Brief Update on Illinois Pension Reform

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on May 31, 2012

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!


Three Hard Lessons from Illinois Public Pension Reform

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on May 30, 2012

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 …

Making Sense of the 2012 Social Security Trustees’ Report

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Apr 24, 2012

Yesterday, the Trustees of the Social Security and Medicare Trust Funds issued their annual report on the financial status of these entitlement programs.  These annual reports have been published for decades, and are generally recognized as the most credible, unbiased, and objective assessment of the long-run financial situation facing these programs.  I am going to focus on the Social Security program in this post.

Interest groups and policy analysts from across the political spectrum immediately issued press releases trying to spin the findings of the report.  Here are the first two that crossed my virtual desk yesterday:

The National Academy of Social Insurance (of which I was a member for many years before finally resigning over frustration at their defense of the status quo) issued a release spinning the report in the most positive light possible:  The 2012 Trustees Report shows that Social Security is 100 percent solvent until 2033, but faces a moderate long-term shortfall. In 2011, Social Security had a surplus – revenue plus interest income in excess of outgo – of $69 billion. Reserves are projected to grow to $3.1 trillion by the end of 2020 … While the trustees’ projections indicate that major changes are not needed, modest changes should be made in a timely manner and can bring Social Security into long-term balance.

In sharp contrast, the Committee for a Responsible Federal Budget issued a release stating:  “Today, the Social Security and Medicare Trustees released their 2012 report on the financial status of Social Security and Medicare, showing that reforms will be needed soon to make these programs sustainable … Social Security as a whole is on an unsustainable path … Social Security’s financial status has deteriorated significantly since last year’s report … Currently, Social Security is adding significantly to unified budget deficits. Not counting the payroll tax holiday this year and last year, the program is projected to run a $53 billion deficit in 2012 and $937 billion from 2013 through 2022.”

Both NASI and CRFB are highly respected organizations, yet the pictures they paint could not be more different.  So, who is right?  Is it possible to reconcile these two views?

Like last week’s post, in which I tried to cut through the rhetoric over the cost of the Affordable Care Act, this post tries to cut through the rhetoric over Social Security’s finances by using a fictitious debate.  And just like last week, the answer to “who is right?” is “It depends …”

Let’s focus on what appears to be a factual disagreement.  NASI says “In 2011, Social Security had a surplus.”  CRFB says “Social security is adding significantly to unified budget deficits.”

How can the program be running both a surplus and adding to the deficit?

The answer is that it depends on whether you think about interest on the Social Security trust funds as being income or not.  One’s views about the Trust Funds also help shed light on whether we should view Social Security as being in financial distress now (the CRFB view), or whether we still have two decades before we have any real problems (the NASI view).

How does the Trust Fund work?  (For this post, I am going to ignore the distinction between the retirement and disability trust funds – implicitly, I am assuming that Congress will simply re-allocate the payroll tax revenue across the two programs, as they have done in the past when needed).

Let’s go back a few years to the pre-financial crisis, say, 2007.  Suppose you earned $50,000 that year.  You and your employer each paid 6.2% of payroll into the system, for a total of 12.4%.  This was approximately $6,200 that the U.S. Treasury collected, and this money was designated for the Social Security Trust Fund.

Social Security took most of that $6,200 (just to keep that math easy, let’s say they took $5,200 of it), and paid it out to current retirees and other beneficiaries (such as disabled workers, widows, etc).  The remaining $1,000 was not needed in that year, so it was handed back to the U.S. Treasury.  In return, the U.S. Treasury issued a $1,000 special-issue U.S. Treasury bond to the Social Security trust funds.  Like other U.S. Treasuries, this one was backed by the full faith and credit of the U.S. government.

Now, back in 2007, like in most years in recent history, the U.S. government was running budget deficits.  Thus, the Treasury department basically took your $1,000 and used it to finance the government spending that we were doing in excess of the income tax revenue we were bringing in.  They did not actually invest the money in financial securities – rather, they spent it.  Of course, they still owe the $1,000 to the Social Security trust fund.

This has been going on for about three decades.  As a result, the Social Security trust fund now owns several trillion dollars’ worth of government bonds.  And the U.S. Treasury pays the trust funds interest on these bonds.

Today, to a first approximation, the entire $6,200 that a $50,000 per year worker and her employer pay into the system is all going to pay benefits.  So there are no more new deposits to the trust fund.  But the balance of the account is quite large, and is spinning off interest.

So here is the key question.  Should the interest that Treasury is paying to the Social Security trust funds be counted as income?  Here is how a discussion might go between NASI and CRFB representatives.  (Any misrepresentations of views are mine alone).

