments. If boards decide the anticipated rate of return on investments needs to be lowered, they can do that gradually too.
The consequences for taxpayers of these decisions about timing can be enormous. Postponing additional required contributions for too long may mean that small shortfalls become unmanageable. But front-loading payments increases their size, and may force unnecessary tax increases and service cuts, benefit reductions, or all three.
San Jose front-loaded its payments. Pension trustees lowered estimates of future returns without easing in the change. They declined to lengthen the amortization period, spreading increased contributions over a shorter amortization period than they had to. And the city made an enormously expensive decision to pre-fund retiree health care rather than funding it on a pay-as-you-go basis as most other jurisdictions do, voluntarily increasing its immediate payroll costs for retiree health care to 17% of pay, and 15.5% for employees.
Together with the city’s earlier inflated estimates of the contributions that would be required to compensate for investment losses, these choices allowed San Jose to magnify pension shortfalls and intensify pressures to reduce benefits,
Pensions and Economic Recovery
San Jose’s pension cuts are currently in litigation. If they are upheld, the price for city workers will range from just under 30% to just over 40% of take-home pay: 15.5% for retiree health care; additional contributions for pensions of up to 16%; and a 10% to 12% pay cut—all in addition to existing contributions of 13% of pay. Alternatively, city workers, who like many public-sector workers don’t participate in Social Security, may be able to opt for a lower tier of benefits being created for new employees, provided the scheme is approved by the IRS. Not surprisingly, San Jose is now having trouble retaining and recruiting personnel.
The price for city residents has also been severe. In addition to what Doonan characterizes as “wrecking the labor market,” Reed’s divisive campaign increased mistrust of the city by its unions, and of unions by city residents, many of whom might well have worked in coalition with city workers for solutions, including a one-quarter-of-one-cent sales tax increase that could have avoided the bloodletting and improved the city’s fiscal position as well. As Bob Brownstein of San Jose-based Working Partnerships USA put it, “When you have a perfect fiscal storm from capital projects you can’t staff, a bad economy, falling revenues, and investment losses, then any chance you get to push expenditures off to the future or bring revenues forward, you should probably take. Anytime is going to be better than now.”
It’s in the context of these votes in Wisconsin and San Jose, and another similar result in San Diego, that AEI’s Andrew Biggs is calling for a national movement for to cut public employee pensions by referenda in order to bring them “closer in line with what stressed private sector workers can expect in the 21st century”—a cruel joke, since most private-sector workers have no pensions.
The price of such widespread take-backs would be enormous, not just for future retirees, but for economic recovery and future growth. The real estate bubble was the last stage of a decades-long transformation in which the contribution of manufacturing profits and employment to the U.S. economy fell and the role of the finance industry and debt expanded. The transition was disastrous, both for workers’ wages and economic stability. Five years into a severe downturn, the official unemployment rate is still 8.2%. The youth unemployment rate is 16.4%. The critical challenge is economic growth to reduce unemployment and raise wages, not further tax reductions.
Far from just supporting retirees, defined-benefit pensions contribute to economic recovery by providing a long-term, stable source of counter-cyclical spending—spending that continues even during economic downturns. The National Institute on Retirement Security calculates that each dollar of benefits from a defined benefit pension supports $2.37 in economic output. In 2009, defined benefit pension dollars spent in the economy supported 6.5 million jobs nationally, or 4.2% of the labor force.
To the extent that pension funds use dividend income from investments to pay benefits, they also redistribute income that would normally go to high-income investors, making income more equal across the economy. This in turn boosts spending, since lower-income workers spend much more of their income than the wealthy do.
Finally, as David Marchick, managing director of the Carlyle Group, has explained to Congress, defined-benefit funds have a responsibility to actively invest their capital in order to produce long-term returns, not just short-term profits. As a result, they are a critical source of the long-term, patient investment and venture capital needed for sustainable growth and job creation, a role that has been even more vital during the crisis and recovery.
Neither defined-contribution plans nor other kinds of individual savings provide these same benefits. Because workers have to worry about outliving the income from these accounts, they are more reluctant to spend it, limiting its stimulus effect. Small individual accounts don’t provide the opportunity for the large-scale, targeted, job-creating investments that pension funds routinely make. And because defined contribution plans are tied to individual savers who have shorter investment horizons and can afford to take fewer risks than professional managers in large funds, they characteristically have 20% to 40% lower returns over their life than defined benefit plans. They also have higher fees.
As a result, defined benefit plans cost half as much to fund as defined contribution plans. Put another way, each dollar contributed to a defined contribution plan delivers half the benefits of a dollar contributed to a defined benefit plan.
Any further large-scale switch from defined benefit to defined contribution plans as currently structured would thus not only undermine retirement security and overall, or aggregate, demand in the economy, it would place heavier burdens on future generations of taxpayers. On the one hand, saving more to achieve the same benefits lowers spending and aggregate demand today, hurting the recovery. On the other hand, not saving more and ending up with lower benefits reduces aggregate demand—what will be spent—in the future, hurting long-term growth. To the extent that lower benefits fail to meet basic needs for retirement security, they pave the way for higher poverty rates, raising the need for public assistance down the line, creating longer-term fiscal problem for state and the federal governments—and taxpayers.
