Potential Impact of Governor Brown’s Pension Reform Plan on Low Wage Workers

Potential Impact of Governor Brown’s Pension Reform Plan on Low Wage Workers

January 4, 2012

by Nari Rhee, Ph.D.
Associate Academic Specialist
UC Berkeley Center for Labor Research and Education


On October 27, 2011, Governor Brown released his “Twelve Point Pension Reform Plan” designed to reduce pension and retiree health costs for state and local government.  The plan includes several sensible proposals, such as the elimination of pension spiking and capping defined-benefit (DB) pension benefits at a reasonable level.  However, two key elements of the plan may impose a disproportionately large burden on low-wage workers.   One is a “Hybrid” pension for new employees that will combine a reduced DB pension benefit with a defined-contribution (DC), 401(k) type plan in which employees bear all the risk. The other is the proposal to increase the age at which employees can receive full retirement benefits to 67 across the board for new, non-safety employees.  Low-wage workers are ill-equipped to bear the risks and increased costs of a 401(k) style plan, need to replace a greater portion of earnings than do middle- or high-wage workers in order to meet basic expenses in retirement, and begin their working careers much earlier, and experience shorter life expectancy, than professional workers. Because of these factors, the two proposals could have significantly greater impacts on workers at the bottom of the wage spectrum. 

 “Hybrid” Risk-Sharing Pension Plan for New Employees

The Governor’s hybrid pension proposal has three key dimensions.  First, retirement benefits for new employees will be composed of a reduced DB benefit and a 401(k)-type DC plan.  Second, benefits would be targeted to replace, in combination with Social Security, 75 percent of pre-retirement earnings after 35 years of service for non-safety employees and 30 years for safety employees.  Third, DB, DC, and Social Security would each provide roughly one-third of the total benefit, i.e., 25 percent of pre-retirement earnings.  This proposal is intended to distribute pension risks and costs between employers and employees while attempting to provide retirement income that allows workers to maintain their standard of living after a lifetime of service.  In reality, the proposals would have a disproportionate impact on the retirement security of lower wage workers and those in occupations requiring higher levels of physical activity. 


401(k) type plans entail a host of risks and costs that lower-wage workers are ill-equipped to absorb.

401(k) plans were originally instituted as a tax shelter for corporate executives, and were never meant to be a vehicle through which to save and invest for basic living expenses.  These plans not only shift investment and market risks from employers to employees; they entail fundamentally greater risks and inefficiencies overall compared to DB pensions.  These risks and inefficiencies can be mitigated, though only partially, by higher up-front contributions during the accumulation phase—about 72 percent more compared to a DB pension.  This is a high price tag for public employers in the state.  Even higher contributions would be required on the part of employees if the possibility of an ill-timed market downturn is taken into account.  Unfortunately, low-wage workers have extremely limited capacity to absorb such costs.  As retirees, they will experience disproportionate hardship if the market does not perform as expected because their target retirement income provides only for basic expenses, not luxuries that can be easily cut back. 

