Center for Business & Public Policy
Collaborative blog exploring the relationship between market forces and public policy.

Like millions of Americans, I was deeply shaken by the horrible tragedy that unfolded at Sandy Hook elementary school in Newtown Connecticut one week ago today.  As a father, as an American – simply, as a human being – I was horrified by the thought that anyone could be capable of gunning down innocent and helpless children.  My rage toward the killer was outweighed only by the terrible sadness for the children and deep sympathy for their families.

As the hours and days have gone by, however, my raw emotional response has slowly – if not fully successfully – made some room for my inner economist to begin to examine the situation from an analytical perspective.

Today, Wayne LaPierre, the head of the NRA, stated that “the only thing that stops a bad guy with a gun is a good guy with a gun.” This is a provocative statement, so I thought it was time to examine this issue more closely.

So let me ask a simple question: “Would America’s children be safer if we had more guns, or fewer guns?”

I would like to assume that, with the exception of a few sociopaths, everyone wants our children to be safer.  I do not subscribe to the extremist rhetoric from either side that assumes they are the only ones with the moral high ground and that the “other side” is somehow anti-kids.  Rather, I think both sides agree on the goal – to keep our kids safe – but have a very different view of how to get there.

But who is right?  Would our children be safer with more guns or fewer guns?

To provide some insight, I would like to adapt a simple model that is used to discuss tax policy (stay with me here!) – the “Laffer curve.” (Click here for information on the Laffer curve). 

If there were zero guns available in the U.S., then by definition there would be zero gun-related deaths.  Starting from zero, as the number of guns increases, the frequency of gun related deaths would surely rise, at least initially.  But it probably would not rise forever as shown in this graph.

Why?  Consider the other extreme – the vision of the NRA – where virtually every citizen was armed.  Teachers, professors, airline pilots, nurses, truck drivers, accountants … everyone.

According to the NRA, in such a world, criminals would be reluctant to commit a crime because they know that they would be putting themselves in grave danger.  Or even if they did, an armed good guy would stop them.

What this means is that if gun violence is low at low levels of gun ownership, and also low at high levels of gun ownership, then there must be a horrible “peak” in between where the number of gun-related deaths is at its highest (the peak).

We have over a quarter of a billion guns in the U.S. The question is whether this is above or below the peak.  If it is below the peak, then more guns cause more gun-related deaths, and deaths would decline if we had more effective gun control laws.  In contrast, if we are above the Peak, then small decreases in the number of guns can actually cause more deaths.  Relatedly, if we are above the Peak, then increasing the number of guns can reduce the number of gun-related deaths.  This is what the NRA seems to believe.

This is a simplistic model.  But it does provide an important insight: theoretically, gun control could make us safer or it could make us less safe.  Gun control advocates are implicitly assuming we are to the left of the peak.  Gun rights advocates are implicitly assuming we are to the right of the peak.

So, what does the evidence say?

The good news is that it is possible to test this.  The bad news is that it is very hard to do it well.  One cannot simply assert that “in country X, they have tighter gun control laws and also fewer gun deaths, so therefore fewer guns causes fewer deaths.”  To do so would be to ignore countless other factors – cultural, religious, legal, economic, demographic – that might cause country X to have fewer deaths and also cause them to pass more stringent gun control laws.

Fortunately, some economists have written good papers on gun control.  (Sadly, other economists have written bad papers on gun control, meaning that they are sloppy, confuse correlation with causation, and therefore should not be used to guide policy debates.)

University of Chicago economist John Lott is the most well-known researcher on the issue.  His findings are easily summarized by the name of his book “More guns, less crime.”  In other words, Lott believes we are way past the peak and that people would likely be safer if we had fewer restrictions on guns.  As is often the case when someone writes something so provocative, Lott’s research has come under attack.  A summary of the controversies and criticisms can be found here.

Aside from just attacking Lott’s work, others have tried to examine this issue on their own.  In my opinion, the single best study on this topic was conducted by Prof. Mark Duggan, a Harvard-trained Ph.D. in economics who is now a professor at the Wharton School at the University of Pennsylvania.  His paper, “More Guns, More Crime” was published in one of the most elite peer-reviewed economics journals in the world.  He finds that “changes in homicide and gun ownership are significantly positively related” (thus, his title – more guns lead to more crime.)  Importantly, he also finds that “this relationship is almost entirely driven by the relationship between lagged changes in gun ownership and current changes in homicide.”  This is really important because it is evidence that this correlation comes about because guns lead to more homicides, rather than an increase in homicides leading more people to buy guns.