The Real Crisis: Retirement Insecurity
Economist Dean Baker of the Center for Economic and Policy Research has calculated that virtually the entire shortfall in public pension funding was caused by the sudden drop in the stock market and cutbacks in contributions during the downturn. The Center for Retirement Research in Boston estimates that if markets continue to recover, pensions are likely to rebound from their crisis low of 75% funded in 2011 to 82% by 2015. The Center for Budget and Policy Priorities calculates that most states can correct remaining shortfalls by easing in increased contributions of up to 1.2% of their budgets over the next five years and modestly scaling back benefits. The exceptions are the handful of states—Illinois, Kentucky, and New Jersey among them—that took “contribution holidays” during the bubble or that promised benefit increases without funding them, where more substantial measures will be needed.
The real pension crisis isn’t the acknowledged $800 billion in public pension shortfalls. It’s the estimated $6.6 trillion gap in private savings that Retirement USA estimates workers need to achieve retirement security.
Since Social Security’s establishment during the Depression, policy makers have viewed retirement security as a “three-legged stool” composed of Social Security, employer pensions, and private savings. Today, less than half of all private-sector workers participate in pensions of any sort. Median-income households with 401(k)s and a head-of-household between 60 and 62 (a group that has lived through two recent stock-market crashes and the bursting of the housing bubble) have saved just one quarter of what they need to maintain their standard of living in retirement. Younger workers face another lost decade of economic growth before they can start saving. In California, 55% of workers aged 25 to 44 can expect to retire on less than $22,000 a year.
The best way to address the real retirement crisis while supporting recovery is to preserve and strengthen Social Security without cutting benefits; defend defined benefit pensions where they exist; and build a universal system to strengthen individual saving among the increasing number of workers who have no pensions.
Saving individually for retirement maximizes three types of risk: longevity risk—the risk of outliving savings; investment risk—the risk of poor diversification or investment choices; and what is referred to as market risk—the risk of retiring in a severe market downturn.
As a result, most proposals for universal coverage start by pooling individual investment accounts into professionally managed funds that can more effectively diversify investments, share longevity risk, and spread gains and losses over much longer periods than individuals can. These techniques for managing risk allow the funds to take appropriate risk to achieve much higher returns, making retirement savings more efficient for individuals and for society.
Senator Tom Harkin of (D-Iowa) has disseminated a proposal for a national system of pooled accounts that would pay annuities based on a combination of the individual contributions workers make and the performance of the investments. To encourage saving, the system would enroll workers automatically, but allow them to opt out or contribute less than the automatic minimum. Because Harkin’s program is national, it would be completely portable. Harkin’s plan also strengthens Social Security by tailoring its cost-of- living allowance to cover seniors’ basic needs, removing the cap on wages subject to the Social Security payroll tax, and modestly boosting benefits by approximately $60 a month for most workers.
Pension economist Teresa Ghilarducci has made proposals for state and national level plans that overlap with Harkin’s but would guarantee a minimum return above inflation. Because most tax breaks aimed at encouraging pension saving currently subsidize 401(k) contributions by higher-income savers, Ghilarducci’s proposals re-weight assistance towards middle- and low-income savers who would otherwise not be able to save for retirement.
Because of the current political climate that makes expansion of government benefits highly contested, both Ghilarducci’s and Harkin’s plans are structured to avoid government payment of benefits and to work in tandem with Social Security and existing defined benefit pensions. A number of states, including California, are also developing proposals for universal private-sector pension plans.
Recasting the Debate
A robust defense of pensions is no longer possible without a robust fight for universal coverage linked to the broader fight for economic growth. As Jelger Kalmijn, president of a California local of the Communication Workers of America, put it, “Just fighting to keep the defined benefit plans is like fighting to keep the people who are currently in unions in unions. If you only fight to keep the contracts we have and don’t organize anyone new, we’ve all agreed that’s a loser.”
The biggest challenge in building a universal pension system is to begin. The challenge in defending existing pensions is to broaden the fight so most workers have a positive stake in winning,
When viewed against the realities of pension economics or the broader macroeconomy, the facts in Wisconsin and San Jose don’t support the electoral results achieved. But the electoral results do match the political reality on the ground: the profound anxiety and suffering caused by decades of job losses in manufacturing jobs across the country, the stagnation of hourly wages, and the shredding of benefits. Without concrete solutions many of these workers are holding on to what little they have, which in too many cases comes down to their tax dollars. It’s up to unions to lead the fight for those solutions, even though the solutions go beyond traditional union membership or coverage under a contract.
As union density shrinks, fighting for universal benefits will broaden the political playing field. While the educational and political battles will be long, making the fight a concrete one now by making it about pensions for all is what it will take to change the terms of the debate and move from playing defense to playing offense.
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