NASI: “Of course the interest should count as income.  The interest grows the trust funds, and the trust funds represent a legal claim by the trust funds that will be backed by the full faith and credit of the U.S. government.”

CRFB: “Yes, but while these bonds – and their interest – represent an asset to Social Security, they are a liability to the U.S. Treasury.  And because the Treasury spent that money rather than saving it, it is crazy to think that we should count this as income.  The interest payments are just an accounting fiction, not a real flow of money into the government as a whole.”

NASI:  “Ah, but the trust funds do represent real savings.  If the Treasury had not issued this debt to Social Security, they would have had to increase public borrowing.  So the Trust Fund balance represents money that the U.S. did not have to borrow – and that is a form of saving.”

CRFB: “But for decades, Congress used the Social Security surpluses to hide the deficits in the rest of the government.  As a result, Congress spent more money over the past few decades than they would have if they had not been able to hide the true cost of their profligacy behind a unified budget framework.”

NASI: “There is no way to know for sure that the Social Security surpluses led to increased spending by Congress.”

CRFB: “Ah, but there is – at least two academic studies (here and here) have shown that this is exactly what happened.”

NASI: “Academic studies aside, there is no question that we should count this interest.  And if we do count it, it is clear that Social Security is running a surplus.  It is also clear that the program can pay 100% of promised benefits at least until 2033.”

CRFB:  “But that is a narrow perspective.  We care about the government budget as a whole – not just the narrow question of the Trust Funds.  From that perspective, what we know is that the amount of money we are collecting in payroll taxes today is no longer enough to cover the payments to beneficiaries.  The days of cash flow surpluses are gone.  And because interest on the trust fund is just one arm of government (Treasury) making a paper transfer to another arm of government (the Trust Funds), this does not represent real income to the government as a whole.  As such, the program is in dire straits, and needs to be fixed now.”

That fictitious debate roughly captures the economic disagreement underlying these two very different assessments of the latest Trustees’ Report.

I happen to support the CRFB view that the problem is serious, that we need to address it sooner rather than later, and that there is no pain-free solution.  But at the end of the day, it is impossible to fully refute the NASI view because we cannot go back in time and re-run an alternate history to know how spending would have responded in the absence of past Social Security surpluses.

Regardless of which view one holds, it is becoming increasingly difficult to deny the existence of a financing problem.  Even if you take the NASI view that we do not have a problem until the trust funds run dry in 2033, it is worth noting that this date is quite a bit earlier than what has been previously estimated.  Furthermore, 21 years is not a very long time when we are talking about a retirement program.  After all, nearly half of today’s 65-year olds will still be alive in 2033 and relying on Social Security benefits.  Today’s 46-year olds will reach their normal retirement age in 2033.  And today’s college students will be nearly half-way to their own retirement age.  We need to make changes now – so that we have time to phase-in the changes gradually and to allow individuals to adjust.

So, regardless of one’s views about the trust funds, it seems obvious to me that the real story behind the release of the Trustees’ Report is that the problem is real, it may be larger than we previously thought, and that it is not going to go away on its own.

Making Sense of the War of Words over the Cost of Obamacare

Filed Under (Health Care, Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Apr 18, 2012

A war of words (and numbers) has broken out in the policy wonk world over the effect of Obamacare on the deficit.  It is important, entertaining, and confusing.  This blog attempts to bring a bit of clarity to the debate.    

 It began last week with an article, written by Charles Blahous and issued by the Mercatus Center, that argued that Obamacare increased the deficit.  The piece was discussed in the Washington Post (and on my blog) on the day it was issued.

It took almost no time at all for Paul Krugman to denounce the study.  He first began, in typically unfortunate fashion, by attacking the credibility of the author through a suggestion that Blahous was just another Koch-funded crazy who should not be believed.  He then went on to make a slightly more substantive argument about the fact that Blahous’ result rested upon a view (that Krugman called “bogus”) about what Obamacare spending should be compared with.

Blahous publicly responded, defending his position.  A few days later, former CBO Director and former OMB Director Peter Orszag joined the broadside attack against Blahous.  Peter also joined in the credibility attack and went on to also attack Blahous’ choice of baseline. 

So who is right?   The point of this post is to try to provide a bit of clarity on the issue. 

