Center for Business and Public Policy
at the University of Illinois, Urbana-Champaign

Earlier this year, the University of Illinois instituted a “Voluntary Separation Incentive Program” for academic professionals and civil service employees.  It also instituted a Voluntary Retirement Program for tenured faculty and some other academic employees.  Both of these programs were implemented to help downsize the university in order to cope with both temporary and longer-term budget problems.  In an email to faculty, the Chancellor of the Urbana-Champaign campus noted on 8/27/10 that:

“more than 500 employees took advantage of our Voluntary Separation Incentive Program, and some 90 tenured faculty members and 16 adjunct professors and lecturers will leave the University under the Voluntary Retirement Incentive Program. Achieving this reduction in staff through voluntary programs minimized the dislocation and disruption that would have resulted from more drastic measures.”

Over the past 6 months, I have heard a lot of discussion among university colleagues and members of the community as to whether these incentive programs are really a good thing or not.  Concerns seems to focus on two aspects. 

1. Are these programs really cost effective?  For example, how do we know that we are not just subsidizing retirement that would have happened anyway?  If 50% of the people who retired under this program were planning to retire this year anyway, this would essentially doubles the per-incremental-retirement.

2. How do we know that the “right” people are retiring?  For example, might it be the case that the most productive employees are the ones accepting these packages, because they are the ones with the best non-University alternatives for producing income?

I do not have the administrative data from Illinois that one would ideally like to have to answer these questions in our case.  But I did find a wonderful 2004 paper by John Pencavel of Stanford University, entitled “Faculty Retirement Incentives by Colleges and Universities” in which he discusses these and other topics.  I encourage you to read the whole paper if you have the time.  But here is my brief summary of some of his findings (based on his own research and that of other economists):

He examines the early retirement programs used by the University of California for tenured faculty in the first half of the 1990s and finds that:

1. Faculty are indeed responsive to monetary incentives.  He finds that an incentive equal to a one percent increase in a pension replacement rate is associated with a 3.7 percent increase in the acceptance of the early retirement incentive.

2. He shows that it is exceedingly difficult to accurately forecast who accepts such a package, which in turn makes it very difficult to accurately predict behavior in advance.  In the paper (around pages 30 and 31, he explains the reasons in detail).
3. Contrary to the concern raised in my question #2 above about the “best” faculty being most likely to retire, he finds that after controlling for age, length of service, academic discipline, and campus, one can treat salary as a proxy for the “quality” of a faculty member (i.e., if we compare two 60 year old professors in the same department who have been on the same campus for the same number of years, the more highly paid one is, on average, “better.”)  He finds that “those individuals with higher salaries were less inclined to accept the buyout program, a finding that is commonly found in studies of the relationship between pay and quit rates.”  In other words – on average – the better employees (as proxied by salary) were less, not more, likely to accept early retirement.     

4. For those that object to the use of salary (conditional on age, campus, dept and years of service) as a proxy for quality, he also reports results of another study that found that in the years before the early retirement programs, “those faculty with lower research output were more inclined to accept the severance incentives than other faculty.”  Again, this suggests that the most productive faculty are less likely to retire under an incentive program than are less productive faculty.

On net, I confess that reading this research makes me feel better about the program that the University implemented.  However, Pencavel concludes by cautioning against declaring an early retirement program a success simply based on the reduction in payrolls and the absence of adverse selection in who retires.  A full cost-benefit analysis would require an analysis of a much broader range of implications – including the overall impact on the quality of teaching and scholarly output.

In short, only time will tell …

One of the most despised provisions of the Social Security regulations is known as the WEP – an acronym for the “Windfall Elimination Provision.”  This provision is poorly named, poorly designed, and poorly understood.  But that does not mean it should be eliminated.  While the Social Security Administration does a truly horrible job of communicating it, the WEP (or something like it) has a legitimate reason for existing.

What is the WEP?  It is a provision in the law that alters the way Social Security benefits are calculated for individuals who work for state and local employers who do not participate in the U.S. Social Security system.  For example, the earnings of employees of public universities and public schools in Illinois – who participate in Illinois SURS and Illinois TRS – are not covered by Social Security. 