•    Individual 401(k) accounts typically garner lower investment returns than do DB pensions, which can diversify their investments over a wider array of vehicles and invest over a very long time period.  Retirement benefits that rely heavily on 401(k)s also require funding to last several years past average life expectancy, while DB plans pool longevity risk and thus only need to be funded for the group’s average life expectancy.  For men born in 1970, average life expectancy in the US after age 65 is about 19 years, or age 84.   Private financial planners typically advise such individuals to plan savings to last an extra 6 years, to age 90, in order to eliminate most of the risk of running out of money when they are most vulnerable.   
•    Because of these and other factors, it costs 46 percent less to provide comparable benefits through a DB pension than through a 401(k).   Conversely, it costs 72 percent more to provide the same retirement income through a 401(k) as through to a DB pension.   Indeed, the University of California recently chose to maintain its DB pension system rather than convert to a 401(k) system for new hires because it found that the latter would be significantly more expensive.    
•    In addition, 401(k)s entail significant risk that workers’ retirement income will be substantially lower than anticipated because of unfavorable market conditions when they retire, i.e., steep market downturns that depress average returns despite a lifetime of prudent saving and investing.  For instance, if a 401(k) account earns a healthy 6 percent average real return, it would take 5.5 percent of a typical low-wage worker’s earnings to meet the 25 percent replacement goal.  This is equal to $138 a month for a worker earning $30,000 a year.   But if real returns averaged 3 percent for a particular cohort of workers because the market crashes and fails to quickly recover just as these workers retire, the 401(k) would replace only 13.5 percent of their income, leaving them significantly short.  DB plans manage this problem by averaging high and low returns across age groups, but the only strategy available to workers in individual 401(k) accounts is to contribute a much higher percentage of earnings:  10 percent in this scenario, or $250 a month.  
•    It is unclear how the 401(k) contribution burden will be estimated under the governor’s proposal, or exactly how it will be distributed between employers and employees. To the degree that the plan depends on savings by employees to meet the targets, lower wage workers have less disposable income and are at greater risk of falling short of the necessary savings amounts.
•    If the 401(k) portion of the Governor’s proposed hybrid plan functioned to provide supplemental income, with Social Security and the DB pension covering basic expenses, the above risks, costs, and outcomes might be acceptable.  However, the lowest paid public employees in the state—physicians’ assistants, classroom aides, janitors, groundskeepers, etc.—typically can only expect to meet basic living expenses with their target retirement income, just as they have very little discretionary income with which to hedge against poor market performance.  Consequently, a retirement benefit that depends significantly on a 401(k) plan means much greater hardship than for them than it would for a higher paid worker with the same benefit structure.  In some cases, it may mean reliance on public assistance.   


The target earnings replacement ratio of 75 percent (combining Social Security, a DB pension, and a 401(k) plan) is insufficient for lower-wage workers.  

•    To begin, 75 percent is a relatively conservative estimate of income replacement sufficient to maintain pre-retirement standard of living for middle and high income households.  It is important to note that studies that seriously examine the cost of health care arrive at much higher income replacement needs. For instance, the target increases to 92 percent for a middle-income, dual earner household when health care is included, and to 98 percent when both health care and long term care insurance are included.   Since the Governor’s 12 point pension reform proposal includes significant reduction of retiree health benefits, the corresponding increase in health care expenses for future pensioners needs to be taken into account when calculating income replacement targets.     
•    Furthermore, the percentage of earnings required to maintain a household’s pre-retirement standard of living varies significantly depending on income level, with low-wage workers needing higher replacement rates than other workers.  This is because the claims on income that typically decrease or disappear in retirement--income taxes, savings, and work related expenses—take up a smaller share of a typical low-wage worker’s pay.  Thus low-wage workers need a higher percentage of their income replaced during retirement in order to maintain their pre-retirement standard of living.  
•    Studies typically estimate retirement income replacement needs for low wage workers–those in the bottom third of the income distribution—to be between 80 percent and 90 percent depending on marital status.   (Among full time workers in California, someone at the 25th percentile of the wage distribution earns about $25,000 a year.)   Accounting for health care and long term care expenses would push up replacement needs for these workers past 100 percent.  

Depending on how benefits are distributed between the DB and 401(k) plans in coordination with Social Security, the proposal could result in a regressive pension formula for public employees in the state.

The governor essentially proposes that Social Security, DB, and DC benefits will each replace about 25 percent of pre-retirement earnings.  This represents a DB pension benefit formula of roughly .7 percent of final pay per year of service, based on a 35 year career.  First, this represents a dramatic reduction from the current range of DB benefits, which starts at 1.5 percent.  Second, there remain crucial questions about how state sponsored benefits will be coordinated with Social Security; depending on plan design, low-wage workers could end up receiving proportionally less benefit from their employer sponsored pension, including the secure DB pension, than high wage workers.  Third, it is unclear how the proposed new pension formula would be applied to part-time workers.    
•    How will pension benefits be adjusted in relation to the Social Security benefit structure, which replaces a higher share of earnings for low-wage workers than for high-wage workers? 
o    Will the 75 percent replacement rate apply to all workers, regardless of income, or will it be adjusted by income level? Will the DB payout be adjusted in relationship to social security, lowering the DB replacement rate for lower wage workers, or will it be stable across income levels?  If the net income replacement burden (after deducting estimated Social Security benefits) is split evenly between DB and DC plans, low-wage workers would see a dramatically lower DB pension formula relative to their earnings than high-wage workers.
o    How will the proposed new tier of retirement benefits account for potential reductions in Social Security?
•    How will the 35 year career standard for reaching 25 percent income replacement through the DB pension apply to part-time workers? Currently, pension benefits for part-time workers are calculated based on pro-rated pension service credits (.5 service credits for 1 year for a half time worker) and full time equivalent pay.  A policy requiring 35 years’ worth of service credits rather than 35 calendar years to achieve the target income replacement goal from the DB pension would have the effect of severely penalizing part-time workers, making it impossible to earn full pension benefits proportionate to their employment.      

