O'Malley's pension plan makes sense. Does that mean it's doomed?
Originally Published in the Washington Post
Public pensions have been dominating the headlines, with the protests in Wisconsin and Ohio capturing attention across the country. Indiana Democrats took a cue from their counterparts in Wisconsin and fled the state to forestall votes on a bill targeting collective bargaining. Illinois has made news with its desperate attempt to meet its pension obligations with additional borrowing, a move many actuaries and investors view as unsettling. But let's not forget that public pension reform is on the table in Maryland as well.
After all, while various numbers have been thrown around for Wisconsin's budget deficit (the latest, I think, is $3.6 billion), that's over two years. Maryland, meanwhile, faces an almost comparable $1.5 billion deficit over a single year. The bigger difference between the two states is in pension funding. While Wisconsin's main pension system is nearly fully funded, none of Maryland's systems is more than two-thirds funded. Several years of ballooning state contributions have finally forced pension reform onto the legislative agenda.
During the gubernatorial race, Gov. Martin O'Malley (D) offered few specifics about pension reform other than to say he had appointed a commission to study it. This was a calculated political decision to avoid serious discussion about the issue before the election; honest talk about pension reform was unlikely to win him many supporters. But the time for equivocation is over, and surprisingly, the commission and the governor have stepped up with a reasonable plan.
I say surprisingly because the proposal does more than tinker around the edges. Faced with unsustainable payments, the governor has taken to heart the commission's recommendation to adjust benefits for current workers. Benefits that have already been accrued will be untouched, but the plan would offer employees a choice: Keep the current benefit level and pay a increased contribution (7 percent of salary, up from 5 percent) to help fund it, or continue to pay the current contribution and accept a slightly lower benefit.
New employees will be required to contribute 7 percent of their salaries and will be given the lower benefit level. Other changes include increasing the vesting period (from five years to 10), increasing the early retirement age (from 55 to 60), and linking cost-of-living adjustments to inflation and pension fund performance for future retirees.
The state's huge unfunded pension liability cannot be addressed effectively without changes for current employees. But the changes being proposed are hardly draconian or unfair. Employees in the private sector are facing similar challenges: Many employers have discontinued matching 401(k) contributions, and very few private-sector employees have a guarantee of future benefit levels.
Opponents of reform argue that it's unfair that benefit enhancements enacted in 2006 are on the chopping block even before being fully phased in, and that those enhancements were necessary because Maryland's benefits ranked poorly when compared to other states. But both these points are misleading. Ordinarily, benefit enhancements are only applied to service going forward, for good reason: Retroactive increases add to a system's liabilities without delivering any associated contributions. But Maryland's 2006 enhancements extended benefits back to 1998, meaning neither the government nor the employees have made contributions to cover the higher benefits. This change added significantly to the system's unfunded liabilities.
As for the point that Maryland's benefits ranked poorly compared to other states, it's critical to note that the governor's proposal would still offer benefits significantly above prior levels. Indeed, benefits for current employees need not change at all, as long as they are willing to contribute slightly more. Furthermore, a more relevant comparison is between this proposed reform and reforms currently being undertaken by other states, not what those states offered before the Great Recession.
Unlike some of those advocating reform, I don't view a switch to a defined-contribution system as a panacea. That strategy is plagued by the same sort of transition costs that affect proposals for privatization of Social Security. It would also face serious legal and political hurdles, delaying reform when time is of the essence. But defined contribution does have a place; the General Assembly would do well to permit new employees to choose a defined-contribution system when they start work. Given that vesting periods are increasing, a portable defined-contribution system could well have a more immediate positive effect on recruitment than future promises of payments from a struggling pension system.
On the whole, however, the governor's pension proposal is reasonable. I only hope that this is not its fatal flaw. For liberals and union members, it goes too far. For conservatives and libertarians, it does not go far enough. In politics, as in other realms, a good compromise leaves no one satisfied.