If you want to destabilize a defined benefit public pension plan with the least amount of effort, include automatic cost of living adjustments (COLAs). It’s the fastest way to add benefits that haven’t been paid for, while surrendering outcomes to forces beyond the plan’s control.
The Colorado Fire and Police Pension Association (FPPA) runs a defined benefit plan for the state’s police officers and firefighters. For the last 30 years, it has been at or over 100% funding. It should resist the temptation to start using COLAs.
In general, benefits are calculated based on a worker’s highest earnings (usually averaged over some number of years), the number of years worked, and various actuarial considerations, such as expected lifespan and rate of return on assets. The money simply hasn’t been paid in to compensate retirees for unexpectedly higher inflation through higher benefits.
Some history
Up until the inflation of the 70s, most public pensions were in relatively good shape. They provided modest benefits under mostly predictable conditions. But the inflation of the late 60s and 70s led to political pressure to tie benefits to price increases. In 1972, President Nixon signed COLAs into law for Social Security beginning in 1975.
Around the same time, public pensions began doing something similar to ease the effects of inflation on pensioners. While studies show the COLAs didn’t keep pace with inflation, they were enough to start setting some of those pension funds behind, and their limited success was enough to keep them in place long enough to store up financial trouble.
The power of COLAs can be seen in what happens when they’re not around. In the 2000s and 2010s, public pension problems deepened, forcing the bankruptcy of a number of cities and threatening the credit rating of some states, including Colorado. While the courts wouldn’t allow states and cities to cut “core benefits,” because COLAs tended to fluctuate anyway, they permitted reductions in them.
Colorado’s 2018 reform of the Public Employees Retirement Association (PERA) defined benefit plan included curbs on COLAs. Those curbs have proven to be among the most effective tools in bringing some level of stability back to the plan, even if it remains in danger of eventual default.
Staying the course
While those restrictions have also brought some pain to existing retirees, any and all proposed fixes have involved variations of one-time payments or special tax exemptions rather than restoring the COLAs. Those “fixes” are objectionable on their own merits, but they acknowledge the underlying destabilizing effect of automatic COLAs.
By contrast, FPPA has never had automatic COLAs, and most years has had no upward adjustments in benefits at all. In fact, state law explicitly permits, but does not require, benefit adjustments in order to keep the plan solvent. Recent legislation replaces the term “redetermination of benefits” with “cost of living adjustment,” which may have produced some expectations on the part of beneficiaries. For instance, it appears to change the upper inflation limit from 3% to the greater of 3% or the consumer price index (CPI).
Even as other plans were getting into trouble, FPPA has been able to stay within a few percentage points of 100% funding (see Figure 1).
Certainly, part of the plan’s success has been rising contribution rates, beginning in 2014. But those have been steady and gradual, raising the employee contribution from 8% to 12% in 2022, and the employer rate from 8% in 2020 to 13% in 2030.
The plan has stayed at full funding not by fiddling with its assumptions but by making sure it doesn’t overspend, nor surrender its judgment to forces beyond its control. If inflation pushes up projected benefits for existing employees, it only does so because of rising salaries, which imply rising contributions, so the money is mostly there to cover those benefits.
What we don’t see is sharply rising benefits for those no longer contributing to the system.
If the plan is to remain at full funding, COLA-induced benefits could only come from two places: future benefits or increased contributions, both of which are unfair to current employees.
If the plan were to implement a 10% COLA over the next 4 years, it would increase the liabilities by roughly 9% without increasing the assets at all, and it would drop the funded ratio from about 100% to about 90%. FPPA has already increased contributions, and it would have just voted to increase benefits, so it’s hard to see what options it would have to get back to full funding.
Of course, a plan doesn’t have to have COLAs to get into trouble. The Denver Employees Retirement Plan has been spiraling downward for some time, and it doesn’t have any COLAs at all. Its problems stem from over-reliance on unsustainable investment returns.
If FPPA wants to keep faith with its members, retirees, and taxpayers, it will resist the growing political pressure to open up that can of COLA.
Joshua Sharf is a senior fellow in fiscal policy at the Independence Institute, and and sits on the Colorado legislature’s Pension Oversight Subcommittee.