The Duggan study also specifically examines the Lott study.  He agrees that, theoretically, concealed carry laws could increase the likelihood that potential victims could carry a gun, and thus reduce the homicide rate (my simple model above).  However, he concludes that he finds “no evidence that counties with above-average rates of gun ownership within CCW states experienced larger declines in crime than low-ownership counties did, suggesting either that gun owners did not increase the frequency with which they carried their guns or that criminals were not being deterred.”  In other words, there is no evidence to support the NRA’s view.

I came into this debate over the past week with an open mind.  My reading of the evidence, however, suggests that more guns cause more crime, and that concealed carry laws would not reduce crime.

Our nation may still decide not to restrict guns because of the Second Amendment.  But if so, let’s at least do it with our eyes open.  We should not be pretending that we are helping kids by promoting gun ownership.

Retirement plans such as the 401(k) receive favorable tax treatment under the U.S. income tax system.  Historically, this favorable tax treatment was provided to increase individual saving.  Recent research has called the efficacy of this approach into question, suggesting that individual saving rates may not be all that responsive to marginal tax rates.

Last week, I wrote about the danger of drawing the conclusion that tax incentives do not matter and that we should therefore look to eliminate the tax preference for retirement saving.  My focus was on the role that tax preferences play in providing an incentive for employers to offer plans, and to design them in a way that uses behavioral nudges to increase saving.

This week, I want to focus on a different aspect of this issue, the public discussion of which has been misleading – how much this tax preference costs the U.S. Treasury.  My contention is that the cost figures being bandied about (including my own use of the $100 billion figure in last week’s post) are substantially overstated.  The point of today’s post is to note that the amount of revenue that the government would receive by eliminating the preferential tax treatment for retirement saving would be much less than what it might appear.

To understand this, one must understand (1) how retirement plans are treated under U.S. tax law, (2) how the government actually accounts for the foregone revenue, and (3) how the government ought to account for the foregone revenue.  These are complex topics, but some simple exposition is sufficient for seeing the main point.

(1)   How are retirement plans treated under U.S. tax law?  In a nutshell, the income tax on retirement plan contributions is deferred, not eliminated.  This is an important distinction.  If I receive an additional $1000 in cash salary, and I am in a 35% tax bracket, I owe the government an additional $350 in taxes.  If, however, I receive this additional $1,000 in the form of a contribution to a 401(k) plan, I owe no taxes today.  However, I will owe taxes on the money when I withdraw it during retirement.  Of course, there is financial value to deferring my taxes (what we economists call tax free “inside build-up”), but it is not as if the initial contribution escapes the tax system entirely.

(2)   How does the government account for the foregone revenue?  The U.S. Department of Treasury and the Congressional Joint Committee on Taxation prepare annual estimates of what they label “tax expenditures.”  These tax expenditures are basically just an estimate of how much additional tax would be collected if a particular activity went from being untaxed to being taxed, assuming no behavioral response to the tax.  (As an aside, the fact that they do not account for a behavioral response is why they are careful to always note that “a tax expenditure estimate is not the same as a revenue estimate.”)  In the case of retirement plan contributions, they roughly calculate the amount of money being deferred, apply the relevant marginal tax rates to it, and obtain a rough estimate of how much revenue is not being collected as a result of this tax preference.  However, a key point is that they do not estimate this over the entire life of the account, but rather use an arbitrarily truncated time horizon to estimate the effects.

Going back to my simple example: suppose I contribute an additional $1,000 today to a 401(k) plan.  That saves me $350 in taxes today, and costs the government $350 in foregone revenue in the current tax year (assuming I would save the same amount either way).  So far, so good.  But suppose that I plan to pull the money out in 20 years.  I will pay income taxes on the amount I withdraw.  The present discounted value of the tax that I pay in 20 years will likely be less than $350, but it will be much greater than zero.  For the sake of example, suppose it is worth $150 in present value.  If so, then the net gain to me (and the net cost to government) over my lifetime is $200.  The problem is that the government does not use a present value method.  Instead, it looks at just the front end, and thus overstates the value of the deduction.

(3)   How should the government account for tax expenditures?  Ideally, the government would compute these tax expenditures using the “present value” concept just explained.  A number of experts have made this suggestion.  For example, a paper by the American Society of Pension Professionals and Actuaries (ASPPA) boldly states “tax expenditure estimates for retirement savings provisions should be prepared on a present-value basis” because this “would allow an ‘apples to apples’ comparison” with other tax deductions.

What does all this imply?  A paper written by two Treasury Department officials and published in the December 2011 National Tax Journal found that “the long-run NPV cost can be dramatically different if measured using relatively short time horizons.”  The calculations are a bit tricky because one must make assumptions about rates of return, the appropriate discount rate, current and future marginal tax rates, and so on.  And the extent to which estimates differ depends on the time horizon being examined.

