The voices of Urban Institute's researchers and staff
March 28, 2011

The Real Problem with Local Pensions

March 28, 2011

Late last week, Los Angeles mayor Antonio Villaraigosa and union leaders agreed to nearly double the amount city workers must contribute to their retirement plans. Forcing workers to contribute more toward their pensions lets the city pay less. This change, along with other cost reductions, would cut spending by more than $400 million, according to city officials.

Like cities across the country, LA is struggling to close a gaping budget deficit. Even though pension contributions amounted to only 3 percent of state and local government spending in 2008, many cities (and states) are looking to save money by trimming employee retirement plans or requiring workers to pay more of the costs themselves.

Reforms like the one hammered out in LA will indeed cut city retirement costs, but they don’t address a much larger problem with government pensions. The traditional defined-benefit pension plans paid to public-sector workers create strong incentives to retire early. That might not seem like a problem today, with unemployment at 8.9 percent nationally and 12.2 percent in California. But as the economy recovers, baby boomers retire, and the size of the working-age population flat-lines, talented workers will become relatively scarce. Today, a third of all state and local government workers are between 50 and 64 years old, up from just a fifth in 1990. As these workers are pushed into retirement by pension plans that penalize work at older ages, local governments stand to lose valuable skills and experience, and it will become increasingly difficult to replace retirees.

To understand how government pensions push people into early retirement, consider a woman who begins working for the LA city government at age 25. In return for her hard work each year, she receives future retirement benefits along with her current salary and health benefits.

Once she retires, she’ll receive a pension each month until she dies that’s equal to 2.16 percent of her final salary multiplied by her number of years on the job. So after 10 years of service, her pension would replace about a fifth of her salary, and after 20 years it would replace more than two-fifths. If she stays for 30 years, she can begin drawing her pension at age 55 (instead of having to wait until 60), and she would receive nearly two-thirds of her age-55 salary. These additional benefits significantly increase her compensation each year. The increment to future pension benefits equals a third of her salary in her forties and actually exceeds her salary at age 55.

But this pattern reverses after age 55.  Every month she delays retirement, she’s passing up a month of pension benefits she could have collected. Her future monthly benefits will keep increasing, but not enough to offset the benefit payments she’s giving up by working longer. By her early sixties, this loss in lifetime pension benefits adds up to a fifth of her salary every year.

Faced with such sharp cuts in total compensation, it’s no surprise that many public workers choose to retire in their fifties and early sixties, depriving taxpayers of their skills and experience.

By raising employee pension contributions, Mayor Villaraigosa doesn’t address this problem at all. In fact, the deal he negotiated with the union makes it worse. If LA and other cities want to encourage valued workers to stay on the job longer, they’ll need to switch to a pension design that doesn’t rob workers of pension benefits when they work beyond the plan’s earliest retirement age.

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