The unfunded pension liability of the State and counties has continued to worsen due to a prolonged negative global investment return environment. Rising to more than $8 billion, it remains a dark cloud over the fiscal health of our State.

To fix the problem, the Legislature in 2011 enacted pension benefit changes that will help ameliorate this onerous financial deficiency. Those changes include: increasing the employee and employer contribution rates; reducing the pension benefit accrual rate; doubling the number of years a person must be employed to be eligible to receive a pension; increasing the retirement age for most employees to age 65; and reducing the post-employment cost of living adjustment rate by 40%. The Legislature also passed a law prohibiting future pension benefit enhancements until the ERS is fully funded.

Although the changes enacted are significant, they only affect future liability for benefits of public employees hired from July 1, 2012, and will not affect pension benefits of existing employees. Consequently, the changes will have a material impact over time, but they will do little to close the gap in the unfunded pension liability in the near term.

Another feature of the pension plan that needs to be fixed is the manner in which the pension benefit is determined for a retiring employee. Currently the formula for calculating the pension benefit includes both the base salary and all overtime pay during the highest three years of compensation enjoyed by an employee. Multiplying the years of employment and the average earnings of the “high three” to calculate the final pension benefit, the formula opens up an unintended loophole that can exacerbate the unfunded liability of the ERS. When the “high three” results in a much higher earnings level than expected (based on the employee’s previous earnings history), it results in “spiking” of the pension benefit for the employee. During the entire term of employment both the employer and the employee made pension contributions based upon a lower expected “high three” and when in fact a higher actual “high three” is the result, then a funding gap for that employee’s pension benefit is created.

This was evidenced by the report of the Auditor for the City & County of Honolulu recently identified several cases of Emergency Medical Service (EMS) employees working extraordinary amounts of overtime. In one case an employee whose annual base pay was about $60,000 saw his or her annual earnings jump to $180,000 with overtime over a three year period from 2008 – 2010. If that employee retired (given certain assumptions), his or her pension benefit (under the maximum allowance) could triple from about $30,000 to $90,000 per year under the Hybrid Plan. Just that one case alone is estimated to add between $500,000 and $1 million in red ink to the ERS’ unfunded liability.

The same City Auditor’s report noted 9 other cases where EMS employees increased their earnings substantially over their base pay because of overtime. If those employees were to retire in the near future, then it is estimated the ERS’ unfunded liability will increase by another $3 million. The combined impact of the 10 cases on the unfunded liability of the ERS could be over $4 million.

The examples indentified by the City Auditor, while extreme, are not isolated incidents. A review of employees who retired during 2008, 2009, and 2010 revealed that 674 had earned additional non-base pay earnings during their “high three” to increase their pension benefits. These additional benefits increased the ERS’ unfunded liability by approximately $39 million primarily because of the impact of overtime.

The Trustees of the ERS have proposed that the 2012 Legislature enact legislation that would help close this design flaw. The proposal would cap “spiking” so that employees would no longer be unrestricted in their ability to increase their non-base pay during their “high three” years. An employee would only be able to increase their non-base pay earnings during their “high three” years by 20% above what their non-base pay earnings were prior to the “high three” years. This change is proposed to apply to all employees hired from July 1, 2012.

For current employees hired prior to that date, any “spiking” in their non-base pay earnings beyond the 20% threshold would not be allowed if it resulted from earnings calculated after July 1, 2015. Beyond this change, the proposed legislation would also allow the ERS to assess the employer of a retiring employee for the unfunded cost of the “spiked” pension benefit. This will help ensure that employers will be accountable for covering the true cost of the pension liability resulting from extraordinary amounts of overtime incurred.

The proposed legislation will close a serious flaw in the design of the pension plan that negatively impacts the funded ratio of the pension plan. The Trustees of the ERS are hopeful that the Legislature will act favorably upon these recommended changes to restrict “spiking” of pension benefits and further strengthen the integrity of the ERS.

About the authors: Colbert Matsumoto is the Chairman of the Board of Trustees for the Hawaii Employees’ Retirement System and Wesley Machida is the administrator.