But, these caveats aside, the ASPPA study concludes that “the present-value tax expenditure estimates of contributions made in the first five years are 55 percent lower than the JCT five-year estimates and 75 percent lower than the Treasury five-year estimates.”  That is a huge wedge.

How does all this matter for policy?  The fiscal cliff has DC policymakers scouring the four corners of the earth looking for ways to boost revenue without raising marginal tax rates.  One way to do this is to eliminate tax expenditures.  However, some of those tax expenditures exist for good economic reasons, and the provision of favorable tax treatment for retirement saving is one of them.

As noted last week, the elimination of this provision could have serious unintended consequences for the availability of retirement savings programs through employers.  Now add to that the fact that any revenue implications of such a policy change are substantially overstated and what you get is the potential for good intentions (closing the fiscal gap) to lead to bad policy.

Relevant Disclosures:  I serve as a trustee for TIAA, a provider of retirement plans to the not-for-profit sector.  I have also received compensation as a consultant or speaker for a wide range of other financial services institutions.  The opinions expressed in this blog (and any errors) are my own.

Earlier this week, I released a report co-authored with Avijit Ghosh and Scott Weisbenner (both of the University of Illinois) and Steve Cunningham (Northern Illinois) that – yet again – tries to make the case for pension reform.  The news release can be found here and the full paper (including a one page summary) can be found here.

In a nutshell, the plan has three components:

1.  Change some of the SURS rules to reduce costs and increase transparency.  This includes pegging the SURS’ effective rate of interest to long-term bond rates.  For my prior musings on this topic, click here to see the blog I wrote on this back in June of 2010, entitled “A Hidden Pension Subsidy in SURS.”

2.  Providing participants with an opportunity to opt out of their automatic annual adjustment (sometimes called the COLA) in exchange for a lump-sum that is calculated to give participants a bit of a “haircut.”  We consider this to be a reasonably fair exchange, especially given its voluntary nature, in sharp contrast to the forced choice that has been proposed in other legislation (for example, see Nolan Miller’s post entitled “The Choice Between Two Unconstitutional Options is Not Constitutional.”)

3.  Expand the Illinois state income tax base to include retirement income.  There is really no compelling economic reason to exempt retirement income from the Illinois state income tax, and this may be the only way to get the retired generation to be able to contribute to solving our fiscal problems.

Whether or not our proposal has an influence on the debates in Springfield is anybody’s guess.  But one thing is clear: absent some time of substantial reform, Illinois is teetering close to a true fiscal cliff, one that will make the Washington DC fiscal cliff look like a small step down.

Earlier this week, the New York Times Economix Blog wrote a piece “Study Questions Tax Breaks’ Effect on Retirement Savings.”  The article summarizes the findings of a fantastic research paper issued by the National Bureau of Economic Research (NBER).  A quick summary of the paper written by the authors themselves can be found here.  The short version is that the researchers used data from Denmark (where much better date is available) to provide evidence that tax subsidies have little effect on overall savings rates.

Their main finding is that “when individuals in the top income tax bracket received a larger tax subsidy for retirement savings, they started saving more in retirement accounts.  But the same individuals reduced the amount they were saving outside retirement accounts by almost exactly the same amount, leaving total savings essentially unchanged. We estimate each that $1 of government expenditure on the subsidy raised total savings by 1 cent.”

The policy implications of their finding are extremely important given the current debate about fiscal policy in the U.S.  After all, if tax subsidies for saving do not actually increase saving, then perhaps we should re-think the $100 billion per year that we forego in tax revenue by exempting retirement savings from the income tax base?  Such a conclusion would be quite tempting to politicians who are desperately seeking ways of raising revenue without raising tax rates.

But I say “not so fast.”  Although I do not disagree with the empirical findings of the study, I strongly disagree with the assertions being made by some that this finding justifies the elimination of the tax preference for 401(k) and other retirement vehicles.

The study itself is an outstanding intellectual contribution, and one that will likely (and deservedly) end up being published in a leading scholarly journal.  I can personally vouch for the high intelligence and research integrity of the two U.S. authors.  Raj Chetty was named a MacArthur “Genius” earlier this year, and is widely expected to be awarded the prestigious John Bates Clark medal sometime in the next 6-8 years.  John Friedman of Harvard is also an emerging research star in the economics profession.

So, the researchers are top notch, the study is extremely well done, and the conclusion is that tax subsidies do not generate net much net savings.  So, why not simply eliminate the tax preference for 401(k) plans in the U.S. and raise a trillion dollars of revenue over the next decade?