Given these considerations, a fair pension system would take into account the higher income replacement needs of low wage workers, and their limited capacity to absorb the high costs and risks associated with a 401(k) type plan.  The current proposal has the potential to penalize low- and middle-wage workers if it Social Security’s progressive benefits as an offset in tandem with a single income replacement target regardless of wage level. 

Increasing the Retirement Age

Governor Brown proposes to raise the retirement age for new hires across the board to 67, in line with the scheduled increase in the age of eligibility for full Social Security benefits.  Public safety workers are exempted, although their retirement ages also will be raised after consideration of the impact on public safety given the physical demands of specific occupations.  The rationale is that life expectancy, and thus the number of years of pension benefit per retiree, has increased; and raising the age at which workers can receive their maximum DB pension benefit will help decrease pension expenses.   However, when combined with important differences in career timing and life expectancy by income and occupation, the costs of this policy will be borne disproportionately by low-wage workers and blue collar workers who start their working lives earlier and who die younger than professional workers. 

An across-the-board increase in full retirement age to 67 for non-safety workers would force lower-wage workers and workers in manual labor occupations to work longer careers, and live through shorter retirements, relative to their college educated counterparts. 

•    Highly paid white collar professionals start their careers later after spending four or more years in higher education and are able to sustain long careers.  In contrast, people working in physically demanding jobs, which tend not to require higher education, typically enter the paid workforce years earlier.  Janitors, groundskeepers, and hospital orderlies who started working at age 18 or 20 may be many years shy of full retirement benefits under the Governor’s plan when their bodies give out after 40 or even 45 years of work. Furthermore, they may face difficulty transitioning to another, less physically demanding occupation due to skills mismatch.
•    In addition, this proposal would translate to lower retirement benefits for lower-earning, less educated workers who do not live as long and who have benefited least from the historical growth in life expectancy.  The growing gap in life expectancy by education and income in the US is well documented.  For instance, between the generation that retired in the 1960s and the one that retired in the 2000s, life expectancy at age 65 increased by 5.5 years to age 86 for men in the top half of the income spectrum.    Their counterparts in the bottom half of the income spectrum gained one year, to age 81.  Significant variations in life expectancy by socioeconomic status (e.g., income and education combined), controlling for race, have also been documented in California.  

Summary

Lower wage workers could be significantly disadvantaged if the Governor’s proposals for a hybrid pension and increased retirement age for new hires is applied without regard for wage level or occupational characteristics—through a severely downgraded pension benefit that fails to provide meaningful retirement security and a longer working career/shorter period of retirement compared to higher paid workers.     

Senate GOP’s Sudden Interest in Fixing Pensions

November 9, 2011

To: Interested Parties
From: Steve Maviglio, Californians for Retirement Security
Re: Senate GOP’s Sudden Interest in Fixing Pensions

Senate Republicans will march in front of reporters today to pound fists and call for a special session on pensions. But perhaps someone should remind them that lawmakers from both houses and both parties already are holding interim hearings to examine California’s pension system. (Sen. Mimi Walters, perhaps, who is on the committee?)

Or maybe someone should show them the report issued just yesterday by the Legislative Analyst’s Office warning that it would be a huge mistake for California to rush through pension changes. The LAO made it clear: “The Legislature should take a few months to get the details right.”

“…with several thousand public employers and many different pension and retiree health packages offered to public employees, it is very difficult to fashion a workable, fair, sustainable set of legislative provisions that accomplishes the type of changes envisioned by the Governor. We strongly urge the Legislature to take several months to fashion a pension plan in response to the Governor’s proposals.”

So Senate Republicans are clamoring to do exactly the opposite, whisk lawmakers back to Sacramento to throw together a pension package.

these are many of the same folks – half the caucus including Sens. Bob Dutton (now GOP leader) and Sam Blakeslee - who last year tried to block SB 400’s pension rollbacks that have saved hundreds of millions of dollars from the state budget.

