Public employee pension spiking is expensive flaw that needs fixing

There is a serious flaw in the design of the public employee pension system. Currently the system allows a retiring employee’s pension benefit to "spike" if the employee received much higher than normal compensation during short periods of employment tenure. If pension spiking is not fixed, it will worsen the unfunded liability of the state Employees’ Retirement System (ERS) and further jeopardize its financial stability.

ERS pension benefits are calculated based on an employee’s highest three years of compensation. Employees who significantly increase their compensation in their final years of employment by working an abnormal amount of overtime can significantly boost or "spike" their pension benefit. This results in a funding problem for the ERS since the employee’s final pension benefit was not funded with contributions calculated to adequately fund the spiked pension. Because there is no provision to ensure that the spiked pension is properly funded upon the employee’s retirement, the unfunded liability of the ERS worsens.

ERS pensions are funded by employee and employer contributions over the entire working career of the employees and the investment earnings from those contributions. The actuarial methods used to determine the amount of the annual required employee and employer contributions do not take into account sudden late-career boosts in employee compensation that spike the pension benefit.

This design flaw has been a material factor in the rise of the unfunded pension liability of the ERS which stood at $7.1 billion as of 2010.

The problem can be understood from the following example based upon an actual case. An employee works for 30 years and retires at age 55. The employee’s base salary steadily rises during the first 27 years of employment and reaches approximately $50,000. But in the final three years of service, the employee’s compensation spikes to an average of $200,000 per year because of overtime pay. Based upon the current pension benefit formula, that employee becomes entitled to receive an annual pension benefit of $120,000 for life. That amount is 355 percent more than the normal pension without spiking.

In this example the ERS would have normally accumulated at least $450,000 in assets to finance the employee’s pension for retirement at age 55 based upon an average final compensation of $50,000. However, because of the substantial increase in compensation in the final three years of employment, the ERS needed to have accumulated approximately $1.6 million in assets to cover the lifetime benefit for that employee. That funding deficit causes the ERS unfunded pension liability to increase over $1.1 million based upon a single case.

The consequence is future employer contributions must increase to make up the shortfall (employee contributions are fixed by law). This adds to the funding burden of the public employer (state and counties) and leaves less money available for other purposes including pay raises for active employees.

But it is not only the public employers who suffer the financial burden.

Earlier this year, to manage the alarmingly high level of the ERS unfunded liability, the Legislature passed a number of pension plan design changes to address the deficit. Among those changes was increasing the employee contribution rate for employees hired by the public employers from July 1, 2012. In effect, future employees along with taxpayers will have to share the burden of paying for the funding shortfalls caused by factors like pension spiking.

Pension spiking is a design flaw that needs to be fixed. The financial integrity of the ERS along with fairness to other public employees who do not have spiked pensions require that action be taken sooner rather than later to correct the problem.

Wesley Machida is the administrator of the Employees’ Retirement System of the state of Hawaii. He was appointed to the position in July 2010.