Because of the important role of plan sponsors, that is why.

For better or for worse, the employer plays a central role in the U.S. retirement system.  Although there are several reasons that employers offer retirement plans and other employee benefits (e.g., to differentially attract certain types of workers, to help manage retirement dates, to motivate workers, etc.), there is little question that the large tax subsidy  looms very large in their decision to use retirement plans – as opposed to other types of benefits – to achieve these outcomes.

To qualify for favorable tax treatment, employer provided retirement plans, including the 401(k), must meet a long list of “plan qualification requirements.”  These requirements are what provide Congress and regulators the ability to influence the design of retirement plans.

An important example is the set of “non-discrimination rules” designed to ensure broad-based participation in an employer’s plan.  These rules provide incentives for plan sponsors to find innovative ways of encouraging saving by their employees.  Indeed, it is not much of a stretch to suggest that these rules are the reason we have seen the widespread adoption over the years of employer matching contributions, automatic enrollment, automatic escalation of contributions, and numerous other innovations in the retirement plan space that have been shown to increase saving.

The authors themselves note that “automatic enrollment or default policies that nudge individuals to save more could have larger impacts on national saving at lower fiscal cost.”  I agree that behavioral nudges have had an enormous impact.  But in an employer based retirement plan system, the only way to get employers to offer those nudges is to provide them with a compelling financial reason to do so.  In essence, tax subsidies are the nudge for employers to provide the nudge for employees.

Of course, this does not necessarily mean that the existing system should be treated as sacrosanct.  It may be that employers would continue to offer 401(k)’s – along with their numerous savings nudges – if the financial incentive were provided in a less expensive way (e.g., by capping deductibility).  That is a debate we ought to have (hopefully informed by evidence of the same high quality as the NBER study).  My point is simply that any policy discussion should recognize the very important role that employers play as trusted sponsors of the plan, and be careful not to throw out the baby with the bathwater.

Indeed, given that only about half of US workers have opportunities to save through their current employer, we should be looking for ways to encourage more employers to sponsor plans.  If we go after the tax incentives for retirement saving, we must be careful not to inadvertently destroy the plan sponsor infrastructure that is the foundation of retirement security for millions of Americans.

Relevant Disclosures:  I am a Research Associate of the NBER (through which the study above was released) and Associate Director of the NBER Retirement Research Center (through which the authors have received some funding for their study).  I am also a trustee for TIAA CREF, a provider of retirement plans to the not-for-profit sector.  I have also received compensation as a consultant or speaker for a wide range of other financial services institutions.  The opinions expressed in this blog (and any errors) are my own.

I find myself bemused by the sheer number of commentators that have labeled vice presidential candidate Paul Ryan a “radical” because of his views on the federal budget.  His core view – that we ought to keep federal spending as a share of GDP at a level approximately equal to where it has been for the entire lifetimes of most Americans – strikes me as far less radical than the current policy status quo.

Let’s start with some basic facts.  In the post-war period in the U.S., federal spending has averaged just under 20 percent of GDP.  (You can confirm this for yourself by going to the White House OMB site and downloading Table 1.2).  There have clearly been some ups and downs over this period for a variety of reasons, but it has never exceeded a quarter of GDP except for 2009 – the depths of the Great Recession – when outlays reached 25.2% of GDP.

In other words, for 60 years – through military conflicts great and small, through booms and busts, through the creation and demise of countless government programs, and through tectonic shifts in the global economic landscape, the U.S. has found it possible to keep government at about 20% of GDP.  And throughout this period, the economic engine of the U.S. remained the envy of the world, even now in the aftermath of the Great Recession.

Absent substantial changes to our public policies, however, U.S. government spending as a share of GDP is projected to rise at an unprecedented rate.  According to the CBO’s “extended alternative fiscal scenario,” which they describe roughly as a continuation of current policies, spending as a share of GDP is projected rise to 35.7% of GDP in just the next 25 years.  This seems to me to be prima facie evidence that our future fiscal problems are being driven by rising spending, rather than a lack of revenue.

Given this, what sounds more radical?  Suggesting that we make cut the growth rate of spending to keep the ratio of government-to-GDP near historical levels, as Paul Ryan has suggested?  Or allowing government to grow from 20% to over 35% of GDP?

Google’s definition of radical is “affecting the fundamental nature of something.”  A failure to change policy course would affect the fundamental nature of the U.S. economy.  Now that is radical.