Illinois is not alone.  Approximately one fourth of all public employees in the U.S. do not pay Social Security taxes on the earnings from their government job according to the U.S. Government Accountability Office (GAO).  This includes approximately 5.25 million state and local workers, as well as approximately 1 million federal employees hired before 1984. 

However, many of these public employees – including the author of this blog – will still qualify for Social Security benefits, either as a result of switching between covered and uncovered employment at some point in their career or because they simultaneously work two or more jobs that span both covered and uncovered employment.  For example, a teacher in the State of Illinois may spend his summers working in covered employment.  Alternatively, a professor may spend part of her career working at a private university covered by Social Security, and part of her career working for a state university that is not covered. 

If Social Security benefits were calculated as a simple “linear” function of lifetime earnings, this would not present any problems.  If you earned 50% of your lifetime income in Social Security, you would just get 50% of the benefit that you would have earned had all your earnings been covered.  The only thing Social Security would need to know is how much you paid into Social Security.  Whether you have other “uncovered” earnings would be irrelevant.

But Social Security does not have a “linear” benefit formula.  Rather, it is explicitly designed to offer a higher ratio of benefits-to-taxes-paid for low income workers than it offers to higher income workers.  It is designed this way in an attempt to redistribute income from the rich to the poor.

And therein lies the problem.  If Social Security only observes part of a person’s total earnings (e.g., they know someone’s earnings from a summer job, but not their university salary), then they might mistakenly classify this person as a low-income individual, even though they might be a high income individual who just had a small part of their earnings covered by Social Security.  As a result, blindly applying the same benefit formula to this person gives them a benefit that is too high relative to other individuals who have the same total lifetime earnings!  In essence, we would be paying too much to people who only worked a small part of their career under Social Security.      

In order to adjust for this, the Windfall Elimination Provision (WEP) was enacted as part of the 1983 Social Security Amendments.  This provision is meant to downward-adjust the Social Security benefits of affected workers in order to eliminate the “windfall” (a poor choice of words, I am the first to admit!) that arises when, for example, an individual with high lifetime earnings (based on both covered and uncovered earnings) would appear as if he or she were a low earner when evaluated solely based on covered earnings. 

It is easiest to see the problem that would be created if there were no WEP provision in place through an example.  Consider the three individuals shown in the table below.  “Larry” is a very low income worker who works his entire life under Social Security, with an average lifetime monthly earnings of only $500 per month.  Using the 2008 benefit formula, Larry would have a full benefit $450, or 90% of his pre-retirement income.  “Mo” is a higher income worker with all of his earnings covered under Social Security, thus having an average monthly income while working of $5,000.  Under the benefit rules, Mo would have a full benefit of $1891.34, or a 38% of their working life income.  Thus far, this example simply illustrates the “redistributive” nature of the benefit formula, as Larry receives a higher replacement rate than does Mo, owing to the fact that Larry has lower lifetime earnings.

Social Security Primary Insurance Amount If No WEP Adjustment Applied

Now consider Curly, a public employee.  Curly’s total lifetime earnings of $5000 are identical to Mo’s.  Had all of Curly’s earnings been covered by Social Security, Curly would have the same 38%replacement rate as Mo.  However, only 1/10^th of Curly’s earnings were in employment covered by Social Security; the rest were in non-covered public employment.  If Social Security applied the standard benefit formula to Curly’s covered earnings without any WEP adjustment, Curly would receive a monthly benefit of $450, equivalent to Larry.  This provides Curly with a ratio of benefits to (covered) earnings of 90%, which is substantially more generous than the 38% ratio provided to Mo, even though Mo and Curly have identical lifetime earnings.  To use the language of the provision designed to address this issue, Curly would receive a “windfall.”  The WEP adjustment is designed to calculate Curly’s benefits differently, so that they end up looking more like Mo’s, since they both have similar lifetime incomes.    