Before proceeding, I should disclose my own personal biases.  First, I consider both Chuck Blahous and Peter Orszag to be personal friends – and I believe both would agree with that assessment.  I have known and worked with both of them for over a decade.  I have an incredibly high level of respect and admiration for both Chuck and Peter as public servants, as intellectuals, and as individuals.  This is not the first time they have publicly tangled (they did so frequently over Social Security reform).  Ideologically, I almost always find myself on the same side of issues as Chuck.  But Peter is an outstanding economist, and when his views are also echoed by other highly respected economists like David Cutler of Harvard (one of the most highly respected health economists in the world, who engaged in a debate with Chuck on my Facebook page), I often find myself temporarily in a state of cognitive dissonance.  When this happens, I try to figure out the core reason for the disagreement.  Is it different values (e.g., perhaps one cares more about redistribution and the other more about economic efficiency)?  Is it different assumptions (e.g., fundamentally different views about how the politics will play out or on how future health costs will evolve?)  In such cases, two very smart people can disagree on policy, without either being “wrong.”

But this debate seems different.  This is – or at least should not be – an ideological debate.  The question here is deceptively simple.  It is a debate over a “fact.”  Either Obamacare increases the deficit, or it does not. 

So who is right?

The correct answer is “it depends.”

To understand the long-term effect of any public policy change, one must first ask the question “compared to what?”  And this is where Blahous and Krugman/Orszag differ.

The following is a FICTITIOUS conversation between Blahous and his critics.  I am trying to be clear on their views.  The material in “quotes” is taken from their writing.  The rest is my own attempt to explain their views, and I alone am responsible for any misattributions.  The Orszag quotes can be found hereThe Krugman quotes are here.  Blahous’ views can be found in his original paper, his follow-up post on Forbes, and a new post at E21.  The use of the term “Obamacare” is mine.    

Me:  “If I look at the new spending programs under Obamacare, and compare that to any spending reductions or tax increases under Obamacare, does the program increase or decrease the deficit?”

Blahous:  Over the next ten years, the increases in spending from Obamacare – Medicaid/CHIP, new exchange subsidies, making full Medicare benefit payments for an additional eight years, etc. – exceed the ways that it reduces spending or raises taxes by $346 billion through 2021.  (This is based on a CBO projection of $352 billion adjusted slightly by Chuck.)

Krugman:  This is just “another bogus attack on health reform.”

Orszag:  Indeed.  The cost savings exceed the new costs by $123 billion through 2021.   

Blahous:  But you are both ignoring the cost of extending the solvency of Medicare!  One of the effects of Obamacare is to extend our full financing commitment to Medicare through 2024.  This costs money.  Add up all the things the legislation does, and it is $346 billion more than the legislation’s cost-savings.

Orszag:  This is a “trick.”  The Blahous analysis “begins with the observation that Medicare Part A, which covers hospital inpatient care, is prohibited from making benefit payments in excess of incoming revenue once its trust fund is exhausted. He therefore argues that the health reform act is best compared to a world in which any benefit costs above incoming revenue are simply cut off after the trust-fund exhaustion date. Then, he argues that since the health-care reform act extends the life of the trust fund, it allows more Medicare benefits to be paid in the future. Presto, the law increases the deficit by raising Medicare benefits.” 

Blahous:  Look guys, this is really simple.  Without the ACA, Medicare would have been insolvent in 2016.  Under the new legislation, we are making a binding commitment to make full benefit payments through 2024.  These are real payments to real people.  How can you ignore the extra commitments through 2024?  After all, you claim the Medicare solvency extension as one of the achievements of the ACA.

Krugman:  “OK, this is crazy. Nobody, and I mean nobody, tries to assess legislation against a baseline that assumes that Medicare will just cut off millions of seniors when the current trust fund is exhausted.”

Blahous:  But under a literal interpretation of current law – which is how most budget scoring is done in Washington – a law that extends Medicare for additional years would be scored as a cost.  Do you acknowledge that under a literal change in law, this legislation puts us $346 billion deeper in the hole? 

Krugman:  The literal law does not matter.  Everyone knows that Congress is not going to allow Medicare benefits to be slashed in 2016.  To suggest these costs are a cost of Obamacare is misleading.  “In general, you almost always want to assess legislation against ‘current policy’, not ‘current law’; there are lots of things that legally are supposed to happen, but that everyone knows won’t, because new legislation will be passed to maintain popular tax cuts, sustain popular programs, and so on.

Blahous: But we have to abide by these budget rules in other contexts.  For example, let’s look at the Alternative Minimum Tax. The Congressional Budget Office counts the revenue from the AMT in its baseline budget projections, even though it knows full well that Congress is likely to continue to provide AMT relief before that revenue is collected.  Similarly with the “doc fix” in Medicare!

