Early Retirement Incentives: Weighing the Risks for State and Local Governments
February 22, 2021
By Ana Champeny, Director of City Studies, Citizens Budget Commission
Early retirement incentives (ERIs) are offered by state and local governments, often during fiscal distress, to reduce headcount and achieve savings, while avoiding furloughs or layoffs. Many states, counties, and cities used them during the Great Recession, and many are considering them now, as a response to the current COVID-19 pandemic fiscal crisis.
However, these incentives are not without risks. In fact, the Government Finance Officers Association (GFOA) issued an advisory that recommends against using ERIs. The Citizens Budget Commission’s (CBC) recent analysis of a proposed ERI for New York City municipal employees concluded that “while an ERI can induce employees to leave city employment quickly, it is a more costly workforce reduction strategy than attrition or layoffs. In light of the City’s fiscal stress and the availability of other options to balance the budget, the City should reduce its workforce through attrition and not pursue the ERI.”
What are ERIs and How Do They Work?
ERIs provide a financial incentive for an employee to retire. The ERI financial incentive is usually an additional pension credit that boosts the pension benefit of the employee, or a lump-sum payment to the employee, either fixed or variable, based on years of service. (Some ERIs offer additional benefits, like extended health coverage). The decision to take the ERIs is in the hands of the employees which is an advantage over furloughs or layoffs.
The primary savings derive from the salaries that would be paid to the employee, assuming that the position is kept vacant or filled by an employee with a lower salary.
But there are costs as well, including lump sum payments, pensions costs, payouts of accrued leave, and the costs of recruiting and training replacement personnel. Furthermore, for incentives increasing pension benefits, the actuarial cost to government can be spread out over time, which can increase near-term savings while deferring costs that may also violate the principle of intergenerational equity.
So, while an ERI can save money, there are fiscal risks. The ERI may be more costly than expected; maximizing savings requires keeping the newly vacated positions unfilled, and structuring an incentive that it is attractive enough to employees but minimizes costs. One reason the GFOA cautions against ERIs is that governments can overstate the savings and understate the costs.
New York City’s Proposed ERI
New York City, with a fiscal year 2022 budget of $95.6 billion, is facing severe fiscal challenges due to the pandemic and recession. With the economic shutdown, fewer commuters, and a drastic reduction in the number of tourists tax revenues have fallen. As of January 2021, tax revenues for fiscal years 2020 to 2024 (collections to date and current forecast) are $20 billion below January 2020 projections. Part of the City’s budget-balancing plan is to achieve $1 billion in recurring annual labor savings. Negotiations with municipal labor unions have not yet yielded these savings, and an ERI is under consideration.
The CBC recently analyzed a NYC ERI proposal in the State Legislature (bills establishing similar programs for state and other local employees have also been introduced). The NYC proposal has two parts: one provides additional pension credits, while the other eliminates an early retirement reduction.
The Actuary for the City of New York estimated that the additional pension contribution would average $110,000 per retiree, which the City would pay over four years, with a one-year lag (years two to five), while the average salary of a retiree would be $90,200. Using those data points and a set of assumptions about fringe benefits and replacement hiring, the CBC simulated the costs and savings from 10,000 separations under the ERI compared to 10,000 voluntary separations. Key findings were:
- The incentive cost of about $1.1 billion would equal about 19 percent of the potential five-year salary savings of $5.9 billion, if the positions are kept vacant.
- Approximately 32 percent of the ERI incentive cost is likely to be an unneeded expense, flowing to employees who would have retired anyway, based on a CBC analysis of a similar program.
- If one-third of the vacant positions are filled in the first two years at 70 percent of the salary of the retiree, potential savings would be reduced by 31 percent, to $3.3 billion. This follows the City’s current hiring freeze that permits agencies to replace one of every three vacancies (excluding health and safety).
- The savings under similar rates of voluntary separations would be $4.3 billion over five years (32 percent higher). Significant reduction through attrition is achievable in NYC given an annual separation rate of about 7 percent for a municipal workforce exceeding 300,000 full-time employees.
Lessons Learned from Los Angeles
The City of Los Angeles offered ERIs in 2009 and 2020. The 2009 program was similar to the New York City proposal. However, repayment to the pension plan was spread out over 15 years, beginning in 2011, which has two important ramifications. First, payments will continue until 2026—five years from now. The second is that this long repayment, coupled with other fiscally dubious actions, resulted in the funding ratio of the pension fund declining from 90.1 percent before the Great Recession to 73.1 percent now.
In 2020, Los Angeles implemented a Separation Incentive Program that provides a lump sum payment based on salary and years of service, capped at $80,000, rather than a pension benefit boost. The lump sum payments are spread over two fiscal years, which provides fiscal relief to Los Angeles, and spreads out the retirees’ personal income tax liability.
Early retirement incentives were used by many states and cities during the Great Recession to reduce the workforce and achieve savings. However, they come with a significant cost that might have long-term implications for fiscal stability. If localities are considering an ERI, it is important to do a thorough analysis of the costs and benefits and commit to a strict hiring freeze, or the ERI could actually cost more than expected.