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Public-Sector Pension Mediation to the Rescue

March 31, 2011

By Nicole Gelinas

Veronique and Eli: I agree (and disagree) with both of you (and Yuval, too). Three points:

1. Discount rates. People in the private sector must save and invest for their retirements and assume that those savings and investments will earn a return every year, thus contributing to their personal savings pots. State governments, too, must save and invest for state and local employees’ retirements and assume that those savings and investments make a particular return.

Right now, many states assume their pension funds will return 8 percent annually, and many pension reformers would like states to assume a lower return. Eli contends that “it makes little sense to use a 4 percent discount rate for pension liabilities” because history indicates higher returns over time.

This argument is credible, as far as it goes. The S&P 500 is ten times what it was 30 years ago. Over the past 21 years, Calpers, California’s now $226 billion public pension fund, has returned an average of, well, exactly 8 percent a year. Over the past ten years, though, it’s returned only 4.51 percent annually.

No one can know if the future will look like the recent past, the longer-term past, or something else. But it’s certainly true that if risky financial assets can’t generate an average of 8 percent annually over a decades-long time frame, the nation has problems bigger than its unfunded pension liabilities.

The real question is, should states award benefits based on investments in risky assets? There is a hazard here that doesn’t exist in private-sector retirement accounts. Public workers and pensioners benefit from their states’ successful investments in risky assets, including stocks, bonds, private equity, and real estate. But the public employees don’t take the risk that those investments won’t be successful. How’s that? When the markets do well, states often reward public workers even better benefits; when markets do poorly, taxpayers must make up the shortfall, as states guarantee these benefits.

Current and future public-sector retirees shouldn’t earn a reward from risks that they’re not taking. The risk that they are taking is not the same risk that a private-sector worker or retiree takes. Rather, it’s the risk that a state or locality won’t pay out on its contractual, and often constitutional, promise.

This risk should be smaller than the risk needed to earn an 8 percent return, as Veronique notes. The states’ discount rates, then, should be lower — creating higher unfunded pension liabilities. (If it turned out that the risk that states won’t pay what they’ve agreed is higher, we’d have an odd situation in which states’ inability to make their pension payments would reduce their pension liabilities, which makes a sort of sense, if you think about it.)

Winner: Veronique.

2. Problem relativity. Eli says that pensions are a problem but not the problem, and that it’s “easier and better” to look at other problems, including collective-bargaining rules and health benefits. Veronique disagrees, noting that eight states, including Illinois and New Jersey, could see their pension funds run out of money in a decade.

Eli is right that states that fix their own and their localities’ pension plans for future employees won’t see big savings for years, even decades. Veronique is right, though, too, in that some “long term” disasters loom soon.

The solution? It can’t hurt for states to offer new employees much less expensive pension plans, and for everyone to hope that growth takes care of much of the pension disaster that’s already built in. On the East Coast, proposals by Mayor Mike Bloomberg (?., NYC) and Gov. Chris Christie (R., N.J.) to hit current benefits before having fixed future problems are more distracting than helpful. Nor can it hurt to do what Eli suggests, and tackle other problems at the same time that we attack future pensions, including today’s health benefits and collective-bargaining rules.

Winner: draw.

3. Missed opportunities. Yesterday at the U.S. Chamber of Commerce, Caterpillar CEO Douglas Oberhelman used his company’s example to give advice to his home state of Illinois as well as other states.

Oberhelman talked about how much attention Caterpillar has paid to “legacy costs,” including pensions, noting that when it comes to “our very valuable cash” — all of which is coveted by various factions, including shareholders and workers, before it is earned — “we keep one eye on today and the other eye on tomorrow.” To that end, Oberhelman said forthrightly that the company has changed its retirement and health-care plans so that it has enough money to invest in research & development and new factories.

Could Caterpillar have theoretically afforded to spend more on pensions and less on R & D? Sure — for a while. By the same token, Illinois can “afford” its status quo if it raises taxes and neglects infrastructure, as it has done. But the state can only do so for a while — and the decision comes at a great future cost.

Every percentage point matters — and every dollar that Illinois or New York or California spends on a future pension when it doesn’t have to make that outlay to keep a qualified workforce is a dollar not deployed elsewhere creating wealth.

Losers: citizens and taxpayers, so far.

Original Source: http://www.nationalreview.com/corner/263483/public-sector-pension-mediation-rescue-nicole-gelinas

 

 
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