If we want to avoid this, then we need to re-think the role of government.  Most of the future projected growth of government is due to a rising health care costs and an aging population.  One cannot slow rising health care costs and population aging simply by cutting spending, as any serious student of the budget – of which I consider Paul Ryan to be one – already knows.  Nor is it obvious we really want to stop all those trends – at least some of the rise in health spending brings new health benefits, and most of us are quite happy to live longer.

What we can do is recognize that our programs need to change with the times.  Remaining life expectancy today, conditional on reaching age 62, is about 50% longer than it was in the 1960s.  Yet we continue to encourage people to exit the labor force early.  Even worse, we have created a mentality where most Americans seem to believe that they have a God-given right to have their retirement income and health care expenses paid for by taxpayers after they reach age 62 or 65.  At a minimum, we should recognize that if people are living both longer and healthier lives than they were in decades past, we ought to make them wait longer to start receiving benefits.

There are good reasons to have Social Security and Medicare.  But we need to recognize that the fiscal burden they are placing on taxpayers is going to grow rapidly in the years to come, and that the best way forward is to reform them to make them sustainable for future generations.  Paying for these rapid cost increases through an inefficient tax system that depresses investment, discourages entrepreneurship, penalizes work, and retards economic growth is the real “radical” solution – and the one that should work hard to avoid.

Today’s Wall Street Journal carried a piece called “Should Tenure for College Professors Be Abolished?”  It pitted two individuals with strongly held views against each other on the issue.  As so often happens when people are advocating rather than analyzing, both sides selectively examined the issue.

In favor of abolishing tenure, the WSJ featured Naomi Schaefer Riley, a critic of the tenure system who appears to believe that teaching is the only worthwhile activity in which academics engage.  It was a bit ironic for me to read this on a day in which I am sitting at an academic conference on consumer financial decision-making in Boulder, exchanging ideas with some of the nation’s top scholars from a diverse set of fields (including law, economics, marketing, psychology, law and public policy) regarding new research that is both widely read and enormously impactful in the real world.  As but one example, the conference was kicked off yesterday by Shlomo Benartzi at UCLA, who reminded audience members how academic research led to a revolution in retirement policy in the U.S., improving the retirement security of millions of Americans by increasing participation and contribution rates to 401(k) plans by leveraging the insights of psychology and behavioral economics.  Apparently, Ms. Riley does not believe that such activities add much value and that we academics should just stay on campus and teach.

Defending the tenure system was Dr. Cary Nelson, an English professor at my own academic institution (the University of Illinois) and President of the American Association of University Professors.  Dr. Nelson seems to believe that tenure is “the ultimate quality check” and that academic freedom would crumble if people were not granted lifetime tenure.  I am unaware of any compelling evidence supporting such claims, although I cannot refute them either.

As an economist, I think that both authors – neither of whom I found particularly persuasive – missed an obvious way to frame this issue.  Namely, tenure is a form of insurance.  And like any insurance, it has both positive and negative effects.  Here are a few:

1. Tenure reduces the cost of hiring faculty.  Tenure – insurance against job loss – is highly valuable, and therefore substitutes for other forms of compensation. In a competitive labor market (and, contrary to what many non-academics believe, the market for faculty is extremely competitive), tenure means that institutions do not have to pay faculty as much in the form of cash or benefits.  If we abolish tenure, the new market equilibrium would result in higher average salaries, thus further increasing the cost of education.
2. Tenure creates moral hazard:  Moral hazard is the well-established phenomenon that people behave differently when they have insurance than when they do not.  Because tenure provides insurance against the loss of a job  – in spite of Dr. Nelson’s protests to the contrary – tenure can have the effect of making some faculty members reduce effort.

To be clear, I honestly do not believe this reduction in effort is the case with the vast majority of the tenured faculty members that I know – in fact, most of us lament the fact that, post-tenure, our work hours and the demands on our time increase.  Indeed, I think the selection effect is huge – gaining tenure is so difficult at the top institutions that the only people who make it are, by their nature, extremely driven individuals.  Most of these people do not shut-down after tenure – it is simply not in their DNA.  So, one way to view the tenure process is that it creates enormously strong incentives to excel for during the probationary, pre-tenure period (that typically lasts anywhere from 6-10 years).  This is not all that different from many partnerships – law firms, accounting firms, etc. – that work their junior associates to the bone in exchange for eventually becoming a partner.  I am not suggesting that partners have indefinite tenure, only that the incentive effects early in one’s career make untenured assistant professors some of the hardest working people I have ever met.

However, although it is the exception rather than the norm, all of us in the academy know members of the faculty – thankfully, far fewer in numbers than most non-academics imagine – that take advantage of their protected status by slacking.  Their research productivity declines, they spend less time preparing for classes, and they are less engaged in their departments and professions.  This “dead wood” – while not exceedingly common – is exceedingly costly when it occurs.  Most of us in universities would love to rid ourselves of this problem.

