Catherine Fisk is an OnLabor Senior Contributor. Brian Olney is an Associate Attorney at Hadsell Stormer & Renick.
Advocates of weakening public sector unions, both some who have filed briefs in the Friedrichs case and others who support anti-union legislation in Wisconsin and other states, assert that public sector unions contribute to state budget deficits and that public employee pensions are a main culprit. The truth is more complicated. Unionization doesn’t cause either budget deficits or unfunded pension liabilities. Bad governance does. Some unions may contribute to bad governance but they are not the sole cause, and unions can help solve the problem.
Although labor costs consume a relatively larger share of revenues in the public sector than in the private sector, studies show this is because government tends to provide more labor-intensive services, and also services that require a higher level of education and training (e.g., teachers and public health workers). Collective bargaining, in the states that allow it, is only one aspect of a complex web of law that, in every state, regulates compensation and working conditions for public employees. A bewildering array of state and local constitutional or charter provisions, statutes, and administrative rules specify pay, benefits, and pensions for government workers by job category. Elimination of collective bargaining will not eliminate the budget or pension funding deficits that exist. But it may eliminate the last defined benefit pension plans, which would be bad for workers and bad for the economy as a whole.
Government employees are more likely than private sector employees to have defined benefit retirement plans, as compared to a defined contribution retirement plan (or no retirement plan at all). A defined benefit plan is a pension plan that promises a specified monthly benefit at retirement, such as $100 per month or X percent of the employee’s average preretirement salary. In contrast, a defined contribution plan lets employers or employees or both invest specified sums annually on participants’ behalf and offers a benefit based on the total contributions plus (or minus) earnings (or losses) but does not guarantee any specified benefit. Examples include 401(k) plans, 403(b) plans, employee stock ownership plans, and profit-sharing plans. A defined benefit plan places the risk of investment loss, or the risk that an employee will outlive expectations, on the employer. In contrast, a defined contribution plan places the risk of investment loss or longevity on the employee. Although defined benefit plans used to be the norm in the private sector because unions bargained to place risk on the employer, over the last three decades many private sector employers have converted their defined benefit plan to a defined contribution plan, shifting risk to employees.
Because a defined benefit plan typically promises benefits for the life of the plan participants, sound actuarial practice requires plan sponsors to contribute enough to cover promised future liabilities; many experts recommend that the plan be funded at least at 80 percent of its future liabilities. Some governments have underfunded their pension plans, effectively pushing onto future government officials the task of raising revenue to fund the pension promises of the past. The problem of underfunding of pension plans varies from state to state. The funded ratio for state and local pension plans was 75 percent at the depth of the Recession in 2011. This was only slightly below the 80-percent level recommended by many experts as sufficient for public plans. Some state plans are significantly underfunded, but those include both states with collective bargaining rights, like Illinois, and states without, like West Virginia.
Estimates of total state and local pension liabilities vary because they employ different discount rates, which carry different assumptions about the pension funds’ likely investment returns. Lower estimates of unfunded pension liabilities assume pension funds will continue to earn the same return they have historically earned, about 8 percent. Larger estimates assume that in the future pension fund investments will only grow at the “risk-free rate” of the safest investments like Treasury bonds, around 4 percent. Some have criticized the use of the risk-free rate as actuarially mistaken and bad policy.
Pension shortfalls do not pose an immediate crisis for states under budgetary pressures for the same reason a homeowner need not pay the entire balance of her mortgage together with the month’s bills. Current accounting rules allow states to specify an extended period (typically thirty years) to pay off or “amortize” liabilities. Some studies have estimated that state and local governments can fully fund their pension plans by increasing their annual contributions over the next thirty years. Alternatively or in addition, states can address shortfalls through modest changes to employee contributions or benefits, as most states have already done.
When discussing the connection between government employee unions and unfunded pension liabilities it is important to remember that all states have public retirement plans, and studies (here and here) show no correlation between collective bargaining rights and either the financial health of the plans or the size of the state’s annual contributions to fund the plan. One of the best-funded state pension plans in the country in 2012 was Wisconsin, which was funded at 100 percent. It is also important to note that public pension eligibility and benefit rules are generally established by statute rather than solely by collective bargaining agreement and that funding levels are (or could be) regulated by statute and not by collective bargaining.
Defined benefit pension plans are the most efficient method of financing retirement. Participants benefit from professional management and superior investment returns, better management of longevity risk, and the ability to maintain a balanced portfolio throughout an individual’s lifetime. One study found these advantages enabled defined benefit plans to deliver retirement income at 48 percent lower cost than defined contribution plans.
There is no evidence that unions prevent solutions to the problem of unfunded pension liability. On the contrary, a number of unions have advocated sensible reforms both in funding and in eligibility and benefit formulas. Several years ago, the American Federation of Teachers (AFT) recommended funding reforms, including that public employers should pay their annual required contribution every year, that future changes to benefits should be reviewed for their impact on the plan’s long-term financial health, that pensions should establish a reserve fund to assist in offsetting market volatility, that maximum benefits should be capped, and that prohibitions on increasing compensation at the end of a worker’s career in order to inflate benefits (a practice known as “spiking”) and on collecting a pension while employed in another job (a practice known as “double-dipping”). Moreover, because vesting rules in many jurisdictions prohibit unilateral reduction of vested benefits, agreement to reduce vested benefits is necessary and unions may facilitate such agreement, whereas individual negotiations with individual pensioners may be more time-consuming and difficult.
Defined benefit plans offer annuities on a fair basis over the life of the retiree. The country benefits from a retirement income system in which every retiree is guaranteed some income for the entirety of his or her life. While unionized workplaces are far more likely than nonunion workplaces to have defined retirement benefit plans, that’s a good thing. And unions can help those states that have underfunded their public employee pensions to fix the system.