Taking a closer look at legacy costs and state pensions
It’s no secret that the Detroit Three auto companies are at a considerable industry disadvantage because of their legacy costs. These costs arose mostly from two fringe benefits components: 30-and-out lavish pensions and health care benefits for retirees and their survivors.
GM has been particularly vocal about its legacy cost burden. Its pension costs and other fringe benefits grew to almost 60 percent of total compensation over the past 40 years. By some estimates, GM has legacy costs equal to $60 billion in retiree health benefits and another $87 billion in pension obligations, equivalent to about $2,000 per auto sold.
As legacy costs grew over the past four decades, profit margins steadily fell. GM’s financial problems — a minor bump in the good old days of high sales and high profit margins — were a fast track into Chapter 11 bankruptcy.
Without the federal government’s rescue, GM likely would be history by now. Instead, more than $50 billion in financial assistance saved the company. Also saved were retiree health benefits. The UAW agreed to GM’s 2007 request to transfer retiree health care obligations to a VEBA trust (Voluntary Employee Beneficiary Association) by 2010. The bailout allowed GM to fund the VEBA by transferring a 17.5 percent ownership stake into it.
For the entire U.S., the portion of workers covered by pension plans declined from 80 percent in 1985 to about 21 percent by 2006. Why? An important reason is to limit or avoid legacy costs. Today, most pension plans are found in unionized companies. The same is true for retiree health benefits.
There can be no denying that most of us have learned important lessons during the past two years of economic turmoil. Perhaps the most important one is that financial excesses cannot be sustained, and that they will eventually bankrupt many businesses and individuals. Further, one need only look at General Motors’ experiences to see the dangers of large legacy costs. In fact, one of the easiest ways to endanger the financial health of organizations is to insist it pay both pensions and retiree health care plans for retirees.
The advent of defined contribution plans such as 401(k), 403(b) and 457 plans, gives employers an attractive alternative to pensions. The decline in pension plans over the past 20 years almost exactly matches the increase in defined contribution plans. From an employer’s perspective, defined contribution plans offer several advantages. Perhaps the most important is the shifting of investment risk from the employer to the employees. If employees don’t contribute enough money to their plans, or don’t diversify their investments sufficiently, or the stock and bond markets gyrate, the risk is on the plan participant, not the employer.
Unfortunately for Michigan taxpayers, we face another financial tsunami — unfunded pension promises made to state employees. The state of Michigan’s two largest employee pension funds —the Michigan State Employees’ Retirement System and the Michigan Public Schools Employees’ Retirement System — are seriously underfunded. The shortfall will disappear if the stock market keeps rocketing upward in an extended bull market, but that outcome is probably just a dream.
Both state pension trusts assume an annual rate of return on invested trust assets of 8 percent per year. Given the actual experience of the past decade, that value seems high. It is certainly at the high end of the range most financial planners consider prudent when they analyze whether a client can retire. If the state’s large pension funds earn just 1 percent less than the assumed 8 percent rate, the level of underfunding will increase nearly 17 percent.
Michigan doesn’t have the money to fund these two retirement trusts. In addition, if the financial markets don’t average at least an 8 percent return over the next several years, the amount of underfunding will be even larger. Instead of wishing for miraculous stock market returns, Michigan citizens face two choices: Either allocate a higher portion of state income tax revenues to its pension trusts, or cut pension benefits.
Allocating a higher portion of income tax revenue to pensions will short-change the other important areas of state spending such as K-12 public education, higher education, the prison system and Medicaid. Campaigning for cuts in any of these areas, or increasing the income tax rate to make up for pension shortfalls, may be political suicide. The reality is that changes to these pension rules, and not new taxes or reduced funding of other areas of state spending, are necessary.
Michigan would be in even worse shape except for an important change made in 1997: New state employees hired on or after March 31, 1997, cannot participate in the MSERS pension plan. Instead, they participate in the state’s defined contribution plan. Except for that change, it’s likely the MSERS pension fund would be in even worse financial shape. It’s interesting to note that all public school employees are members of the MPSERS, and none participate in a defined contribution plan.
So what’s the solution? Unlike with the Detroit auto companies, the federal government won’t bail out Michigan’s public pension funds. There is no federal program to bail out state pension funds. Consequently, Michigan taxpayers must fix the problem themselves.
It’s time for the state to bite the bullet by closing the MPSERS to new employees, and instead, beginning a defined contribution plan. That won’t generate immediate benefits, but it will prevent unfunded pension liabilities from becoming even greater. It also will bring public school employees into the same world as employees of profit-seeking companies, where a pension is mostly a lavish fringe benefit from bygone days.
Another possible change is to raise the minimum retirement age. The current 30-and-out practice is lavish when compared with most private industry workers. Yes, it’s the same benefit as UAW members have, but it’s also what contributed to the near death off GM and Chrysler. Faced with the same sort of state pension shortfall as Michigan, Illinois recently took drastic action. It increased the minimum retirement age for full benefits to 67 from 55, and capped the size of annual pensions for the highest paid workers. Those changes apply only to new employees, but at least it’s a start to balancing the state’s budget.
It’s time for the state legislature to get serious about fixing the chronic underfunding of state employee retirement trusts. State employees will fight any changes reducing their benefits. That’s human nature. But employees of most private sector companies either never had retirement benefits comparable to state employees, or gave them up years ago for defined contribution plans.
Let’s prevent legacy costs from doing to Michigan what they did to Chrysler and GM.
Gregg Dimkoff is professor of finance and director of the certificate program in financial planning at Seidman College of Business, Grand Valley State University.