Orszag:  Yes, but by your logic, if we just assume that Medicare benefits are cut when the trust fund runs dry, or that Social Security benefits are cut when its trust fund runs dry a few decades later, then we do not have a long term budget problem!  Indeed, Chuck, you are “far too modest. The government is not legally allowed to issue any debt above the statutory limit, so (you) should have assumed the deficit would disappear when we reach that limit at or around the beginning of next year.”

Blahous:  Look, when you make Medicare benefit payments, real money leaves the US Treasury.   We can’t send the same check to Medicare and to Medicaid.  If you want to take credit for all the benefits of the ACA – one of which was to extend Medicare – then you have to account for the Medicare commitments as well as the Medicaid ones.  Even if you don’t think we would have allowed benefits to be suddenly cut, historically Congress has always enacted other savings to avert Medicare insolvency.  And, now that Medicare solvency is extended through 2024, the pressure on Congress to enact further savings is reduced.  So it’s not only as a matter of literal law but as a matter of practical budgetary behavior that the ACA worsens the outlook.  No matter how exactly you think things would have played out under prior law, this legislation still worsens deficits by $346 billion relative to prior law.

Krugman:  Don’t believe any of this.  The Mercatus Center is funded by the Koch brothers.  The Koch brothers, by golly!!

Blahous:  Look guys, I am trying to make a real point here, not engage in character assassination.  If carried to its logical conclusion, this is not only a departure from interpreting actual law, it is also fiscally dangerous.  You guys are basically saying that there are no prior law restraints on Medicare spending.  So every time we extend the program’s solvency, it does not cost anything!  

Me:  Okay, guys, thanks for clearing that up.  I understand it all so much better now. 


So there you have it.  A knock-down, drag-out battle over budget baselines.  The debate is not over the cost of things like the coverage mandate.  It is a debate over the proper way to account for an extension of Medicare’s solvency. 

To summarize:

Relative to a world where Medicare expenditures are brought into balance with revenues within the next few years (which does appear to be required under the literal reading of current law), ACA increases Medicare expenditure and the deficit.  This is the Blahous view.   

Relative to a world in which we project current practice forward, ACA reduces Medicare expenditure and the deficit.  This is the Krugman and Orszag view. 

I think most reasonable people can understand both points.  And I don’t think this really calls for name-calling and credibility-questioning.  But in Washington, that is what passes for debate.

Most ordinary people probably think that what we should be doing is making some cuts, but not cut so deeply as to eliminate the entire Medicare shortfall.  If so, the effect on the deficit is better than if we did nothing, but worse than if we solved the problem. 

So most people probably think the “truth” (whatever that means in this context) lies somewhere in the middle.

How the Supreme Court can Reduce the Deficit: The Fiscal Impact of Ending Obamacare

Filed Under (Health Care, U.S. Fiscal Policy) by Jeffrey Brown on Apr 10, 2012

West face of the United States Supreme Court b...
(Photo credit: Wikipedia)

Last week’s U.S. news was dominated by the oral arguments before the Supreme Court of the United States (SCOTUS) on the constitutionality of the Patient Protection and Affordable Care Act (PPACA), also known more succinctly as the Affordable Care Act (ACA), or, simply, “Obamacare.”  Most of the news coverage revolved around legal issues, such as how to define a “limiting principle” that would distinguish health insurance from other goods and services.  A few of those analyses, including one by my colleague Nolan Miller at the University of Illinois, provided useful economic insights on these legal questions.

But what I have not seen much of – until now – is a careful analysis of the impact of repeal on the federal budget.  Yes, there is plenty of rhetoric around this topic, with Democrats arguing that PPACA saved money and Republicans arguing that it created a huge new entitlement.  But there has been very little careful analysis.

That changed today, when the Mercatus Center at George Mason University released a meaty new report written by Charles (“Chuck”) Blahous.  His analysis shows quite clearly that the Supreme Court now finds itself in the position of having an enormous impact on the long-run fiscal situation in the U.S.

As background, Chuck Blahous is one of two public trustees of the Social Security and Medicare trust funds, having been appointed to this post by President Barack Obama and confirmed by the U.S. Senate.  Previously, Chuck served all eight years of the G. W. Bush administration at the National Economic Council.  After spending over two decades in both the legislative and executive branches of the U.S. government, Chuck knows the ins and outs of federal budgets.  He is also widely respected on both sides of the aisle as a serious policy analyst.

