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How to Make States' Public Pension Funds Solvent

July 05, 2011

By Edward Glaeser

Last week, Atlanta’s City Council voted unanimously to address a $1.5 billion public-pension liability by increasing worker contributions and reducing benefits. Florida also increased public-worker contributions.

These are steps toward solvency, but the structural forces that create our public-pension problem remain in place.

The best way forward is for the public sector to follow private companies and switch from defined-benefit plans to defined-contribution plans. We are in the midst of a great debate over our national budget, but states and cities are also in financial trouble, despite their much tougher balanced-budget rules. Among the states’ biggest problems is an unfunded pension liability, which economists Robert Novy-Marx and Joshua Rauh calculate at more than $2.4 trillion.

Nancy’s Law (named by me, after my spouse) is that the three most mind-numbing words in the English language are “unfunded pension liability.” My wise wife regularly warns me that my columns on public pensions push the outer envelope of dullness, but I’m always interested in exploring new frontiers.

In fact, the public-pension problem derives from the dullness of the subject. Because no one can pay much attention to costs far in the future, our political debate favors public pensions.

Rate of Return

Because these costs are routinely undercounted, big pension deals don’t look expensive. When states estimate the size of their pension liabilities, they typically assume an 8 percent or higher rate of return on existing assets, or an interest rate of about 8 percent to evaluate future cash flows.

Assuming such high returns should make it relatively easy to meet future commitments, though state financing falls short even under such rosy scenarios. Novy-Marx and Rauh argue that a more sensible approach would be to discount future liability using the U.S. Treasury bill rate, because only Treasury bills offer the security to meet presumably fixed pension liabilities.

They compare the projected cost of financing under different scenarios and find that “the difference between assets and liabilities is therefore $1.26 trillion under taxable muni discounting and $2.49 trillion under Treasury discounting.” The almost 100 percent difference is a reflection of how easy it is to obfuscate when it comes to pensions.

Unsurprisingly, politicians prefer costs, like pensions, that are easy to hide. That tendency helps neither workers nor taxpayers.

Today or Tomorrow

The problem with public pensions isn’t that teachers or firefighters or police officers are overcompensated. These are tough jobs. The problem is that public workers get too little of their pay while they work and too much when they retire. According to a new paper by Maria Fitzpatrick of Stanford University: “Schools and other public sector employers contribute nearly three times as much per hour worked to the pension benefits of their employees as their counterparts in the private sector.”

Many public workers would vastly prefer to get more money today in exchange for lower pension payments, Fitzpatrick finds in the study, “How Much Do Public School Teachers Value Their Retirement Benefits?”

In 1998, Illinois upgraded the pensions that teachers would get on future earnings and gave these employees an opportunity to increase their pension payout based on past earnings. Teachers had the option of making a one-time payment equal to 1 percent of their salary per year of service prior to 1998, up to a maximum of 20 percent.

Upgrade Offer

The returns of taking the deal were quite high, Fitzpatrick wrote. “The average price of the upgrade offered to employees with 25 years of experience in 1998 was $15,245 while the expected costs of providing them with the extra retirement benefits if they all purchased would have been $94,166.”

Yet even given those extremely generous terms, plenty of teachers preferred to have more money immediately: “More than 20 percent of these employees do not purchase more retirement benefits even when offered them at just 16 cents on the dollar.” Using a sophisticated statistical procedure, she determines that “averaging along the entire demand curve, employees in [Illinois Public Schools] are willing to trade just 30 cents for a dollar’s worth of future benefits.”

This work suggests that we should offer cash to public workers in exchange for giving up some of their future benefits. If public workers really only value their pensions at 30 cents on the dollar, then a deal where we paid workers 65 cents today to reduce the net present value of their benefits by a dollar, would essentially make both public workers and taxpayers 35 cents richer.

Home-Firm Bias

Our defined-benefit system also means that undercompensated state-appointed investment officials are managing multibillion- dollar portfolios. Unsurprisingly, they make mistakes, sometimes for very understandable political reasons. Rauh co-wrote a study with Yael Hochberg that examines the private-equity investments of public pensions and finds that they display a substantial home bias. On average, state pensions invest more than 12 percent of their private-equity funds with in-state firms.

Twenty-three percent of Tennessee’s public pension investments in private equity go to in-state firms. Out-of-state public pensions place less than 0.2 percent of their funds in Tennessee. These in-state investments seem to reflect politics rather than economics. The net internal rate of return for out- of-state private-equity investments is 4 percent; the return for in-state investments is 0.4 percent.

Lost Opportunities

If Hochberg and Rauh are right, then pension funds are forgoing billions by parking their money with local investors.

Moving forward, the natural solution is to switch to defined-contribution 401(k)-style plans. The biggest virtue of these plans is that their cost is immediately obvious, which eliminates the hidden cost bias that pushes toward excessive pensions.

Because many public employees don’t have the cushion provided by Social Security, we might need a hybrid system that provides them with some base benefit, but beyond that there is no reason why public workers shouldn’t have the same type of retirement benefits as private workers.

Original Source: http://www.bloomberg.com/news/2011-07-05/how-to-make-states-public-pension-funds-solvent-edward-glaeser.html

 

 
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