This week unions received two powerful messages about the security of their pension plans. Illinois approved pension reforms that are less generous to state workers. In Detroit, a bankruptcy judge allowed the city’s case to proceed and ruled that the city workers’ pensions are not safe as the case moves forward. These two developments should send an ever stronger message to unions that to trust in the promise of pensions is folly. Only 401(k)-style plans where the money is all in personal accounts or, at a minimum, in union-controlled trust funds are safe.
The Illinois State Constitution specifically protects public worker pensions, stating that they may not be cut once promised. Yet, the Illinois State Legislature passed a pension reform law which will lower the inflation adjustments for retirees, make new retirees wait five years to get their first cost of living increase, and raise the retirement age for younger workers by five years. In hopes of having this plan declared legal by the courts, the legislators included in the plan that the contribution of workers towards their pensions will be lowered by 1 percent of their salaries and the state will be required to fully fund pensions going forward.
Regardless of whether this pension reform effort succeeds or not, Illinois is considered the most financially troubled state in the country and its pension fund is underfunded by at least $100 billion. Unions have continued to fight to defend their rights to their promised pensions even though it is clear to everyone else that the money to meet the promises does not exist. The proof of this is that the just-passed pension reform was led by a Democratic governor and Democratic speaker of the state house.
In Detroit, Judge Steven Rhodes ruled on Tuesday that the city’s bankruptcy case can proceed and that the city workers’ pensions are not untouchable during the bankruptcy. The ruling was based on the fact that federal bankruptcy law trumps the Michigan State Constitution clause that protects the pensions from being reduced. This is the first such ruling in the nation, but is unlikely to be the last.
Unions need to learn two important lessons. First, most pension funds are severely underfunded. State, municipal, and private sector, employers find it easier to make promises that keep workers happy than to actually follow through on those promises and pay enough money into their pension funds. Second, after five years of recession and weak recovery the taxpayers who support state and local government pensions are not interested in paying higher taxes in order to reward public sector retirees with pensions that are generally much more generous than anything those same taxpayers receive. Customers of private sector businesses are not looking to pay higher prices to fund pensions either.
The two lessons above should lead unions to an obvious conclusion. Unions and their members should stop relying on their employers to fund pensions simply because of some old infatuation with the supposed risk-free nature of a defined payment retirement plan. A pension that promises retirement benefits according to a set formula is not risk-free when the employer can simply fail to live up to its side of the bargain. Unions have traded market return risk for employer non-payment risk and that trade is looking worse every day.
In order to protect themselves, unions should switch to defined contribution plans. In this form of retirement benefit, commonly known as 401(k) plans in the private sector, employees pay in a set percent of their salary which is augmented by employer contributions. These funds are generally kept in individual accounts and strongly protected by law so that the employer cannot underfund them or steal the money once it is in the accounts.
Yes, the workers then accept the risk that the monies in their accounts may not grow to their satisfaction and they may end up with too little money at retirement to withdraw as much money as the pensions they are currently promised. However, workers avoid the chance of getting only a minimal pension because of underfunding or bankruptcy.
As an alternative, if unions refuse to give up their attachment to fixed pensions, then they should at least remove the risk of employers failing to fund those promises. Unions should negotiate contracts under which the employers pay the pension contributions to the union, thus ensuring that the payments are made. Unions can then invest the funds for their members and pay out the promised pensions as their members retire.
Several unions, most famously the United Auto Workers, have taken similar action with regard to retiree health benefits. In such arrangements, unions are given money as their members work and invest those funds. The proceeds are then used to pay for health insurance for those members after they retire. Clearly, unions can undertake such obligations. Assumedly, workers would rather trust their own union than their employer.
The recent legislative action by Illinois in reforming their state worker pension system to make it less generous combined with this week’s court ruling that the pensions of Detroit’s city workers are not protected during its bankruptcy proceedings should be signaling loudly to union workers around the country. While pensions may sound risk-free, they are not proving to be very reliable.
It is disappointing that so many cities, states, and companies have so casually made promises to their workers that they put little effort into keeping. In a perfect world, people would keep their promises and our laws would make it harder for employers to break the promises they make to workers. In the real world, workers would be much safer with retirement plans in which they control the money, either directly or through a union. The risk of low market returns appears to be much lower than the risk of nonpayment due to employers failing to live up to their end of the bargain. In theory, pensions sound safe, but, in practice, workers cannot afford the risk.
