Incremental Changes Can Yield Big Savings over Time By Laurie Van Pelt
As governments across the country attempt to eliminate deficits and balance their budgets, the results are often drastic cuts to citizen services, employee lay-offs, and steep reductions in salaries and benefits for the remaining employees. The recent economic environment and the still-depressed real estate market are the primary reasons for the immediate financial woes that face most governments today; however, there could be more financial woes on the horizon, perhaps as a result of unfunded pension and other postemployment benefit (OPEB) obligations. When governments can no longer avoid funding those obligations, they are likely to engage in another cycle of slashing costs wherever possible with the difference being that this potential funding crisis has been foreseen and might be avoidable. Eliminating the golden handcuffs for future employees can vastly reduce employee resistance to making benefit changes. It can take several years, though, before a government can realize significant savings from prospectively changing benefits. But, like a snowball rolling downhill, a change that starts out small can pick up impressive momentum. Oakland County, Michigan, attributes much of its budgetary success to long-term financial planning, including proactive employee benefit reforms. The county has implemented these reforms in increments over the past several decades, and the earlier efforts are now yielding big dividends, while more recent changes promise to yield significant additional savings in the future (see Exhibit 1). Employee compensation is the single largest expense for most local governments. Compensation is broadly defined to include salaries, overtime, employer-paid compensation taxes, activeemployee benefits, pensions, and OPEB. Many government officials know from painful experience that reducing compensation for current employees can be very difficult, time consuming, emotional, and sometimes unsuccessful. Implementing compensation changes for future employees who are not yet hired is far less challenging, particularly when those changes include reductions in benefits. FORWARD THINKING Years ago, you might have heard public-sector employees say they d like to seek employment in greener pastures, but they were bound by so-called golden handcuffs. Those handcuffs were benefits that had been designed to retain employees for the long term: incremental pay increases rewarded for longevity, a fixed pension based on the number of years served, the promise of insured health care upon retirement, and so on. How are employees likely to feel about giving up those long-awaited benefits, after investing many years with one employer and, perhaps, foregoing other employment opportunities? At the same time, however, the majority of employers in both the public and private sectors can no longer sustain the costs associated with such benefits. The recent economic environment and the still-depressed real estate market are the primary reasons for the immediate financial woes that face most governments today; however, there could be more financial woes on the horizon. PENSION PLAN SAVINGS One example of a benefit change that yielded big savings is closing the defined benefit pension (DB) plan. Oakland County employees hired after July 1, 1994, are not eligible to participate in this plan; instead, they participate in a 401(a) defined contribution (DC) plan. Employees hired before July 1, 1994, had a limited window of opportunity for switching from the DB plan to the DC plan, and nearly 1,200 employees opted to switch more than a third of those eligible, at the time. The county contributes an average 8.2 percent of salary for the DC plan, across all employee groups. The amount is based on each employee, depending on his or her hire date and negotiated bargaining agreements, if applicable. Each employee contributes a fixed percentage of salary as well, ranging from 3 percent to 5 percent, again depending on hire date and bargaining group. Employees become vested in the employer s contribution to the DC plan according to the following schedule: Years of Service Completed Percent Vested Less than 2 years 0 percent 2 years 20 percent 3 years 40 percent 4 years 60 percent 5 years 80 percent 6 years 100 percent April 2012 Government Finance Review 35
Exhibit 1: Major Changes in Benefits and Compensation 1984 Discontinued longevity pay for 1987 Began prefunding retiree obligations. 1994 & 1998 Buy-out offered to deferred retirees to waive future health care. 1994 Defined benefit pension plan closed to Defined contribution plan offered. 1997 Health-care contributions required for 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1985 Retiree vesting schedule lengthened for Sick days discontinued and replaced with personal days and disability insurance. 1993 Early retirement incentive for DB. 1995 Retiree vesting schedule lengthened for new hires; graduated schedule implemented. Oakland County started saving money shortly after implementing the DC plan, and those savings have continued and grown. In 1996, the annual savings from the DC plan were more than $3.1 million, with 259 newly hired employees that year, 1,126 employees who converted to the DC plan, and 2,148 employees who were still in the DB plan. Fast forwarding to 2010, the annual savings were almost $7.2 million, with more than 80 percent of eligible active employees in the DC plan and fewer than 20 percent in the DB plan. Total cumulative savings from the DC plan through 2010 have been more than $84.5 million (see Exhibit 2). DC plans can obviously save employers money, but they also benefit employees. To the degree that employees are vested, their account balances are portable and belong to them, providing more career flexibility than a DB plan. Also, upon death, the remaining plan assets can be passed on to surviving beneficiaries. This flexibility was one of the factors that persuaded nearly 1,200 county employees to switch from the DB plan. Since employees in a DC plan are making investment decisions, they do bear some investment risk. Employers therefore need to offer a broad array of high-quality investment funds, along with educational resources. They should also provide employees with investment advisors to help them understand potentially foreign concepts such as investment strategies based on an individual s risk tolerance and length of time until retirement age, as well as diversification strategies to reduce overall risk. DISCONTINUING LONGEVITY PAY Oakland County also once offered another benefit designed to retain long-term employees: longevity pay. This was a percentage of base salary, correlated with an employee s years of service and earned in 2-percent increments over a period of time, beginning with 2 percent of additional pay after 7 years of service and gradually increasing to the maximum service increment, 10 percent after 19 years. The county discontinued service increment pay for employees hired after July 1, 1984. In the 27 years since this benefit was closed to new hires, the county s cumulative savings in avoided salary alone have been $69.5 million, and the continued ongoing salary savings are more than $8 million a year. Beyond the direct salary savings are additional savings in salary-dependent costs such as pension contributions and employer-paid social security taxes. For example, assuming 36 Government Finance Review April 2012
