Curbing the incentive for pension padding: correcting the employer contribution mismatch.

• Author: Elghanayan, Jacob N.
• Position: New York

ABSTRACT

An often overlooked issue in the debate over New York's runaway pension costs is the practice of pension "padding" or "spiking," whereby a public employee works overtime during his final years of employment, inflating his total compensation during his peak-earning years and, more significantly, distorting his pension calculation. In the most egregious examples, this practice results in some employees receiving pension benefits that exceed their salary during their final year of employment. While legal--and indeed protected for current employees by the nonimpairment clause of New York State's Constitution--pension padding contributes to unsustainable pension costs and incentivizes structural abuse of the pension system. To date, most reform efforts have focused on limits to employee benefits, but these reforms fail to address the following fundamental mismatch: An employee's benefits are calculated based on his final three years' salary, whereas the employer's costs are calculated based on the employee's total lifetime salary. Whether as part of an implicit or explicit understanding between certain public employers and employees, or simply an overlooked quirk of New York's pension system, employers lack the requisite incentive to reduce overtime while employees have every incentive to work overtime (maximizing their pay) during the years in which their pension benefits are calculated. Stated simply, employers do not bear the costs of their employees' increased benefits. This article proposes an alternative reform that assesses employer contributions to the public retirement system on the same final three years' salary that is used to calculate employee pension benefits, thereby aligning the interests of public employers with those of New York's taxpayers. As an additional advantage, this reform could be immediately applied to all current public employees and survive a challenge under the nonimpairment clause.

1. INTRODUCTION II. DESCRIPTION OF THE MISMATCH A. Overview of the New York System B. The Mismatch. C. Pension Padding in Practice III. ORIGINS OF THE RETIREMENT SYSTEM. IV. ALTERNATIVE REFORM OPTIONS. A. Past New York Reforms B. Greater Home Rule. C. Reforms From Other States V. BENEFITS OF CHANGING THE FORMULA ON THE EMPLOYER Contribution Side A. Reforms That Change the Contribution Method Can Be Implemented For Current Employees. B. How Can This Proposal Be Implemented?. VI. OBSTACLES TO REFORM AND POTENTIAL DRAWBACKS. A. Challenges Posed By Collective Bargaining and the Triborough Amendment. B. Local Governments Would Not Encounter Further Financial Challenges As A Result of My Reform Proposal VI. CONCLUSION FIGURES APPENDIX A: SCHEMATIC OF NEW YORK CITY & RETIREMENT SYSTEMS APPENDIX B: NEW YORK STATE COMMON RETIREMENT FUND- FLOW OF PAYMENTS I. INTRODUCTION

   The share of public employer resources absorbed to support pension benefits has skyrocketed over the past decade, reaching between 20% and 30% of total payroll for most New York public employers. (1) Contributing to taxpayers' frustration are reports of public employees receiving six-figure annual pension benefits, which in some cases exceed the employee's final base pay. (2) Together, these two phenomena have instilled a sense of urgency to fix the New York public retirement system.

   The practice of pension "padding" or "spiking," whereby a public employee is able to inflate his salary in his final years of employment and thus also his pension calculation, has drawn particular scorn. Concern over pension padding led to the passage of a 2010 law that limits the inclusion of overtime in the pension calculation for public employees hired subsequent to the law's enactment.3 More recently, Governor Andrew Cuomo proposed eliminating overtime from the calculation completely. (4) The purpose of the retirement system--"to provide an incentive to an employee to faithfully perform his duties over an extended period"--is being threatened by the response to its abuses. (5)

   The proposed reforms fail to address a fundamental mismatch in the way public pension benefits and employer contributions are calculated in New York. Whereas employees' benefits are calculated based only on their final years of work, employers' contribution rates are assessed against their entire payroll. (6) Employees take advantage of the system by maximizing the portion of their lifetime salary that occurs in their final years of work, when benefits are calculated. (7) Employers have similar incentives to create a back-loaded pay pattern, because employees at every career phase are included in payroll and therefore contribution costs, but only the final years' compensation is used to determine employees' benefits.(8) By shifting a greater portion of the cost of employee compensation from salary to pension benefits, employers are able to transfer part of their true costs to other employers in the system. Thus, not only do public employees benefit from pension padding, employers also benefit by shifting part of the burden of their employees' compensation to the entire retirement system. The mismatch creates an incentive for both employees and employers to pad pensions.