Oh and these are the same folks who dug in their heels this summer, flat out refusing to consider a budget deal that would have saved pension costs and extend tax extensions to prevent budget cuts to schools, healthcare, parks and public safety.

We can only think this is a stunt to grab a few of the pension headlines dominating political news in California. Or just another plain bad idea.

 

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Fact Check: Public Employees Already Are Giving at the Office for their Pensions

November 2, 2011

To: Interested Parties

From: Steve Maviglio, Californians for Retirement Security

Re: Fact Check: Public Employees Already Are Giving at the Office for their Pensions

Not a single signature has been affixed to paper and the rich ideologues and ex-Capitol insiders collecting fat pensions of their own who are pushing the latest effort to attack California’s middle class are grossly twisting the facts. Their bogus claim? That anybody who opposes their extreme, probably illegal proposition doesn’t want to do “anything” to repair pensions in California.

Funny thing, the very “unions” and public employees to whom they refer are the only ones who have already actually done something and have concrete results to show for it.

Read more: Fact Check: Public Employees Already Are Giving at the Office for their Pensions

Flawed Report by Marcia Fritz

May 5, 2011

Today’s “Fix Pensions” Report by Marcia Fritz

This morning, the so-called “California Foundation for Fiscal Responsibility” will release a fundamentally flawed report on California pensions. The report is a political document that relies on outdated and skewed data that provides an inaccurate view of retirement benefits for public employees. If you report on this study, please note the following:

Read more: Flawed Report by Marcia Fritz

The Devil is in the Details

April 25, 2011
 
The Devil is in the Details

Although a new Los Angeles Times/USC Poll reports that California voters generally perceive public employee pensions as too generous, it is important to note the wide gulf between the opinions of white and Latino voters.

Latinos, who represent a critical and powerful voice for California’s political landscape and economy, do not believe the level of pension and retirement benefits should be cut for current or future public employees, according to the survey. Nor do they believe the retirement age for public employees should be raised.

Read more: The Devil is in the Details

"Pension Truth Squad" kicks off statewide tour in San Francisco

For Immediate Release: April 14, 2011
 
Public employees and retirees offer facts on the attack on retirement security
 
SAN FRANCISCO – Californians for Health Care and Retirement Security (CHCRS) launched its “Pension Truth Squad” tour today in San Francisco, the first of more than a dozen planned events throughout the state to combat the ongoing assault on the retirement security of public workers.
 
“The people under attack have dedicated years of service to this state and their communities,” said Linda Bryant, a retired California public health scientist who served the state for nearly 40 years and now volunteers to help public school science teachers. “Many of us have worked for less than what we would have earned in the private sector and count on our pensions to provide security for our families.”

Read more: "Pension Truth Squad" kicks off statewide tour in San Francisco

The Sky is Not Falling

April 11, 2011
 
To: Interested Parties
From: Steven Maviglio, Californians for Health Care and Retirement Security
Re: The Sky is Not Falling
 
The Chicken Littles proposing to obliterate retirement security for millions of Californians call it a “crisis.” But as George Skelton points out in the LA Times today, pensions for public employees amount to just four percent of the state budget. “Let's be clear: State employee pensions are not to blame for Sacramento's budget deficit. Not by any math,” Skelton says in the lead of today's column.
 
Even millionaire pension buster Roger Niello, who has introduced a ballot measure to gut pensions of public employees, is quoted in the column making the same point. Here’s what Niello says about the impact on the current budget: "It would not have a significant impact. Frankly, I don't know of anything that can be done [with pensions] that would have a significant impact on this or next year's budget."

Read more: The Sky is Not Falling

Secret Out-of-State Donor Financing Assault on California's Middle Class

Thursday, April 7, 2011

To:        Interested Parties
From:    Steven Maviglio
Re:       Secret Out-of-State Donor Financing Assault on California's Middle Class
 
CaliforniaWatch.Org: Secret out-of-state donor powering pension reform group

An unknown out-of-state foundation has become a substantial backer of an ambitious nonprofit group that is positioning itself at the center of the state's debate over public pensions. Democratic consultant Marcia Fritz, who runs the nonprofit Californians for Fiscal Responsibility, first mentioned at a San Francisco forum last month that the group had received a substantial contribution from an out-of-state foundation. She said the money will be used to research several competing pension plans that are being proposed this year.

