Research & Commentary: Reducing COLAs to Bring Pension Costs Down
In this Research & Commentary, Matthew Glans examines state pension reform and the effects of changing cost of living adjustments.
Many states are providing to state workers automatic cost of living adjustments (COLAs), raising governments’ costs and forcing taxpayers to pay more for the same services. COLAs aren’t only applied to current workers earning government wages. For many pension plans, the benefits received are increased periodically to reflect inflation and the increased cost of living. While COLAs are common in the public sector workplace, in the private market, they are not automatic and only given when funds are available.
COLAs create problems for some states because in many pension systems, they are implemented automatically, regardless of the government’s ability to pay for them. As the number of retirees grows, a funding gap increases over time.
The rapidly increasing cost of state pensions and the market decline that occurred in the wake of the 2009-10 housing crash caused numerous states to reduce or eliminate their COLAs for many of their employees. Between 2009 and 2015, 29 states reduced COLAs. Seven of those states reduced COLAs for current employees and new hires. Sixteen states reduced COLAs only for current employees. Just five states reduced COLAs for new hires only.
Many of the states changing their COLA rules had a fixed guarantee of 2.5–3.5 percent compounded annually. This guarantee created a cost of living adjustment for workers and/or retirees regardless of what was happening to inflation, spurring unsustainable growth of state workers’ retirement benefits and making it nearly impossible for states to maintain a stable pension over the long term.
Lowering COLA can have a dramatic effect on pension liabilities, according to the Mercatus Center; a 1-percentage-point reduction in annual COLAs would reduce a plan’s accrued liability by approximately 10 percent.
There are several options states can pursue to help manage their COLAs. First, states can eliminate COLAs for all or a portion of retirees. New Jersey, Oklahoma, and Rhode Island have taken this route. New Jersey and Rhode Island suspended their COLAs in their pension plans until the plans are 80 percent funded. New Jersey would then require a committee to reactive COLAs, while Rhode Island would tie the COLA to investment performance in the future. Oklahoma took a different path. It required its COLAs to be prefunded at the time of enactment, making implementing a COLA policy difficult.
The second option for states is linking COLA increases to the Consumer Price Index (CPI). Several states have done this, and a smaller number have done so while also implementing a cap. When inflation is low, this method has a minimal effect on pension holders, but it also does little to help the basic pension funding problem. This method is also problematic because CPI is a flawed mechanism in its own right; it only measures the cost of private goods and services, not public goods, and it also lags behind real-world consumer trends.
Richard Ebeling argues CPI has an even more fundamental flaw: “[A]ny price index, whether the CPI or the PCE, are statistical constructions created by economists and statisticians that have very little to do with the actions and decisions of consumers and producers in the everyday affairs of market demand and supply.” If a state cannot move away from a CPI-linked COLA, it should either cap the COLA or keep it as low as possible.
Eliminating or reducing COLAs are a viable option for bringing down pension costs for states, because it is one of the few pension reforms that have consistently passed legal muster. According to the Center for Retirement Research (CRR), of the 17 states that have reduced COLAs, 12 have been challenged in court, and in the nine cases the courts have ruled on, only one cut was struck down. CRR says that for many courts, COLAs are not considered to be a contractual right and can be reduced by the state.
Taxpayers cannot afford for states to continue overpromising and underfunding their pension plans. States should consider reducing COLAs or ending automatic COLAs outright.
The following articles examine state pension reform from multiple perspectives.
COLAs on a Diet
This Economist article examines the growing trend in the states toward reducing cost of living advances in their state retirement systems.
COLA Cuts in State/Local Pensions
This brief from the Center for Retirement Research at Boston College (CRR) provides an overview of the COLA changes in the states, discusses the impact of eliminating COLAs on benefits, and explores the extent to which the courts view COLAs differently from ‘core’ benefits.
The Path to Public Pension Reform
Eileen Norcross and Olivia Gonzalez discuss pension reform and what components a good reform plan should possess. “True reform must address the inherent problems of public-sector accounting and management of pension funds and consider the benefits of defined contribution plans for public-sector workers. Reforms should be equitable for all generations, fund retirement benefits adequately, and have a plan for funding legacy obligations,” wrote Norcross and Gonzalez.
Not So Modest: Pension Benefits for Full-Career State Government Employees
Examining the benefits paid to state and local government employees, Andrew Biggs of the American Enterprise Institute argues drastic benefit reductions for current retirees would be unfair, but reforms to make public and private sector pensions more equitable should be on the table.
The State Public Pension Crisis: A 50-State Report Card
This Heartland Institute report examines problems facing public pension systems, including the enormous burdens public employee pensions pose in some locations. The report ranks each state according to the operation and relative disposition of the pension plans and suggests ways states might go about solving pension problems.
Stopping the Sinkhole
The Commonwealth Foundation argues evidence from the private sector and some reformed public sector pension programs shows pension reform is possible and creates significant savings to firms in the private sector and taxpayers in the public sector. Private firms, while enjoying more flexibility than public pension programs in implementing reforms, still face many of the same challenges as public sector actors. “Therefore, as Pennsylvania considers reform, it is useful to examine the pension reform trend for insights about possible costs of reform and understand the ‘best practices’ of pension reform,” the report states.
The Limits of Retrenchment: The Politics of Pension Reform
Daniel DiSalvo of the Manhattan Institute examines pension reform and argues states that are serious about keeping pension costs under control are increasingly introducing defined-contribution options or hybrid plans. As more states take this step, it will become less controversial and easier for other states.
Keeping the Promise: State Solutions for Government Pension Reform
This report from the American Legislative Exchange Council describes the variety of pension plans governments use today and the advantages and disadvantages of each plan. It also provides several tools legislators can use to ensure governments can affordably fund retirement benefits for their employees.
The Real Cost of Public Pensions
Jason Richwine discusses how to calculate the cost of public defined-benefit pension plans, compares the cost of these benefits to private-sector retirement plans, and refutes two of the most common arguments that attempt to prove public pension benefits are modest.
The Gathering Pension Storm: How Government Pension Plans Are Breaking the Bank and Strategies for Reform
The Reason Foundation discusses the looming crisis created by states’ continued use of defined-benefit pension plans, offering solutions and explaining why the current system is a disaster in the making.
Nothing in this Research & Commentary is intended to influence the passage of legislation, and it does not necessarily represent the views of The Heartland Institute. For further information on this and other topics, visit the Budget & Tax News website at https://www.heartland.org/publications-resources/newsletters/budget-tax-news, and The Heartland Institute’s website at http://www.heartland.org.
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