   This mismatch is best illustrated with a numerical example. (9) Imagine a simplified universe with just two employers, each with a total budget of $90 available to pay three employees, who retire after their third year and receive a pension equal to half of their final year's salary. If one employer chooses to pay each employee $30 per year and the second employer instead chooses to pay $20 each of the first two years but $50 in the final year, this second employer will have garnered an additional $10 per year of lifetime pension benefits for its employee, but both employers will still have the same pension contribution costs. An employer that allows pension padding benefits its employees at a cost to the other employers, and ultimately New York's taxpayers.

   Unlike many of the reforms currently being discussed that address the mismatch by changing the formula for employee benefits, (10) the proposal in this article would correct this mismatch by assessing employer contribution rates on the same salary base as is used to calculate employee pension benefits. (11) Each individual public employer would thus be incentivized to prevent work practices that lead to pension padding.

   In addition to aligning incentives, this proposal addresses the legal impediments to installing reforms that address current employees. Whereas changes to the formula for existing employees' benefits are barred by the nonimpairment clause of the New York State Constitution, (12) using the contribution formula to provide incentives for public employers to avoid abusive pension practices would survive a nonimpairment clause challenge. Thus, unlike a change to the benefit formula, this reform could be implemented to effect existing workers.

   Either the legislature or the comptroller could take up this idea independently, but the reform would be on stronger legal footing if the legislature passed a law that explicitly gives the comptroller discretion to implement a new contribution assessment system. However, there are still significant hurdles to successfully implement pension padding reforms. Beyond garnering the political support for change, the greatest obstacle to this type of reform is the Triborough Amendment, which makes changing public sector collective bargaining agreements very difficult. In order to maximize the effect of changing the compensation incentive for government employers, courts or the legislature must recognize limits on Triborough's protection of the status quo.

   Part II begins with a brief overview of the New York retirement system and a more detailed description of the fundamental mismatch, including a numerical illustration. Part III looks back in time to locate the origins of the mismatch. Part IV considers alternative reforms that could address the mismatch, whereas Part V provides reasons why my proposal is superior, including an in- depth analysis of why it would survive a nonimpairment clause challenge. Part VI considers obstacles to reform, most significantly the Triborough Amendment, and Part VII concludes.

2. DESCRIPTION OF THE MISMATCH

   1. Overview of the New York System

      Like all state public retirement systems, the New York system is exempt from the federal scheme of the Employee Retirement Income Security Act and is instead regulated predominantly by state law. (13) States vary considerably in regulating their public retirement systems and protecting worker benefits. (14) As a result, each state handles the contribution to its pension funds differently. The most salient features of the New York system are described below.

      New York technically has eight different retirement systems. (15) For simplicity's sake, this Article will primarily refer to two of the state systems--the Employees' Retirement System ("NYSERS") and the Police and Fire Retirement System ("NYSPFRS") (collectively referred to as the "New York State and Local Retirement System" or "NYSLRS")--because together they are the largest and most uniform. (16) The primary difference between NYSLRS and the other New York systems is that the state comptroller is the sole trustee of NYSLRS, (17) whereas in the other systems the State or New York City comptroller account for just one seat on a board of trustees. (18) However, unless otherwise indicated, all statements made about NYSLRS also apply to the other systems, except that a board of trustees instead performs the trustee's role.

      By law, the New York retirement system must be fully funded according to an actuarial valuation. (19) In order to determine the amount of contributions needed, the trustee must ascertain the present value of the fund's assets and liabilities. (20) This means that the actuary annually determines the total amount of funding necessary to pay all expected benefits...