In a nutshell, here is what Chuck’s careful analysis finds:

  1. PPACA is expected to increase net federal spending by more than $1.15 trillion over the next decade.
  2. PPACA is likely to add more than $340 billion, and perhaps as much as $530 billion, to federal deficits over the next decade.
  3. Despite these realities, government scorekeeping rules lead to deep confusion over the fiscal impact, and have the effect of making PPACA appear less expensive than it really is.

How can this be?  In part, the law “relies upon substantial savings already required under previous law to maintain the solvency of the Medicare Hospital Insurance (HI) Trust Fund.  These do not represent new net savings … but substitutions for spending reductions that would have occurred by law in the absence” of this act.  There are other issues at play as well.

All of this is “public,” in the sense that it has been disclosed in scoring documents by the Congressional Budget Office (CBO). But the CBO is constrained to report the effect of government tax and spending programs according to various scoring rules – even when those rules deviate substantially from the likely political or economic reality.  Skilled politicians have learned to use these scoring rules to their advantage.

As Chuck points out in his paper:

“A full understanding of the ACA’s budget effects requires appreciation of the distinction between two important points:

  1. CBO found that the ACAD would reduce federal deficits when a specific scoring convention was applied;
  2. The same analysis shows implicitly that the ACA would substantially increase federal deficits relative to previous law.

The paper is over 50 pages in length (including the helpful Q&A in the appendix), but is well worth a read if you want to know the details behind the calculations.

But if you don’t have time to read it, here is the bottom-line: “Taken as a whole, the enactment of the ACA has substantially worsened a dire federal fiscal outlook.  The ACA both increases a federal commitment to health care spending that was already unsustainable under prior law and would exacerbate projected federal deficits relative to prior law.  This is an unambiguous conclusion …”

Were the Supreme Court to strike down all or part of this Act, we should view it as an opportunity to revisit health care reform in a way that reduces, not increases, public spending.

The Risk of Ignoring Risk: The Case of Pensions

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Feb 29, 2012

Several news stories about pensions have crossed my desk in recent days, each of which made me realize how poorly the vast majority of individuals – even many highly educated individuals – understand financial risk.  It might not be so surprising if this lack of understanding was limited to the “general population.”  What is more surprising is how often highly educated financial market participants and regulators exhibit their ignorance of fundamental finance principles.  Unfortunately, these misunderstandings can have real consequences.

Let me give two examples.

Yesterday, a piece appeared on the Reuters MuniLand blog under the (confusing) title of “Greece is not Germany, and California is not Vermont.” In the piece, the author made the following statement, in which she refers to research by Joshua Rauh of Northwestern University:

“Rauh insists that when projecting pension fund returns, the interest rate for 10-year Treasuries must be used. Pensions do not allocate their assets 100 percent into Treasuries, though.”

This is an example where you can take two true statements, put them side-by-side, and end up with a false implication.  It is true that Joshua Rauh and his co-author Robert Novy-Marx use a Treasury rate to discount pension liabilities.  It is also true that pensions do not allocate their assets 100 percent into Treasuries.  The problem is that the second statement is 100% irrelevant to the first!

As any individual who receives a passing grade in my finance courses should be able to explain, the appropriate discount rate to use when computing the present value of a stream of cash flows depends on the riskiness (generally defined as the correlation of those cash flows with the market) of those cash flows.  In the context of pensions, the discount rate depends on the risk of the pension payments to beneficiaries.  In many states – such as Illinois and California – there are strong constitutional protections in place that make already-accrued benefits risk free.  Thus, what Novy-Marx and Rauh do in their research is to apply basic finance principles to come up with a more accurate measure of pension liabilities than what one gets from using official government statistics.  Cate Long fell into the same trap that so many others have – including the Government Accounting Standards Board (about which I have previously blogged here and here) – of thinking that the right discount rate is a function of the risk fo the assets, instead of the risk of the liabilities.  As a result, she – like GASB – completely ignores an enormous implicit put option that is being dumped onto taxpayers.  Her piece also contained other problems that are discussed Josh Rauh’s response.

A second example comes from the ongoing debate about pension funding policy for corporate pensions. In January, the American Benefits Council put out a press release (which you can read here) basically arguing for “relief” from fully funding pensions (“funding relief” is a political euphemism for not meeting the required funding obligations.)  At the core of the American Benefits Council’s case is that interest rates change, and that the result is that pension liabilities look “artificially high” when interest rates are “artificially low.”  What this argument ignores, however, is that any firm could choose – if they so desired – to nearly completely immunize themselves against interest rate fluctuations by investing in a fixed income portfolio that has the same interest rate sensitivity as do the pension liabilities.  Firms choose not to do this for a variety of reasons, but it is a choice.  Some firms – most recently, Ford Motor Company – appear to understand this.  Most other companies choose to expose themselves to risk in the pursuit of higher returns.  That is their right and their choice, but they should not expect a back-door government bail-out in the form of funding relief when the risk then materializes.