Read more: Secret Out-of-State Donor Financing Assault on California's Middle Class

Pot, Meet Kettle

March 21, 2011

To:                   Interested Parties
From:               Steven Maviglio, Californians for Health Care and Retirement Security
Re:                   Pot, Meet Kettle

“We could have made a lot more money in the private sector. We are making more money.” – Michael Genest, former Director, California Department of Finance, Capitol Weekly, 3/17/2011

Critics of public employees have spent a lot of time suggesting that civil servants earn more than private sector employees and receive extra benefits – despite independent studies that show public employees receive 7 percent less – even with benefits. http://www.irle.berkeley.edu/cwed/wp/2010-03.pdf. So it was no surprise that Mike Genest, who, along with his Republican colleagues crafting pension-slashing proposals, are bragging about their lucrative private sector pay while collecting $100,000/year pensions (note: they are among the 2 percent of pension recipients in the state who have pensions of that size). 

Read more: Pot, Meet Kettle

Fact Check: Pension Givebacks

To:        Interested Parties
From:   Steven Maviglio, Californians for Health Care and Retirement Security
Re:       Fact Check: Pension Givebacks

In addition to the $400 million in savings from public employee unions in last year's repeal of SB 400 -- which then-Governor Schwarzenegger praised -- unions have been making significant concessions in local jurisdictions across the state.

Read more: Fact Check: Pension Givebacks

In Sacramento, a need for 'reform' school

March 18, 2011
 
To:       Interested Parties
From:   Steven Maviglio, Californians for Health Care and Retirement Security
Re: In Sacramento, a need for 'reform' school

Ventura County Star's Herdt: In Sacramento, a need for 'reform' school
By Timm Herdt

"Reform" is a perfect word for a politician — it doesn't mean anything specific, and everybody's for it.
The imprecision of that word has made it challenging to try to sort through the rhetoric in Sacramento as a handful of Republican lawmakers and Gov. Jerry Brown have been engaged in clandestine negotiations. These talks may or may not produce an agreement in which a couple of Republicans would sign off on Brown's idea to ask voters to extend temporary tax increases, in exchange for Democrats agreeing to unspecified "reforms."

Details of what "reforms" are being sought have been hard to come by, but the area mentioned most frequently by GOP lawmakers is "pension reform."

It is a curious subject to be raised now because just five months ago the former Republican governor, Arnold Schwarzenegger, was declaring that he had achieved "historic pension reform" as part of last year's budget negotiations.

Read more: In Sacramento, a need for 'reform' school

Roger (Niello) & Me

To:        Interested Parties
From:    Steven Maviglio
Re:        Roger (Niello) & Me

We're shocked, shocked to hear the news that former State Assemblyman Roger Niello is aspiring to higher office, according to a report in the Sacramento Bee this morning.

What else could be the motivation behind Neillo's attempt to inject himself into the discussion about retirement security for state employees?

A simple look at the ballot measure Niello filed last week shows that's written almost as sloppily as the 2005 attempt to gut retirement benefits for police and firefighters that was laughed off the ballot.

Niello’s initiative begins with a catalog of alleged pension shortcomings drawn from a factually slapdash and glaringly unobjective report by the state’s Little Hoover Commission that was roundly criticized by State Treasurer Bill Lockyer and legislators for being unlawful and unworkable.

Read more: Roger (Niello) & Me

Are State Workers Overpaid?

March 9, 2011
 
To:       Interested Parties
From:   Steven Maviglio, Californians for Health Care and Retirement Security
Re:       Are State Workers Overpaid?
 
 
BY LARRY GERSTON, PH.D, Political Science Professor, San Jose State University
For NBC-Bay Area

From coast to coast, state and local government elected officials have targeted civil servant pay as a cornerstone of budget deficits.The thinking goes, there are too many and they make too much. If we just cut their pay and reduce their benefits, we'll be well on the way to balancing budgets.

Taking a budget cleaver to state employees has an intuitive appeal. What do those guys do all day, anyway? But the claims of excessive pay and bloated numbers are just not true.

According to a recent study published by two U.C. Berkeley economics professors, civil servants in California make on average of seven percent less than people with similar jobs in the private sector. Once health and retirement packages are factored in, the study continues, state employees earn about the same pay as their private sector peers.

Read more: Are State Workers Overpaid?