Econ Matters: City can defuse time bomb with defined benefit plan
Columbia’s 2009 financial report said that the city’s pension assets stand at about 65 percent of the liabilities to both the police and fire pension funds. In other words, if we shut down the city of Columbia today and our police and firefighters began receiving benefits at the appointed age, there are 65 cents worth of assets backing each dollar of pensions promised to the current firefighters and police.
Two questions jump to my mind: First, where will the city obtain the monies to eliminate the gap between the assets and liabilities? Second, is there a better way to compensate future police and firefighters?
To answer the first question, budget arithmetic tells us that two types of solutions exist. On the revenue side of the ledger, contributions to pension assets could come from expanding city revenues while holding other expenditures constant. On the expenditure side, contributions could come from cutting city services while holding revenues constant.
There are infinite variations on the two themes, but basically they boil down to those two options. The city made promises to the current group of police and firefighters. Given the stream of city revenues and competing expenditures, allocations are made subject to the constraint of such compensation promises.
The second question is really about whether we should continue paying future police and firefighters hired by Columbia in the same way. A crisis is a terrible thing to waste.
It is fair to ask, why is future compensation worth considering? Note that any worker’s total compensation package can be broken down into the salary part and the benefit part. Companies and workers match and take both components into account. As such, a pension plan is a benefit that guarantees a payment stream. The size of the pension payments will depend on salary, years of service and other factors.
Because the benefit is deferred until retirement, government accounting standards require that future liabilities and the assets backing those liabilities be measured. When the assets are smaller than the liabilities, the pension is underfunded.
The plan is straightforward. The city government has a pretty good idea about the change in the liabilities from one year to the next. Contributions to the pension assets are made to keep up with the changes in liabilities.
Unfortunately, asset values do not grow at the same rate every year. Some years, asset returns are great, and other years, such as the past couple, the returns are negative. So even the best-intentioned city government is subject to risk.
There are good years when returns are high (remember when the S&P 500 increased more than 30 percent for a couple of years). During these times, the above-average returns are like a windfall, and there is an incentive to make smaller-than-normal contributions, keep the pension fully funded and use the excess to increase spending on other items.
In contrast, during those years in which returns are below average, a city is forced to make larger-than-normal contributions. The upshot is that with a defined benefit plan, which is what a pension is, the city government bears the risks of asset value fluctuations. Is this risk-sharing agreement between a city and its police and firefighters the most prudent way to use taxpayers’ money?
There is an alternative compensation package. A defined contribution plan, like a 401K, is based on the employees making their own contributions and the city matching some percentage. For the city government there is one clear advantage; contributions to the defined contribution plan are more predictable. Clearly, asset values still fluctuate, but now the risk of such fluctuations is borne entirely by the worker.
The point is that a defined benefit plan means the government bears all the risk associated with asset value fluctuations while a defined contribution shifts the asset value risk entirely to the worker.
Compared with the current employment match between the city and the police and firefighters, there would be changes if the benefit package were changed. Two countervailing forces would be put into operation. One force would involve the cost of the new risk-sharing compensation package. New police and firefighters would realize that risk is being shifted to him or her. With greater risk to his or her benefit package, a Columbia police recruit might require a larger salary component.
The Columbia police recruit, however, would also know that defined contribution plans have some attractive attributes that do not exist with defined benefit plans. With a pension, benefits end when the worker or spouse expires. With a defined contribution plan, the asset value can be bequeathed to the next generation. This feature might be valued by police recruits, for example, and will, on the margin, reduce the salary component necessary to accept the appointment.
One last point: Some will argue that people are not sophisticated enough to deal with the financial issues. They will even cite scholarly articles claiming that people systematically undersave for retirement when faced with a defined contribution plan. They argue that a pension is necessary to insure a financially secure old age for these poor people.
To these arguments, I say phooey. People make extraordinarily complex economic decisions all the time. One might disagree with these decisions, but they are what makes that person happiest. How could any outsider know what is best for another person?
Once such hubris is eliminated, we can begin to examine the real questions about the city’s budgeting issues with respect to police and fire compensation packages and avoid wasting another good crisis.