In both of these examples – the choice of discount rates and the choice of asset allocation – the common element is a lack of understanding of risk, how to measure it, and how to manage it.  Unfortunately, such a misunderstanding has real economic consequences, and it always seems to be the taxpayer who ends up paying for it.

Is Obama the “Damn Politician” that FDR Warned About?

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Feb 17, 2012

As posted on Forbes yesterday …

In 1941, President FDR explained why he chose to fund Social Security through a payroll tax in as follows:

“We put those payroll contributions there so as to give the contributors a legal, moral, and political right to collect their pensions and their unemployment benefits. With those taxes in there, no damn politician can ever scrap my social security program”

For more than seven decades, FDR’s strategy has proven effective.  Talk to someone in or near retirement – even people who consider themselves small government conservatives – and you will often hear them state that they have a right to their Social Security benefit because they paid for it over their working life.

President Roosevelt knew that the key to the political sustainability of Social Security was the establishment of an entitlement mentality, and the key to establishing an entitlement mentality was the linkage between payroll contributions and benefits.  If Social Security were structured as a means-tested welfare-style program – that is, it if were financed by a progressive income tax rather than through payroll contributions – it might have never lasted this long.

Given this, it is important that President Obama and Congress have just agreed to extend the payroll tax cut and to continue to use budget gimmickry to turn Social Security into a partly general-revenue-financed program.

Here is how it works.  The 2% payroll tax cut reduces revenue to Social Security by about 15 percent.  But Social Security does not have a spare 15 percent of revenue lying around: rather, it is currently running quite close to break-even on a cash flow basis, and faces enormous long-run deficits.  To get around this, President Obama and Congress have decided to replace the lost payroll tax revenue by transferring money from general revenue (which derives primarily from the income tax) into the Social Security trust funds.

This budget gimmick has the short-term political benefit of making the Social Security trust funds seem unaffected by this tax cut.  But it also means that we are deviating substantially from FDR’s vision of a retirement program being paid for (on a pay-as-you-go basis) by participant contributions.  By moving down the path of general revenue financing of Social Security, we achieve the short-term “progressive” aim of increasing the degree of income-based redistribution (because income tax rates rise with income, whereas payroll tax rates do not).

But in the long-run, this has the potential to erode political support for the program.  By shifting the funding burden onto the income tax, the program starts to look more like a welfare program than a contributory social insurance program.

I am not the first to notice the irony of this.  My very good friend Chuck Blahous, who served eight years in the National Economic Council for President George W. Bush, and who was appointed by President Obama as one of two Public Trustees for Social Security, just released a paper explaining why this payroll tax cut is bad policy.  Among the seven reasons he provides is that doing so destroys the “historical Social Security compact.”  In a Washington Post article back in December, Dr. Blahous stated that these budget gimmicks are “a grave step for Social Security.”

This view is not limited to experts on the Republican side: the other Public Trustee of Social Security (a Democrat) – Robert Reischauer, the highly respected president of the Urban Institute — agrees with Dr. Blahous.  While Reischauer was more sympathetic to the tax cut, he also noted that it “could, if it continues for a substantial period of time, undermine one of the foundational arguments that makes the Social Security program inviolate.”

Perhaps the most succinct summary of the irony comes from Jason Fichtner, a Senior Research Fellow at the Mercatus Center and former Chief Economist and (acting) Deputy Commissioner for the Social Security Administration.  He summed it up the situation quite succinctly in an email to me by noting that “in 15 years we might look back on this time in history and discuss how President Obama, as a Democrat, was the president that started the path to killing Social Security.”

So, maybe President Obama really is the Damn Politician that FDR was worried about?


Fiscal Sustainability AND Retirement Security: A Reform Proposal for the Illinois State Universities Retirement System (SURS)

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Feb 9, 2012

I have released a paper today that proposes a new plan for the State Universities Retirement System.  Co-authored with Robert Rich, the Director of IGPA, the paper proposes a hybrid system that would be partially funded by both workers and universities. It contains several components that reflect some of the ideas that have been publicly discussed by state leaders in recent weeks.

 The proposal has four basic components: 

1) Create a new hybrid retirement system for new employees that would combine a scaled-down version of the existing SURS defined benefit plan with a new defined contribution plan that would include contributions from both employee and employer; 

2) Peg the SURS “Effective Rate of Interest” to market rates; 

3) Redistribute the SURS funding burden to include a modest increase in employee contributions and new direct contributions from universities, thereby reducing state government’s burden on state government; and

4) Align pension vesting rules with the private sector, which would decrease the years new employees hired after January 1, 2011 would need to work for their pension benefit to be vested.

