By Tom Ferrick

(Part 5 of 5)

The city’s pension fund keeps eating up more and more of the city budget - and it is no surprise why. The city’s system is a defined benefit plan. Pensions are determined by a formula that takes into account years of service, final salary and a multiplier. The multiplier varies depending on the class of employee, but it usually equals 2.5 percent a year for the first 25 years of service.

To simplify, a 25-year employee who makes $60,000 a year can retire with a pension equal to 62.5 percent of his final salary.

What’s missing from this formula?

It has no relationship to the cost of providing the benefits.

Ideally, the city’s contributions to the fund, plus the money made by investing payments in the pension fund are supposed to cover the cost of paying pensions.

In Philadelphia it does not. The immediate problem is that the pension fund investments have tanked with the drop in stock values. For another, the city has never quite put in enough money to meet costs in the future.

As a result, pension costs are rising and now total $437 million a year.

As I said, what’s missing here is any connection between benefit level and costs. If the fund needs money, there is only one way to get it - from the taxpayers. The problem with pensions is that they are a long-term debt. Any changes you make in the plan (such as lowering the multiplier) will not result in immediate savings.

One reform people have recommended is to switch to a defined-contribution plan - much like a 401K - where the city matches an employees contribution up to a limit, usually 5 or 6 percent. Switching to this system would save money in the long run because it would cap the city’s obligation to its employees to the amount of money it contributed each year. But, it actually would cost more in the short run because the city would have to contribute to the pension fund, plus contribute to the employee’s new 401K-like retirement account.

There’s no easy way out, but there are two steps the city could take - if it wins the right at the bargaining table this year.

It could increase the amount employees must contribute from their own salary to the pension fund. Right now, it ranges from 1.85 percent for non-uniformed city employees to 5 percent for fire fighters and police officers. This is several points lower than other big cities - where contributions can range from 7 percent to 9 percent, according to a recent Pew study.

Increasing the employee contribution level to 6% for all employees would raise about $38 million a year, according to my calculations.

Potential savings over 5 years: $190 million.

Another, more radical step, would be to tie the amount of a pension to the city’s ability to pay.
In years when the city meets it investment goals, the multiplier would remain 2.5 percent. In the years it does not, it would drop to 1.5 percent. In years when it loses money, it would drop to 1 percent.

Using the example above, suppose our $60,000-a-year city employee decides to retire after 25 years. Suppose for 18 of those years, the city met its investment goals, for 6 it fell short, in one year it lost money. Under this formula, his pension would equal 55 percent of his final pay, instead of 62.5 percent - a 12percent reduction in pension payments that would generate savings to the fund over time.

You may say: That’s unfair to ask employee to assume the risk when they have no control over the investments. But, the employees did have reps on the pension board and do have a measure of control over where the money is invested.

Besides, the alternative is to have taxpayers assume all of the risk. And the latest 5-year plan calls for the city to make an additional $395 million in pension payments, partly because the fund’s investments have tanked in the stock market collapse.

In a defined contribution plan - the most common in private business - the employee assumes all of the risk. And, as anyone who had a 401k invested in stocks can tell you, it sometimes results in major losses.
By the way, this indexing is not a new idea. At the Philadelphia Housing Authority, Carl Greene, the agency’s executive director, got his unionized employees to agree to a plan that linked their final pension to the PHA pension fund’s success at investments.

Greene’s plan did not change the multiplier. He linked it to the average final salary that is used to determine pension. PHA is a separate operation from the city but it does have District Council 33 and District Council 47 members, so there is a precedent.

Savings from these steps: Unknown, but potentially significant over time.
You can read the entire series here