Last year, eighteen states adopted pension reforms. The boldest move was in Utah, which joined Michigan and Alaska in enacting a reform that will move many new hires into defined contribution (401(k)-style) retirement plans. Three states--Minnesota, Colorado, and South Dakota--attempted to reduce the Cost of Living Adjustments (COLA) due to retirees and are now waiting to see if their reforms survive litigation. But in most states, "pension reform" just meant tweaking pension funding formulas for newly hired workers--meaning little political resistance from unions and little near-term savings for taxpayers.
Lawmakers in many states are now looking at enacting pension reform in 2011--either because they didn't act in 2010 or because they realize their last round of pension reform didn't go far enough. I evaluated many of these proposals by asking three key questions: First, has the state accurately assessed the size of its pension problem? Second, does the proposed reform achieve significant savings in the near-term while minimizing pain for taxpayers? And third, does the reform break with the defined-benefit model by switching to defined-contribution accounts that limit taxpayers' risk and ensure that workers who spend only part of their careers in government are treated fairly?
While there are some bright spots, the results are mostly not encouraging--most states continue to take the 2010 approach of reform that is too timid and has too few effects in the short term.
1. Will the plan accurately assess pension underfunding? So far, no state has taken up accounting reform. There's a good reason for this. By adopting the discount rate standard used in private sector pensions, states would dramatically increase their reported pension liabilities.
Some states have adjusted their discount rate assumptions down slightly, based on the expectation that the market won't be delivering the typically assumed 8 percent annual return. But assumptions are still well above what would be required under a private sector-style market valuation methodology. States and localities where pension funds have recently adjusted their assumed rates of return downward include Atlanta, California, Illinois, Maine, New York, San Diego County, and Virginia.
At minimum, such adjustments show an awareness that something isn't quite right with the state's assumptions. But states are still operating with an incomplete picture--lawmakers still want to hide the true scope of unfunded pension liabilities.
2. Will the plan achieve real, near-term savings? The most common problem with pension reforms is that they apply only to newly hired workers, meaning they take years or decades to generate meaningful savings. But in the past few months, a handful of states have talked about reforms that would apply to current workers, not just new hires. The importance of these reforms is that they immediately achieve a significant reduction in the amount of benefits being accrued each year, increasing the likelihood--particularly in the worst-funded states--that states will be capable of meeting their pension obligations. This is the brightest spot in the outlook for pension reform in 2011.
New Jersey is leading the pack. Governor Chris Christie (R) has proposed eliminating pensioners' COLA, eliminating a 9 percent benefit enhancement granted in 2001, increasing employee contribution rates, and increasing the retirement age. All of these reforms affect at least some current workers, and thus will have an immediate budgetary impact. Currently, New Jersey's huge unfunded liability will require it to make an estimated $10 billion in extra annual payments by 2020 (as estimated by Joshua Rauh of Northwestern University). These reforms, if passed, will cut the unfunded liability in half, leaving the state far better positioned to pay out accrued benefits.
Illinois, which has the country's worst-funded pension systems, is also considering cuts in the benefits that current employees may accrue in future years. House Majority Leader Michael Madigan (D) is proposing such cuts. However, other powerful figures (including Senate President John Cullerton (D)) are opposed, and there is a dispute over whether such a move would violate a provision of Illinois's state constitution. If enacted, Madigan's reforms would likely have to be reviewed by the state's Supreme Court. Still, Illinois's fiscal situation is so dire that lawmakers may find it worthwhile to take on such a court fight.
Last year, Governor Pat Quinn (D) signed a reform to reduce benefits for new hires, but most everybody agrees that reform will not do nearly enough to make the state's pensions solvent. Illinois Republicans would go farther than Madigan, proposing more structural changes including introducing an option for employees to move into defined contribution plans--but with Democrats controlling both the legislature and the governorship, they will be sitting in the backseat as reforms are enacted.
In most other states, smaller cost-saving steps are on the table. Washington's governor, Christine Gregoire (D), would like to undo a 1995 pension sweetener granted to a small number of the state's teachers and public workers. It's a good start, but only affects a fraction of the state's pension system.
In Virginia, Governor Bob McDonnell (R) started 2011 by asking the state's employees to contribute to their pensions for the first time since 1983--a concession he made more palatable with a three percent pay raise to offset it. Virginia Senator John Watkins proposes creating a defined contribution option for new hires--but his plan was voted down in committee. (In addition to structural reforms, Virginia should start making its annual required pension contributions in full, which it failed to do this year.)
In Maine, Governor Paul LePage (R) proposes to suspend pensioners' cost-of-living increase for the next three years. He would also require teachers to contribute 9.65 percent of their salary toward pensions, up from the current 7.65 percent.
Far less robust reforms are proposed by Governor John Lynch (D) of New Hampshire. He suggests a tweak to the benefit formula--calculating pensions based on the average of the last five years of employment, instead of the last three. The New Hampshire state legislature is debating several proposals, including increasing the retirement age for public safety workers from forty-five to fifty. All of the proposals would only apply to workers with less than ten years of service.
Massachusetts governor Deval Patrick (D) wants to increase the retirement age (for new hires only) while simultaneously decreasing employees' required contribution to pensions, for a small net savings that comes mostly far in the future.
Maryland is considering reforms that focus almost entirely on new hires and include increased contribution rates, lower benefit multipliers, longer vesting periods, a higher retirement age, and an increase in the final salary calculation to the average of the last five years. As far as current employees go, Governor Martin O'Malley (D) wants to give employees a choice to take more salary up front and less in retirement, or contribute more salary today and get a higher payout in retirement later.
Leaders in some states with big funding problems, namely Connecticut and California, have not yet unveiled their pension reform plans. New York governor Andrew Cuomo (D) has talked extensively about the need for pension reform, but has asked a commission to study the issue before he presents specific recommendations.
3. Will the plan abandon the defined-benefit model? Utah was the only state to enact reforms in 2010 that will move many workers out of a traditional pension and into a 401(k)-style plan. But while lawmakers in several other states are backing defined-contribution legislation, they generally do not have much momentum. One key exception is Florida, where Governor Rick Scott (R) is proposing to move newly hired state workers to 401(k) plans. Last week, the North Dakota legislature rejected a bill to move teachers and public employees into a 401(k) plan by one vote.
On the three big questions, lawmakers in most states are failing to accurately account for their pension liabilities or move away from the defined-benefit model that got us into the pension funding mess in the first place. The news is somewhat better on the question of whether reforms achieve meaningful cost savings; several states, including New Jersey and Illinois, stand a strong chance of enacting reforms that do provide meaningful, upfront relief to taxpayers.