In short, because Social Security is a redistributive program, there is a real need for something like the WEP.  Most people affected by it, however, hate it.  And who can blame them given that SSA does a terrible job of explaining it?  In essence, instead of telling a retiree that “your benefit will be $800,” SSA tells them “your benefit would be $1100, but because of the WEP, it is only $800.”  But for the individual in question, the $1100 benefit is a red herring.  In no way, shape or form is the $1100 benefit a relevant amount to start with.  So SSA’s poor communication and negative framing raises a lot of hackles unnecessarily.  As a result, thousands of letters are written to elected officials every year demanding that it be repealed.  And, every year, bills are introduced in Congress to eliminate it.  And every year, those bills fail as they should.

This is not to say that the WEP is perfect.  Far from it.  I have written more extensively elsewhere that the WEP calculation may be close to correct on average, but it is almost certainly wrong for each individual.  Sadly, it hits lower income individuals harder than it should, and does not hit most high income individuals hard enough.  There is a “right” way to calculate the WEP, but implementing it requires that SSA have a full history of both covered and uncovered earnings, but they did not collect the uncovered earnings in a systematic way until the early 1980s.  As such, we probably have to wait another 10 years before they can implement the fix.  In the meantime, SSA could do themselves and a lot of elected officials a huge favor by taking the time to adequately educate affected individuals on the rationale for this program.

As an economist, I often get annoyed when lawyers with no training in economics try to act as if they are experts in economic policy.  As such, all the lawyers out there should be equally annoyed with this blog post, because I – an economist with no legal training – am about to make an observation about state constitutional law. 

Several readers have emailed me the Chicago Tribune op-ed on August 10, 2010 entitled “Pension check may not be in the mail.”   In it, Dennis Byrne states that “if the pension funds go bust, the state has no obligation to step in to pay the benefits.”  This was based on a legal opinion provided by the Chicago law firm Sidley Austin.

According to this legal opinion, the contractual agreement is between the workers and the pension fund, rather than the workers and the state.  I find this a rather odd interpretation. 

In the 1998 “Sklodoswski” decision by the Illinois Supreme Court, “beneficiaries in various state employee pension systems brought suit seeking to compel the state and its officials to appropriate monies necessary to meet statutory funding obligations contained in the Illinois Pension Code.”

Essentially, Supreme Court ruled that while beneficiaries do have a contractual right to benefits, the Illinois constitution does not require that the state pre-fund those benefits. 

The court ruled that:

“allegations of underfunding are insufficient as a matter of law to constitute an impairment of benefits.  Plaintiffs … have alleged only an opinion that present funding levels are insufficient, from a prudential standpoint, to meet the accrued future obligations of the funds.  These claims have no factual allegations that would support a finding that the funds at issue are ‘on the verge of default or imminent bankruptcy’ such that benefits are in immediate danger of being diminished.”

The Court seems to have come awfully close to saying that if the level of funding reached a point where it was “on the verge of default or imminent bankruptcy,” such that the funds were no longer able to pay benefits, then this would constitute an impairment, and the state would have to pony up the funds.  The Court was simply observing that being actuarially under-funded is not sufficient to impair benefits.  And the Court is right on this point – since true impairment comes when the fund runs dry, not when there is an actuarial imbalance.  But once the funds run dry, the unspoken implication is that benefits would indeed be impaired and that the state would have to step in at that point. 

If you don’t believe these hypothetical discussions, then let’s look at some history.  As I noted in my 2009 paper in the American Economic Review (co-authored with David Wilcox):

“Perhaps the most reliable evidence on the riskiness of public pension benefits comes from instances when a public pension plan sponsor suffers from severe financial distress. For example, during the 1970s, the fiscal position of New York City deteriorated so greatly that, by March 1975, it was unable to complete a $912 million offering of short-term notes (Attiat F. Ott and Jang H. Yoo, 1975).  In response to the ensuing crisis, the city negotiated a one-year wage deferral and, over the period to 1978, cut 61,000 jobs from its payrolls, among other steps (David Lewin, 1977).  City pension funds became important sources of financing for the city.  Nonetheless, the city never reneged on accrued benefits under any of its five DB plans.  This protection of pensioners during a period of losses for other parties reflected the non-impairment provision in the state constitution.” 

