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Washington Examiner

 

Pension Debate Postmortem

May 26, 2011

By Josh Barro

On Monday, Economics 21 and the Manhattan Institute hosted a debate on pension accounting and reform, at which I was one of the panelists. The discussion was wide-ranging, but most of the debate boiled down to a key question: Does the government have a special advantage in bearing investment risk, thus justifying the use of defined-benefit pensions?

As I’ve written before, taxpayers are not indifferent to investment risk assumed by governments, as investment losses and gains will be passed through to taxpayers and recipients of government services. While these parties also receive the excess gains when investments do well, that’s not a wash; the gains come when they are least needed and the losses when they are least affordable.

There were a couple of key discussion points at the event that are worth hashing out in writing. Defenders of the status quo often claim that pension costs are not that high and shortfalls can be managed with little impact over a 30-year window.

It’s important to remember that a pension fund shortfall is akin to a 30-year mortgage. Pension funds depend on income generated by assets (typically, an 8 percent annual target return) to cover the cost of benefits. If a pension fund is underfunded, taxpayers must effectively pay interest at that 8 percent rate on the amount of the underfunding, in addition to the normal cost of pension benefits that continue to accrue. Otherwise the funding ratio will continue to deteriorate.

If a pension fund has a shortfall of $X, and amortizes its shortfall over a 30-year period, that does not make annual amortization payment $X/30. Because of the need to pay interest, the actual figure is closer to $X/11. This means that funding shortfalls (which arise because pension funds make risky investments) impose meaningful short-term fiscal costs.

Given the performance of the stock market over the past five years, it is likely that a typical pension fund that was fully funded in mid-2006 is now only 75 percent funded; as a result, doublings of annually required pension contributions should be considered typical, not unusual. Some funds, such as New York’s, which use shorter amortization schedules are seeing even more rapid rises in current-year costs.

So while pension costs have historically consumed about 4 percent of state and local budgets, that figure is likely to be far higher in the next several years, making pensions a major driver of state and local fiscal crises.

We also discussed whether defined-benefit pensions are an efficient tool for attracting talent to work in the public sector. In my view, they are not. A Stanford University study found that when Illinois teachers were offered a pension benefit increase in the late 1990s, they were unwilling to pay for an increased pension benefit unless they were offered a steep discount from the sweetener’s real cost. The fact that large corporations are increasingly abandoning the defined-benefit model is also evidence that these pensions are not especially useful for recruiting.

I think people on the Left generally understand this, deep down, and actually support defined-benefit pensions for paternalistic or altruistic reasons. Defined-benefit pensions may not be an especially efficient way to attract workers, but they do provide a stronger guarantee of retirement security. The problem with this justification (aside from the need to subject it to cost-benefit analysis) is that it is not a reason to offer a program specifically for the benefit of public workers.

In my view, the government ought to be in the business of providing some sort of guaranteed minimum income for the elderly so that people who are too old to work do not end up destitute. This is why I oppose the conversion of Social Security to a system of private accounts. We can discuss whether the floor set by Social Security is too low, but if so then it should be expanded for the whole population. A special benefit just for government workers is not a good solution to a general problem.

Original Source: http://washingtonexaminer.com/opinion/columnists/2011/05/manhattan-moment-pension-debate-postmortem#ixzz1NSiL9h6D

 

 
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