With apologies in advance for the length of this email (there is no simple or easy way to tackle pension reform), we tackle our pension nightmare.

 

Rhode Island's unfunded pension liability is seven billion dollars, or seven thousand dollars for every man, woman and child living in the state.  This one issue, if left unresolved, has the ability to ravage the state's finances as far into the future as one can see.
 
The pension debate is highly charged and difficult to fully understand.
 
In short, the pension benefits that Rhode Island has promised to our state and municipal workers far exceed the state's and worker's abilities to fund.  Though complicated, the math behind this statement is undeniable, and the empirical evidence of our massive unfunded pension liability speaks for itself.
 
What follows is a short primer on the pension situation, followed by the math to back up my previous statements.
 
Definitions
 
Most state employees and many municipal employees in Rhode Island (including teachers) receive pensions. 
 
A pension differs from a 401K retirement account in several key ways:
 
A pension (in the context of our state and local employees) typically pays a retiree a percentage of that employee's salary.  A 401K makes available a pool of money for retirement that an employee has saved up over a lifetime of work. 
 
There is no limit on the funds expended to pay for a retiree's pension.  A retired worker who collects a pension can live for 50 years post-retirement and collect his or her pension.  On the other hand, once a retired employee's 401K accounts have been drawn down to zero, retirement benefits (outside of social security benefits) end.
 
Retirees who receive either pensions or 401K payouts have contributed money into their respective plans. 
 
The taxpayer is on the hook to make good on a pension plan's promises.  No guarantees back a 401K account.
 
Retirees who depend on pension benefits are shielded from the volatility of the stock market.  Although pension funds need to be invested in the stock market to realize returns on investment high enough to make good on promised benefits (much more on this below), it is the tax payer who incurs the risks of investing pension monies in the market.  If a pension fund is decimated by a poorly performing market (a situation we all face right now), the tax payer must provide additional monies into the pension fund to guarantee that all pensions can be paid in full.  A 401K recipient bears his or her own risk of investing in the market.
 
A COLA is a Cost Of Living Adjustment.  A COLA is used to help minimize the detrimental effect that inflation can have on a retiree's income.  In many instances, COLAs are pegged to the inflation rate.  For many RI pensions, fixed 3% COLAs are in place, without regard to the inflation rate.  The net effect of an annual 3% COLA is a 3% 'raise' to all pension recipients whose pension plans have this fixed COLA.
 
Compound interest is a powerful tool for savings.  Compound interest involves adding accumulated interest back to the principal invested, making the amount of invested principal grow, which earns more interest, etc, etc, etc (definition mostly courtesy of Wikipedia). 
 
The problem
 
Take a mythical worker (let's call him Ken) who is working towards retirement with a state pension.  Ken plans on working for 30 years, and has been contributing 9.25% of his earnings towards his pension account.  Ken's pension is calculated by taking 60% of the average of his salary for his last 3 years of employment.  If Ken's average salary for the last 3 years was $50,000, his annual pension would be $30,000.  Ken began working at age 25 and will retire at age 55.  If he lives to be 80, he will draw a pension for 25 years.
 
It is important to recognize that Ken's salary over 30 years has gone up.  When he started contributing to his pension as a new employee, his salary was $20,000, and grew 3% every year for 30 years, culminating with a $50,000 salary.
 
Over the course of 30 years, $91,000 and change was paid into the pension plan by Ken.  Assuming that the plan was earning a healthy (and currently unrealistic) 7% return, the money paid in by Ken with compound interest becomes $273,000.
 
If Ken draws a flat $30,000 annual pension (no COLA involved), he will have exhausted the money saved in his pension account at year 14 of his retirement.  The taxpayers of the state need to make up the difference to fully fund his retirement.  To fill the gap and extend Ken's pension to age 80, Rhode Island must kick in 3.5% of Ken's salary during every year of his employment (keeping in mind a 7% investment return).  If the investment return drops to 5%, the state must then kick in 11.75% of his salary during every year of his employment.
 
The real kicker to this scenario is the 3% COLA applied to many of the State's pension recipients.  Bearing in mind that the 3% COLA increases the annual pension payout to the pension recipient, and also bearing in mind that this 3% COLA is itself compounded for every year that a pension recipient draws a pension, we have a very different set of numbers.
 
With a 3% annual COLA and a 7% investment return, Ken exhausts his initial payments into his pension fund at year 11, versus year 14 without the COLA.  The state needs to kick in 8.25% to meet Ken's pension needs.  With a 5% investment return, the state must kick in 20.75%.  With numbers like these, is it any wonder that we have an unfunded pension liability?
 
If the State's payments into the pension fund for Ken are not made for several years, the real cost to the state to make up for these payments skyrockets due to the compounding of interest.  In the same way that a $91,000 investment over 30 years turned into $273,000, the same is true for funds not paid in to the system.  Every year where RI does not fully fund the pension plan places us further and further behind, with the rate of falling behind accelerating with every year that passes.
 
Since Rhode Island's economy is stagnant and has been for quite some time, it is irresponsible to assume that we can 'grow' our way out of this problem.  If Rhode Island's economy were expanding and our tax revenues increasing as a result of this growth, a case could be made that given enough time we could cover our pension liabilities.  Sadly, the test of time has shown that our economy is shrinking, making a bad problem all the worse.
 
One factor that makes the pension mess even messier is the practice of juicing a soon-to-be-retiring employee's salary at the end of his or her career.  This practice provides a nice assist to the retiree in terms of the pension that he or she can draw, but really crushes the math behind paying for the retirement.
 
Allowing a worker to retire on a pension after only 20 years of service also severely undermines the pension arithmetic, as does the practice of allowing a worker to buy years of vesting in a state pension.
 
What can be done
 
The COLAs for all state pension plans must be significantly reduced immediately.  This reduction must be applied to current pensioners, workers with 20 years or more under their belts as well as newer hires.  Tying COLAs to inflation is one idea, maybe linked to a year or two with no COLA since inflation has been virtually non-existent for the last few years.
 
No worker should be able to begin drawing on their pension until age 67, just like Social Security.  Lowering the number of years that a pension will be drawn upon will have a radical impact on the pension math.
 
These 2 changes will go a very long way towards solving our pension funding problem.  Governor Carcieri touches on the COLA issue with his current reform proposals, but does not go far enough.  He does incorporate raising the eligibility age into his reforms.
 
Conclusion
 
It is vitally important for protect future generations of Rhode Island tax payers (our children and grandchildren) from our unfunded pension liabilities.  It is equally important to ensure that the state pension system remains financially sound and capable of supporting all retirees who will rely on the fund.  These painful adjustments now should head off even more radical changes down the road.