“Another notorious case study occurred in the early 1990s, when Orange County’s Treasurer, Robert Citron, invested heavily in derivatives and long-term bonds, betting that short-term interest rates would remain low.  In December 1994, Orange County filed the largest municipal bankruptcy in U.S. history, following nearly $1.7 billion in losses sustained in Citron’s fund.  In response, the county chief executive officer proposed a 40 percent reduction in the county’s general fund budget, layoffs of more than 1,000 people, and the elimination of more than 500 other vacant positions (Matt Lait, 1995).  In spite of these financial difficulties, however, defined-benefit obligations were met in full.  In part, beneficiaries were protected by the fact that the pension fund was over-funded.  However, they were also protected by a constitutional provision stating that “the assets of a public pension … system are trust funds and shall be held for the exclusive purposes of providing benefits to participants in the pension or retirement system…” (Article XVI §17(a)).  Attempts by the county to use the surplus assets in the trust fund were rebuffed.”

In short, there has never been a case to my knowledge where a pensioner residing in a state with a constitutional guarantee against impairment was denied his or her benefits.

If I were a participant in a state DB plan (which I am not), I would still be pretty comfortable with my pension guarantee.  For perspective, it remains a substantially stronger guarantee than what the other 95% of America gets from Social Security which (a) is intentionally structured as an unfunded, pay-as-you-go system, and (b) which can be changed by Congress and the President at any time.

This coming Saturday, August 14, marks the 75^th birthday of the U.S. Social Security system. Specifically, it marks the date that President Roosevelt signed the Act into law, famously stating:

“We can never insure one hundred percent of the population against one hundred percent of the hazards and vicissitudes of life, but we have tried to frame a law which will give some measure of protection to the average citizen and to his family …”

The original Act specified that benefits were to be paid only to primary workers when they retired at age 65.  The Act established that benefits would be based on payroll tax contributions made during the working years.  Of course, the program has been modified many times over the years (e.g., allowing benefits to be taken at 62, expanding coverage to spouses, disabled workers, and others, dramatic increases in tax rates, changes in benefits, etc). 

Initially, benefits were paid as a lump-sum.  While Ida May Fuller is best known as the first recipient of Social Security benefits, SSA’s historian indicates that the first benefits were paid as a lump-sum, and that:

“The earliest reported applicant for a lump-sum benefit was a retired Cleveland motorman named Ernest Ackerman, who retired one day after the Social Security program began. During his one day of participation in the program, a nickel was withheld from Mr. Ackerman’s pay for Social Security, and, upon retiring, he received a lump-sum payment of 17 cents.”

It was not uncommon for early recipients to receive much more than they put in.  Indeed, it has been estimated that the net transfers to early generations of recipients is well in excess of $10 trillion.  In other words, for most of the last 75 years, the majority of Social Security recipients received far more in payments than they paid into the system (and, yes, this is true even if one accounts for inflation and implied interest on those contributions.)

How is this possible?  Actually, it is quite simple.  Social Security is not a funded pension system.  It is a “pay-as-you-go” transfer system in which the funds paid out to current beneficiaries are provided by current taxpayers.  Such a system can work quite well so long as we have wage growth and so long as the ratio of workers-to-retirees is stable or growing. 

But therein lies the crux of Social Security’s financing problems.  Unlike what many citizens believe, the true problem facing Social Security has very little to do with Congress’ penchant for “spending the Social Security surpluses” of the past 25 years.  It has far more to do with the basic financing structure of the program.

In the 1950s, there were 16 workers paying taxes to support each Social Security beneficiary.  By the time JFK was elected President, it was about 5 workers per beneficiary.  Today we have a bit more than 3 workers for each beneficiary.  In my lifetime, that will fall to 2 workers per beneficiary.

So do the math.  If you want to replace 40% of the average workers income upon retirement, and you have 16 workers supporting each retiree, you only need to collect taxes from each worker equal to 2.5% of their income (2.5 x 16 = 40).  With only 5 workers per retiree, you need to tax them at a rate of 8%.  When there are only 3.3 workers (today’s ratio), you need a tax rate of 12.1%.  (Today’s combined tax rate is about 12.4%).  As the ratio falls to 2-to-1, tax rates need to climb to 20% to keep the system in balance.