I may be in a minority of faculty, but I would personally not mind having a conversation about abolishing tenure and replacing it with a system of, say, 5-year renewable contracts, but not for the naïve and misguided reasons that Ms. Riley states.  Rather, I believe that for the highly productive among us, our salaries would increase and we would have an effective tool for eliminating the deadwood in our ranks.

Granted, the “tenure as insurance” framework is far from the only set of factors that ought to be considered.  Some of the issues raised by Ms. Riley and Dr. Nelson – how tenure affects risk-taking, teaching quality, and so forth – are incredibly important considerations.  It would just be nice to have some solid empirical evidence on the size and direction of these effects before taking a final stand on the issue.  Until I see it, I am going to head back downstairs to the behavioral decision-making context to see some of the research that I honestly believe is going to help improve lives.

I have written numerous blogs about the frustration that the financial economics community has with the Government Accounting Standards Board (GASB) rules that govern the way we account for public pension liabilities in the U.S.  The basic problem is that GASB standards do not account for risk in an appropriate way (in fact, they do not really account for it at all!)  Instead, they allow public plans to under-state the size of their liabilities by acting as if they have a risk-free approach to investing money at approximately 8 percent per year forever.

On occasion, someone will ask me if this is really just an accounting issue, or whether it actually has real effects on real-world behavior.  Although I can give countless anecdotes for why it affects real behavior, it is always better when a highly respected and disinterested party can provide rigorous empirical evidence to support the claim.

Well, now we have such evidence.   Just last month, three financial economists (Andonov, Bauer and Cremers) publicly released a rigorous new research paper entitled “Pension Fund Asset Allocation and Liability Discount Rates: Camouflage and Reckless Risk Taking by U.S. Public Plans?”  In this paper, the authors use an international database to look at the asset allocation decisions and discount rate assumptions of both public pension funds and non-public pension funds in the U.S., Canada and Europe.  What is particularly nice about this paper is that it is able to show what outliers U.S. public plans really are.  Not only do they look quite different from corporate DB plans in the U.S., but they also look different from both public and non-public plans in other countries.

Specifically, the authors state that “U.S. public funds seem distinct in that they can decide their strategic asset allocations and liability discount rates largely without much regulatory interference, due to wide latitudes allowed in the currently applicable Government Accounting Board (GASB) guidelines. In particular, these guidelines link the liability discount rates of U.S. public funds to the (assumed) expected rate of returns of the assets, rather than to the riskiness of the liabilities as suggested by economic theory.”  As I have written before, this is an intellectually vacuous approach to discounting.  What I had not fully realized is how unique this mistake is to U.S. public plans.  The authors go on to state that in Canadian and European funds – both public and private – liability discount rates are “typically … a function of current interest rates,” an approach which (assuming the interest rate is chosen appropriately) is much more in line with basic economic theory.

The most striking finding is the impact that this difference in accounting has on real behavior.  The authors find that “in the past two decades, U.S. public funds uniquely increased their allocation to riskier investment strategies in order to maintain high discount rates and present lower liabilities.”  This really is a case of the tail wagging the dog – by allowing an intellectually flawed approach to discounting to be codified in GASB standards, we have provided incentives for public pension fund managers and their boards to over-invest in risky assets.

There are many losers from GASB-induced deception.  Public workers end up with less-well-funded pensions.  Taxpayers end up bearing financial risk without realizing it.  Investors in public debt are given inaccurate information about the size of the pension liabilities.  Isn’t it time that we fix this?

After a week of legislative wrangling that had more twists and turns than Hawaii’s famous “Road to Hana,” the Illinois General Assembly failed to come to agreement last week on a pension reform package in time for yesterday’s May 31 deadline.  As a result, they will return to Springfield – possibly this week – for a special session facing an even larger hurdle for passing reform legislation: by Illinois law, bills passed after May 31 require a three-fifths vote rather than a simple majority.

Agreement fell apart over the issue of who should pay for the “normal cost” of future public pension accruals.  “Downstate” lawmakers objected to shifting all of the costs onto school districts, public universities and community colleges on the grounds that this would lead to higher property taxes to fund teacher pensions and do grave damage to the ability of our university system to compete for academic talent.  Once Democratic Governor Quinn agreed to pull this cost-shifting out of the bill, Democratic House Speaker Mike Madigan withdrew his support of the bill.

