SACRAMENTO, CA - The contract recently negotiated between the California Department of Personnel Administration (DPA) and the 87,000-member Service Employees International Union (SEIU) provides a salary hike of 3.5 percent this year with a two-to-four percent cost-of-living increase in 2007. The deal also contains some relief for California taxpayers.

In exchange for the wage hike, the union signed off on a plan that would alter the way pension benefit amounts are calculated for new hires. The new formula discourages "pension spiking'' just before retirement in order to boost annual pension payouts. With this change, the state takes a small first step towards reforming its costly pension system.

California's defined-benefit system determines pension allocations through a formula that takes into consideration age, years of service, and peak annual salary, the highest annual amount an employee has earned. Because most employees obtain several promotions throughout their career, typically the peak annual salary arrives near the end of an employee's tenure, most likely the year just before retirement. Unfortunately, this arrangement creates an incentive for employees to take promotions and then rather abruptly retire.
This leverages the higher salary of the new position into the pension payout but leaves taxpayers to pick up the tab, a big one.

Pension spiking is common in California and costs taxpayers an estimated $100 million a year. Add the cost of training replacements for those retirees, and the taxpayers' burden is much higher. A 2004 report in the Sacramento Bee highlighted this very problem by revealing several state employees who took on new positions for the sole reason of inflating their pension benefits. One ex-CHP officer, stayed in his final position for only six months and still qualified for the higher benefit calculation--a figure which produced a 17-percent jump in his already generous annual pension. The costly peak-salary rule that enabled a fatter payout is unique to the Golden State.

The other 49 states avoid such spikes by taking several years' salary into account in the final benefit calculation. Most states use a three-year average of highest annual salary, but others like Minnesota and Indiana require a five-year average. Unfortunately, California has gone without a salary average since 1990 when a back-room deal put the peak-salary rule in place.

That rule was enacted as part of an accord cooked up between the state worker unions and the administration of Governor George Deukmejian. The administration, eager to enact new pension accounting rules with little legislative resistance, offered the peak salary measure as a peace offering. The union accepted and the truce was made. The accounting bill, amended to include the peak-salary rule, was hurried through the
legislature without debate. The bill passed with virtually no opposition. Only Tom McClintock, in the Assembly at the time, voted against it.

Since the rule's implementation, California has witnessed an increase in the number of retirements and a decrease in the average age of those who retire. In the rule's first year, retirements skyrocketed from less than 3,700 employees to more than 6,400. Since that time, the state has averaged around 6,000 retirements a year with an average retirement age of 59, two years under the median retirement age for the entire American workforce. Realizing that the state was encouraging an experienced workforce to leave, the DPA pushed for the
elimination of the peak-salary rule.

Under the new contract agreement, the state will eliminate the rule for new service employees. Workers hired after January 1, 2007, will have their benefits tabulated under a three-year salary average. With this move, the state will help maintain a more cost-effective workforce by discouraging employees from taking positions temporarily in order to spike pensions.

The move away from the peak-salary rule is a good first step towards change but California still has a long way to go. Taxpayers, who gain the most from this move, should take notice and demand further pension reforms.

Anthony P. Archie is a public policy fellow in Business and Economic Studies at the Pacific Research Institute. He can be reached via email at aarchie@pacificresearch.org.