(I am simplifying a bit here, but it is remarkable how closely this very simple calculation mirrors the Social Security Trustees’ long-term financial outlook!)

So, as we celebrate the birthday of the Social Security system, we have to ask ourselves some difficult questions.  Can we afford the system we have?  If not, whose benefits do we cut? High income retirees ?  Low income retirees?  Today’s retirees?  Today’s workers?  Alternatively, whose taxes do we raise?  Everyone?  Only high income households?

Just as most members of the human race who are fortunate enough to live to age 75 begin to notice varying degrees of health declines due to aging, so too must we deal with the unhealthy economic consequences of an aging Social Security system. 

When the financial crisis hit last year, a lot of news sources started speculating that people would be forced to work longer to make up for the losses in their 401(k) plans.  Yet there seemed to be some puzzlement when data started indicating that more people were retiring earlier.  What happened here?

Some new research sheds a bit of light on this.  The answer to the puzzle is essentially that there are different groups out there who were affected differently.  Higher income individuals with large 401(k) balances were indeed likely to postpone retirement as a result of the negative wealth shock.

However, the financial crisis was also accompanied by a deep and prolonged recession that significantly increased unemployment, or more broadly, joblessness.  A study by Courtney Coile and Phil Levine of Wellesley College shows that a rise in unemployment during a recession leads to earlier retirement.  In essence, older individuals choose to retire rather than try to find another job. 

In aggregate, it appears that the unemployment-induced increase in retirement outweighs the 401(k)-loss-induced delay in retirement.  The net result is the average person retiring earlier, not working longer.

Of course, the most important point of all is that both effects are likely to reduce retirement security.  Whether forced out of the labor force early due to job loss or forced to stay in the labor force longer due to a negative wealth shock, individuals are made worse off.  And that, ultimately, is the real story.

Several recent news reports have indicated that Illinois is planning on selling pension obligation bonds in order to come up with the cash to make its contributions to the five state public retirement systems for the next fiscal year.  This is by no means the first time that the state has used POBs: In 2009 it issued just under $3.5 billion of bonds to fund its pension contributions for 2010.  Back in 2003, it issued about $10 billion in bonds for the same purpose.

So, are issuing such bonds a good idea or not?  The answer depends on who you are, and what you are trying to achieve.

If you are a participant in one of the five public plans, the issuance of these bonds sure beats another year of having the state fail to make its contributions.  While I have written before that public employees have little to worry about given the nature of the constitution benefit protections that are in place, any lingering concerns about the state’s inability to make good on pension promises ought to be at least partially mitigated by having additional contributions made into the pension funds.  This is true regardless of whether the funds came from higher taxes, reduced spending, or borrowed funds.

If you are a politician, this is really a good plan because it allows you to – once again – avoid behaving like a responsible adult and making the difficult fiscal choices that ultimately need to be made.

If you are a current taxpayer, it also looks pretty good.  First, we avoid raising taxes now.  Second, we are essentially converting implicit debt (money owed to pensioners) into explicit debt (money owed to bondholders), with the key difference being that it is actually somewhat easier to default on the explicit debt than it is to violate the constitutional non-impairment clause (this is precisely the opposite for Social Security, in which it is easier to reduce benefits than to default on U.S. government debt). 

If you are a beneficiary of other government spending programs, you are also pretty happy.  After all, borrowing to fund the pensions puts less pressure on politicians to cut your favorite spending program.

So far, so good.  Sounds like everyone is a winner.  So, what is the catch? 

The catch is that issuing these bonds takes the pressure off of our elected officials to exert fiscal discipline.  It is like trying to cure a spend-a-holics debt problem by giving them a credit card.    