As I wrote this past Wednesday, one of the grave concerns I have about the leading proposals is that so many of our elected officials seem perfectly content to shift all of the costs onto universities and school districts while maintaining legislative control over the design of the benefits package.  This is a mistake on so many levels.  The separation of responsibility and control is a recipe for fiscal shenanigans.  It is also highly disrespectful of the employer-employee relationship that Bob Rich and I wrote about in our pension reform proposal earlier this year.  

Although I still like the plan that Bob Rich and I put out, it seems clear that the General Assembly has gone another route.  But given that they are stuck on the cost-shifting issue, I thought it might be useful to put forth a more radical proposal that would respect the constitutional constraints, appropriately align the incentives of all the affected parties, respect the employer/employee relationship, and still save the state billions.  Perhaps most importantly from a political perspective, it might overcome the cost-shifting stalemate, because it shifts the costs but offers something very valuable in return.  This proposal would apply to those institutions – such as school districts, universities and community colleges – that, while public, are not part of the state government apparatus itself.  

While “radical,” the idea is deceptively simple.  Here it is in 4 simple steps:

1.       The state agrees to pay 100% of all pension benefits that have been accrued by public sector retirees and current workers as of 7/1/2013.  Whether the state wishes to do this by paying down the amortized unfunded liability, or simply provide the cash as need to pay benefits, is immaterial, so long as they respect the constitutional guarantee and pay it.  Not only does this respect the constitution, but it would also be fair to the generations of workers and retirees who consistently paid their share to the pension fund while the politicians enjoyed their “pension funding holidays.”    

2.       The existing public pension plans – for example, TRS and SURS – are closed to all further accruals as of 7/1/2013.  No new benefits will be earned under any of the plans.

3.       Going forward, each state employer is given 100% autonomy – free from the shackles of state regulation and political interference – to construct a benefits package that is optimally designed for its own employees.  In order to comply with federal law that applies when a state like Illinois opts out of Social Security, each employer would be required to provide a retirement package that is at least as generous as Social Security.  Beyond that, it would be up to each employer to determine the optimal mix of wages, pensions, and other employee benefits that would be required to attract, retain, motivate, and manage the retirement of their workers.  If similar employers wished to joint together as a group (e.g., all community colleges) to provide a common pension plan, or if unions wanted to provide multi-employer pensions funded by a group of employers, they would be permitted to do this.  But if the University of Illinois decided that its needs differed sufficiently from other public universities, they would have the freedom to go their own way.  

4.       The state would agree to a pre-determined, annual “block grant” (basically, an extra appropriation) to each employer that would start out as an amount equal to the “normal cost” of providing pensions, and would gradually decline to zero over a 20-year period of time.  This would slowly shift the entire financial burden of providing pensions from the state to the employers themselves.  

In essence, this plan calls for 100% cost-shifting, but with two critical differences relative to the reform package being debated last week.  First, and most importantly, it accompanies the cost-shifting with a freedom from political interference.  Second, it spreads the cost-shifting out over a much longer period of time (twenty years instead of approximately eight or so) in order to ensure that employers can adapt.

If there is anything I have learned from observing our Illinois state government in action, it is that it cannot relied upon to design a sensible pension package that is fiscally sustainable, credible to employees, and meets the diverse needs of our public employers.  So if they are so eager to get out paying for pensions, let’s take this idea all the way – aside from atoning for their past sins by making good on constitutionally guaranteed promises that they have so far failed to fund – let’s have the state get out of the pension business altogether.  

Doing so would free employers and employees from being subject to the unpredictable whims of the states’ politicians.  And that freedom, it seems to me, is priceless. 

After last night’s somewhat surprising announcement that Speaker Madigan has agreed to the Governor’s request to remove from the pension reform legislation the provision that would have shifted normal costs onto school districts, universities and community colleges, it now appears that particular provision is dead.  Along with it, it appears that the ability of employers to replace the inadequate Tier II pension (for those hired after 1/1/11) wit a new cash balance plan is also dead.

The main provision of forcing a possibly unconstitutional choice between giving up one’s cost-of-living adjustments after retirement or giving up retiree health insurance, however, is still intact.  As is the provision that would freeze pensionable earnings for those that want to keep their current COLA.  And, rumor has it, the legislature is looking for other ways to save costs as well … so look for some additional benefit changes in the final package.

Also, people who don’t work with compound versus simple growth rates on a daily basis may not realize just how big the COLA changes are.  So here is a simple but useful example.  Suppose someone retires at age 60 and lives until age 85.  Under the current law, they receive 3% COLA each year compounded.  Under the proposed law, they get a 0% COLA for the first 5 years, followed by half of inflation or 3%, whichever is less.  If inflation runs at 3% per year, this is a 1.5% non-compounded (i.e., simple) interest.