2002/2003 Early retirement incentive for DB and DC. 2006 Discontinued traditional retiree health benefits for HSAs offered. 2008 Health-care contributions of employees on lower tier match new employees; first half implemented in 2008 second half implemented in 2009. Retirement incentive offered to employees currently eligible to retire. New vendor for prescription coverage and Medicare Parts A and B. Discontinued social security tax for PTNE. Replace with tax deferred retirement accounts. 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2003/2004 Active employees and retirees move to 3-tier prescription co-pay. 2003 Health-care contributions increased for all two tiers. 2007 Buy-out offered to deferred retirees to waive future health care. Raised co-pays and deductibiles for active employees and retirees. Raised retirees Rx drug co-pays equal to active employees Hiring freeze began. Trust certificates issued. Employee wellness program began. 2009 Prescription formulary changed. Raised employee contributions. 2011 Wage reduction of 1.5 percent. 2010 Eliminated deferred compensation match program. Wage reduction of 2.5 percent. the county contributes an average 8 percent of an employee s salary for DC pension benefits, discontinuing longevity pay saves it approximately $650,000 a year in avoided pension costs in addition to the approximately $8 million in annual avoided longevity pay savings. RETIREE HEALTH-CARE PROGRAM CHANGE Retiree health care was a more recent and dramatic benefit change. The county implemented a tax-exempt retirement health savings (RHS) plan for full-time eligible employees hired on or after January 1, 2006, replacing the traditional employer-paid health, dental, and vision plan for future retirees. This is basically a change from a defined benefit type of plan to a defined contribution plan. Under the new plan, the county contributes $1,300 per year per eligible general employee ($50 per biweekly pay period) into each RHS account. The vesting schedule for the county s contribution in the RHS plan is the same as traditional retiree plan the county had offered: Employees are 60 percent vested after 15 years of service, accruing an additional 4 percent vesting increment for each subsequent year of service until becoming fully vested after 25 years of service. When employees retire from the county, they will be able to use the vested amount in their RHS accounts for expenses that are authorized by the Internal Revenue Service. Such expenses include paying for insurance premiums, prescription costs, or Medicare deductible amounts. The new RHS plan limits and fixes the amount of retiree costs that the county pays, creating fiscal stability while continuing to provide employees with a retiree healthcare benefit. Since the RHS program was implemented six years ago, approximately 20 percent of current active employees are in this new plan. Future retiree savings are conservatively estimated at a minimum of $400 million. DEFERRED RETIREE BUY-OUTS On three occasions, Oakland County has offered to buy out vested retirement benefits accrued by members of the DB plan who had already left the service of Oakland County, but deferred. Employees defer retirement benefits when they retire before reaching the required age. This program was a voluntary and time-limited offer; these former employees could either accept the offer or decline it, irrevocably. Deferred retirees who accepted the offer received a lump-sum present-value amount based on the actuarial April 2012 Government Finance Review 37
equivalent of the accrued pension benefit. The DB plan funded the lump sum payments in exchange for a waiver of rights to any and all other retirement welfare benefits, including future county-funded health care. The program reduced the future liabilities of the county s voluntary employee benefit association as summarized below: n In 1994, 78 deferred retirees accepted the buy-out offer, saving the county an estimated $19.5 million in future retiree costs. n In 1998, 32 deferred retirees accepted the buy-out offer, for an estimated $8 million in savings. n In 2007, 19 deferred retirees accepted the buy-out offer, for an estimated $4.75 million in savings. Buying out deferred retirees on a voluntary basis is another example of big savings that can be created by a simple initiative, with no impact on the benefits of current active employees (or even future employees, in this case). Governments might consider a program of this type if they have a well-funded pension system but large liabilities for unfunded OPEB. benefits and compensation in an effort to reduce budgets and achieve sustainability during this time of declining governmental revenues. These examples from Oakland County show that savings from incremental changes in benefits and compensation can be substantial over time. When employers implement such changes prospectively for future employees thus minimizing the negative impact on current active employees it may take longer for actual savings to accrue, but resistance from the workforce will be minimized. Something else for public employers to consider is that with the recent economic downturn, many employees in the private sector have experienced drastic reductions in their benefit and compensation packages. Thus, taxpayers might expect parity in the form of similar reductions for local public-sector employees. Local leaders need to consider this possibility even if there is no immediate need for budget reductions. An approach similar to that of Oakland County s, with continual review and incremental benefit adjustments, might help satisfy taxpayer expectations. y CONCLUSIONS Many public-sector employers are reassessing employee LAURIE VAN PELT, CPFO, is director of management and budget for Oakland County, Michigan. She can be reached at vanpeltl@oakgov.com. Exhibit 2: Cumulative Savings from the County s DC Plan, 1996-2010 Savings Annual Cumulative Actual 1996 3,130,414 3,130,414 1997 3,920,737 7,051,151 1998 4,901,588 11,952,739 1999 4,928,082 16,880,821 2000 4,563,388 21,444,209 2001 4,429,586 25,873,796 2002 5,252,195 31,125,991 2003 5,720,237 36,846,228 2004 5,525,643 42,371,872 2005 6,413,075 48,784,947 2006 6,886,160 55,671,107 2007 7,201,977 62,873,084 2008 7,243,100 70,116,184 2009 7,287,066 77,403,190 2010 7,161,295 84,564,484 38 Government Finance Review April 2012