The plan is intended to substantially reduce state expenditures on public pensions, while still providing a reasonable source of secure retirement income to university employees. 

Click here to read the full paper.

Reducing Regulatory Obstacles to Retirement Income Security

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Feb 7, 2012

With nearly 80 million baby boomers starting their march into retirement, many policy-makers have begun to focus on how to provide secure retirement income in a fiscally sustainable way.  This is no small challenge in an era of enormous deficits.

Although Social Security plays an important role in providing income that retirees cannot outlive, the benefits provided by Social Security are insufficient to ensure that most retirees can maintain their pre-retirement living standards.  However, increasing these benefits would be horrible fiscal policy: because the pay-as-you-go nature of Social Security has collided with an aging population, this program faces enormous fiscal problems that are going to require reductions – not increases – in the rate at which benefits grow.

Thus we have two opposing forces: a need for more retirement income, and a need to cut government spending on entitlement programs like Social Security.  What can be done?

Fortunately, the private sector can play an important role here, but only if the regulatory environment allows for it.  Presently, the regulatory landscape surrounding employer sponsorship of retirement plans is burdensome and enormously complex.  In many cases, the best thing the government can do to promote a greater role for the private sector in providing guaranteed retirement income is to “get out of the way.”  Ironically, however, there are other instances in which the best way the government can promote private sector solutions is to get more involved – if only by providing guidance on how plan sponsors can improve their plans without running afoul of existing regulations.  Getting guaranteed income options into 401(k)’s and other retirement plans is one such case.

In recent years, the financial services industry has increasingly focused on how to provide plan sponsors and plan participants with products that help to provide guaranteed lifetime income.  The resulting innovation over the past decade has been impressive, as companies have introduced a wide range of insurance and investment products that provide individuals with lifetime income.

However, employers that sponsor 401(k) plans have been slow to adopt.  As a result, most 401(k) participants in the U.S. still do not have access to annuities or other income products in their plans.  Although there are many reasons for this, there is little question that part of the reluctance of plan sponsors to provide annuities is that they have been scared off by regulatory and fiduciary concerns.

Last week, the Treasury Department proposed guidance to help address a few of the many issues that stand in the way of better private sector retirement plans.

In a nutshell, the proposed guidance does three things:

First, it makes it easier for plan sponsors to allow retirees to have a mix of lump-sum and annuity choices.  Put simply, it makes very little sense for most retirees to annuitize either 0% or 100% of their retirement assets.  Annuities provide guaranteed income, help to protect against out-living one’s assets, and help to guard against market volatility.  On the other hand, having some non-annuitized wealth available is extremely valuable when faced with uncertain expenses such as for long-term care.  Given that the optimal financial plan for most individuals would be to have some of both (e.g., annuities and a lump-sum), it only makes sense for our regulatory infrastructure to encourage this.

Second, a number of academic papers have established the potential value of annuity products that have a deferred payoff structure.  That is, with a small fraction of one’s wealth at, say, age 65, one can buy a product that will start paying income at age 85.  In the industry, these are sometimes called “longevity insurance” (although the name is very unfortunate, because all life annuities – whether they are deferred or not – are providing insurance against the financial costs of longevity).  The proposed regulatory guidance would help ensure that these products are more easily available.

Third, Treasury issued two “revenue rulings” that clarify how rules designed to protect employees and their spouses apply when a plan offers an income option.

These rules are useful, but far from sufficient.  Looking ahead, plan sponsors and participants would be better off if policymakers also took at least three additional steps.

First, the Department of Labor needs to provide much greater clarity about how plan sponsors who wish to provide lifetime income options can do so while protecting themselves from fiduciary risk.  This could include providing a “safe harbor” rule for the selection of the annuity provider.  Too many plan sponsors continue to be spooked off by the specter of fiduciary liability if they choose an annuity provider that runs into financial distress in the future.

Second, Congress should reform the Required Minimum Distribution rules to eliminate the various implicit and explicit barriers to lifetime income.  These rules were written by tax lawyers to ensure that the IRS could eventually get its hands on tax-deferred savings.  If these rules were instead written with an eye towards retirement income security, they would look quite different.