This may not sound like much.  But don’t be misled — at age 85, this person’s pension would be 37% LOWER UNDER THE PROPOSED LEGISLATION.  If we compute a present value using a 4-6% nominal discount rate, it is a 20% reduction in lifetime pension payments.  This is why the proposal saves so much money.  It is also why it is pretty clearly an impairment or diminishment of benefits!

The Illinois General Assembly stands on the verge of passing an historic public pension reform.  After many decades of serial underfunding, the legislature and Governor have finally agreed to act.  The news for taxpayers is primarily good: through a combination of cost reductions and cost shifting, the public pension fiscal drain on state revenue is being substantially reduced.  This is welcome news in a state with a fiscal situation as dire as Illinois’.

Although the reform provides substantial cost savings to the taxpayers of Illinois, it also comes at significant costs.  In this post, I want to draw three big picture lessons from this reform.  I will post additional material on more detailed features of the reform in the coming days and weeks.

Lesson 1:  Constitutional Benefit Guarantees Don’t Always Protect Participants

Sensible public pension reform in Illinois has been hamstrung by the fact that we are one of the few states whose constitution contains a clause guaranteeing that retirement benefits for public workers cannot be “diminished or impaired.”  In a well-functioning system, the existence of this guarantee would have two beneficial effects.  First, it would lead to better funding (“we had better fund it, because we are going to have to pay it!”)  Second, it would cause workers to fully value the pension benefits being provided: thus, in a competitive labor market, wages would adjust to reflect the value of the pension, and thus the compensation package would be economically efficient.

But Illinois is far from a well-functioning political system.  Thus, what the constitutional guarantee brought us was: 1) Four decades of under-funding: if benefits are guaranteed, why should workers care about funding?  2) The inability to reform the system in a logical, sensible way. 

The constitutional prohibition against benefit impairment took “off the table” a whole host of sensible reforms, including my favorite: raising the retirement age to qualify for full benefits.  Instead, politicians were forced to play a game of “pension Twister,” contorting policy in all sorts of ways to find a way of cutting benefits that might pass constitutional muster.  Sadly, despite all of these contortions, many of us believe that the Courts are still likely to strike down this reform – on this issue, see yesterday’s post by my colleague Nolan Miller. 

Lesson 2:  Separating Responsibility and Control is a Bad Idea

The world is full of bad behavior that results when the entity with the power to make decisions is not the same entity that bears financial responsibility for the results.  In the case of Illinois, this issue manifested itself historically through the fact that universities, community colleges, school districts and other public employers were able to make hiring decisions without any responsibility for the pension liabilities that those decisions created. 

Post-reform, we will have a different manifestation of this problem.  The Illinois legislature has – after a relatively brief phase-in period – absolved itself from any further financial responsibility for future public pension accruals.  The funding of all “normal costs” will gradually be transferred entirely to the institutions themselves.  The problem is that Illinois politicians did not also grant these same institutions the power to design and implement their own retirement plans.  In short, the Illinois politicians still get to design the system – the universities and school districts just now have to pay for it.  Although there are a few safeguards being put in place to guard against the most egregious abuses of this new regime, I predict it will not take long for the state to find a way to curry favor with some voting block and pass the cost onto the employers.

Lesson 3:  Public Sector Accounting Rules Really Do Matter

I have blogged extensively about the many flaws of the public pension accounting standards promulgated by the Government Accounting Standards Board (for some examples, see here, here, here and here).  GASB allows public pensions to discount future liabilities with an inappropriately high rate, thus understating the real scope of the problem by ignoring risk. 

Unfortunately, these flawed GASB standards framed the Illinois debate, and in so doing has had the effect of 1) over-stating the extent to which the state is going to do penance for its past sins of historical under-funding, and 2) under-stating the real size of the liability being pawned off on the universities, colleges and school districts throughout the state. 

The hardest hit by this provision will be those employers – such as the flagship campus of the University of Illinois at Urbana-Champaign (UIUC) – that compete in a global labor market for talent.  If UIUC wishes to maintain its position as one of the leading public research universities in the nation, it will have to continue to provide a competitive compensation package: but it will now being doing so with virtually no assistance from the state.  The even worse alternative would be to watch its best and brightest faculty and staff members run for the exits.

Public pension reform was badly needed in Illinois, and our elected officials ought to be congratulated for having the political will to undertake it.  Unfortunately, I fear that they botched the substance of reform. 

Of course, none of this may matter – I still believe there is a greater than 50% chance that the Illinois courts will overturn it. 

Here is hoping they get it right the next time around …