Wanna' see the difference between a simple COLA and a compound COLA?

From John Curry, May 9, 2010

http://news.cincinnati.com/article/20100403/NEWS01/4040346

COLAs loom large in pension snarl

Calculations become issue as city expenses grow

By Barry M. Horstman • bhorstman@enquirer.com
cincinnati.com, April 3, 2010

It sounds like the kind of arcane accounting question only an actuary could love: How should annual cost-of-living adjustments in Cincinnati's pension system be calculated?

Yet while the cost-of-living adjustment (COLA) is a seemingly small piece of the city's pension puzzle, it comes with huge financial consequences. The answer to the COLA question determines how big and how fast a city retiree's pension grows, an issue with multimillion-dollar stakes for taxpayers - and City Hall.

Under one common method, a retiree who receives an annual 3 percent increase would have to wait 33 years-plus to see his pension double, assuming he lives that long.

But under an alternative now used by the Cincinnati Retirement System, his pension could double in only about 24 years - a crucial distinction that could result in the system paying much higher benefits for more years.

Among the thorny issues before a 12-member city task force examining ways to ensure the retirement fund's long-term solvency is whether to recommend that a so-called simple or compound COLA be used to help retirees' pensions keep pace with inflation.

With a simple COLA, the annual adjustment is based on retirees' original pension for the rest of their life. So, if an individual is entitled to a $50,000-a-year pension and a 3 percent annual increase, he would receive a $1,500 hike yearly, pushing up his pension to $51,500 in his second year of retirement, $53,000 in the third year, and so on.

The compound method, however, includes past pension gains in calculating future ones. Under that method, the retiree's $51,500 pension in year two would be used to compute the next 3 percent raise, producing a $1,545 jump to $53,045 in year three.

While that is only $45 more than under the simple method, the gap widens substantially the longer the pension is paid. For example, after 25 years, a simple 3 percent annual COLA would increase the original $50,000 pension to $87,500, while the compound method would already top $100,000.

At its core, the COLA question measures harsh fiscal realities against compassionate impulses.

Judged from a strictly financial perspective, the simple COLA method would be preferable for a city needing to come up with hundreds of millions of dollars to stabilize its pension system.

It would be considerably less attractive, though, to pensioners. A simple COLA, retirees and current city employees argue, could erode their quality of life, especially during periods of extended high inflation.

"You have to protect the system but also think about how any changes affect current and future retirees," said task force member Marianne Steger, director of health care and public policy for the American Federation of State, County and Municipal Employees - Ohio Council 8. "That's what makes this such a tough call."

Steger's union, the city's biggest public employees union, has not yet taken an official position on the issue.

Until the late 1990s, Cincinnati's retirement system used the simple COLA method, said City Treasurer Jack Walsh. Then, with the system flush following years of impressive investment returns - in December 2000, the pension plan had a $292 million surplus - the city switched to the compound method as a "benefit enhancement" for retirees.

Since then, however, the pension plan's finances have plunged dramatically, the result of under-funding by the city, expanded benefits, soaring health coverage costs and the 2008 stock market meltdown. By December 2008, those factors had erased the surplus and left the system facing an $872 million unfunded liability for projected future payments to roughly 7,600 retirees, current workers and their beneficiaries.

Amid warnings from experts that without major changes, the city's $2 billion retirement system could be bankrupt within 20 years, the task force is pondering whether the pension plan can still afford to pay the more costly compound COLAs, particularly as life expectancies lengthen.

A related question is whether to guarantee retirees an annual 3 percent raise, as now occurs, or to tie the yearly increase to the consumer price index, with 3 percent being the ceiling. At times of mild inflation, the latter approach could produce a lower annual pension bump. In projecting future expenses, task force consultants assume the annual rate would be about 2.5 percent.

"We have to look at everything that helps preserve the basic pension for future generations," Steger said.