Third, we should encourage plan sponsors to report 401(k) and other defined contribution (DC) balances in terms of the monthly income the plan will provide, rather than simply as an account balance.  The Lifetime Income Disclosure Act that received bipartisan sponsorship in the U.S. Senate last year would be a positive step in this direction.  (My Senate testimony on this Act can be found by clicking here).

This need not be a partisan issue.  Republicans should recognize that strengthening retirement income security in our private pension system will give us more freedom to address our burgeoning Social Security deficits.  Democrats should view this as an opportunity to ensure that employers “do the right thing” by providing retirement plans to employees that actually succeed in providing a secure retirement.

Warren Buffett is not the Oracle of Public Finance

Filed Under (Finance, U.S. Fiscal Policy) by Jeffrey Brown on Feb 1, 2012

It is being reported today that Senator Sheldon Whitehouse (D-R.I.) is introducing a bill that would impose a minimum 30% tax on individuals earning more than $1 million per year.  This type of tax policy – which is essentially a new version of Alternative Minimum Tax – has been dubbed the “Buffett Rule” due to the news last year that Warren Buffet had a lower tax rate than his secretary.

Warren Buffett claims to have a tax rate of 17.4 percent.  His claim, however, is only true if one ignores one of the most basic economic principles of tax analysis: that the person who writes the check is not necessarily the same as the person that bears the economic burden of a tax.  In economics, this distinction is known as the difference between “legal incidence” (i.e., the entity with legal responsibility for paying taxes) and “economic incidence” (i.e., a measure of who really bears the economic burden of the tax).

In almost any undergraduate public finance textbook, one can find simple examples of how these concepts diverge.  For example, politicians often make a big deal of the fact that the FICA payroll taxes used to support Social Security and Medicare are split evenly between employers and employees.  But economists tend to believe that nearly all of the economic burden of the payroll tax falls on workers.  In other words, even though employers pay their share of the FICA tax, in the long-run the result is that workers are paid less than they would be paid in the absence of the tax.  Thus, it is the workers and not the firms who are truly paying the tax, in spite of how it appears.

The discussion around Mr. Buffet’s taxes – as well as the more recent discussion around the release of Governor Romney’s tax returns – has completely missed this point.  Those discussions have focused solely on the legal incidence of the personal income tax system, and have failed to think through the economic incidence of the overall tax system.

How so?  It is not uncommon for wealthy individuals like Mr. Buffett to receive much of their income in the form of dividends and capital gains.  This type of income may appear as if it is receiving “preferential” tax treatment, but the reality is that it is taxed heavily.  This is driven by the fact that corporate income is taxed at the corporate level before it is available to be paid out as dividends (or used to repurchase shares, which can lead to capital gains for investors who retain their shares).  The U.S. imposes a very high – 35% – marginal tax rate on corporate income.  Thus, if a firm earns another $1000, it pays $350 in taxes, leaving only $650 to go to shareholders.  If those shareholders are then taxed at a 15% rate, that is another $97.50 that goes to the government.  This leaves only $552.50 in the pockets of shareholders for every $1000 of pre-tax earnings that are paid as dividends.  Thus, the effective marginal tax rate on this income is more like 47.5% than it is 15%.

Of course, there are at least two important caveats to this stylized example.  First, the economics profession has simply not been able to come up with a definitive estimate of who really bears the burden of the corporate income tax.  One of the leading tax scholars of our day – Alan Auerbach of the University of California at Berkeley – wrote a terrific summary of what we know on this topic back in 2005 (the paper, which was ultimately published in the NBER Tax Policy and the Economy series, is available as an NBER working paper here.)  He notes that one of the major lessons is that “for a variety of reasons, shareholders may bear a certain portion of the corporate tax burden … thus, the distribution of share ownership remains empirically quite relevant to corporate tax incidence analysis.”  This is hardly a ringing endorsement that we should assume the entire incidence falls on Warren Buffet and other shareholders, but it is quite clear that we should not be ignoring corporate taxes when making policy statements about the fairness of the tax system.

A second caveat is that not all corporations face a 35% marginal effective tax rate.  Corporate income taxation is nothing if not a complex labyrinth of rules, exceptions, and exceptions to the exceptions.  Again, however, we know that for most corporate earnings, the rate of corporate taxation is well above zero, which is the rate it would need to be for us to feel as if we can ignore it when making statements of the kind Mr. Buffett makes.

A fellow Forbes contributor, Josh Barro, points out a number of problems with the Buffett Rule, the most important of which is that it would exacerbate the already-existing tax distortion that favors debt over equity.  If Congress wants to do this, that is their prerogative.  But we should not allow them to justify potentially bad tax policy on the basis of a naïve and misleading understanding of tax incidence.