As such, the losers are all the future generations of taxpayers and program beneficiaries who are going to be saddled with several additional billion dollars worth of debt that must be serviced because we gave today’s politicians an “easy out” from facing their responsibilities today.  This reduction in fiscal discipline is made all-the-more dangerous when these bonds are portrayed as a way to magically reduce our obligations by more than the amount of the debt issuance.  All too often, one hears proponents of these bonds make statements about how the state can borrow at a low rate and invest at a high rate, and thus make money on the difference.  Invariably, such statements ignore the risk differences in the investments, and are akin to try to create a free lunch where none exists. 

Thus, the biggest downside to the use of these bonds is that they are an “enabler” for politicians who are addicted to deficit spending.  The direct effect of this resulting debt burden will be to increase the pressure to raise future taxes and cut future spending on education, health care, roads, state police and every other spending program that people may value.

The indirect effect is that higher future taxes will turn Illinois into an unattractive place for businesses to invest or for our most talented young people to build careers, homes and families.  Who wants to invest in a state that is saddling future generations of businesses and workers with debt?

Yesterday I wrote about Social Security trust funds.  A reader with a terrific knowledge of Social Security history emailed me to point out an interesting fact that I thought was worth this short addendum.  I stated yesterday that the effect of the Greenspan commisison changes was to put it on a path to run surpluses for several decades.  That is true.  However, the wording of my next sentence (”these surpluses were to be ’saved’ in a ‘trust fund’ … that could then be drawn down once the demographic shift resulted in … deficits”) implies that these surpluses were part of an intentional effort to build up reserves that could be drawn down when the boomers retired.  In fact, as this knowledgable reader helpfully pointed out, that was not the logic used at the time.  He pointed out a quote from Bob Myers, who was the Executive Director of the Commission, who said “It was not intentional.  It has the effect of baby boomers paying for their own retirement … but it wasn’t a controlling element and it was not talked about.  The main thing that was talked about was how do we fix up the short-range problem.”  So the effect was as I described, but it was more of an accident than an intent, although the effect was as I described.  You can read more about this history by clicking here.   (Many thanks to the reader who pointed this out!)

Paul Krugman wrote last week that Zombies have killed President Obama’s Deficit Commission. He refers to a “Zombie lie” having to do with exactly when Social Security will begin its financial problems. It is the typical Krugman approach – rather than have a serious discussion about economics, he instead resorts to name-calling.

So let me try to explain the economics behind this debate (for an interesting view of the politics, check out Keith Hennessy’s post on the topic). Back in 1983, a Social Security reform commission (now referred to as the Greenspan Commission, after Alan Greenspan who served as its chair) made substantial changes to Social Security taxes and benefits. One effect of these changes was to put Social Security on a path in which it would run cash surpluses for several decades. These surpluses were to be “saved” in a “trust fund” (actually, there is more than one trust fund, but we can safely ignore that distinction for now and treat them as one) that could then be drawn down once the demographic shift resulted in benefit payments exceeding annual tax revenue and Social Security starts running deficits (note – we are now virtually there).

On paper, this is exactly what has happened. Since 1983, we have collected several trillion dollars worth of taxes in excess of Social Security benefits paid. And those surpluses have been credited to a Social Security trust fund. When people say that politicians have raided the trust fund, they are not correct - at least technically. This is because every dollar of surplus has been credited to Social Security’s trust fund in the government’s official ledgers.

But that is all just government accounting. And accounting can be gamed and gimmicked. Most importantly, these accounting games tell us nothing about the economic impact. To understand that, we have to understand what these surpluses have to do with national saving.

Suppose, for example, that Congress simply decided to transfer $10 trillion on paper into the Social Security trust funds (such as by retroactively increase the interest rate paid on the trust funds to a very high rate). Suddenly, the trust funds would have much more money in them, and Social Security would appear solvent. Great solution, right?

The obvious problem is that every dollar in the trust fund - which represents a dollar of assets to Social Security - also represents a one-dollar liability to the federal treasury. Thus, if we simply decreed that there were now an extra $10 trillion in the trust funds, all we have done is transfer from one government agency (treasury) to another (Social Security). But ultimately, we still have to find the $10 trillion to make good on this promise.

Where does that $10 trillion come from? Out of the productive capacity of the U.S. economy in the form of higher current or higher future taxes.

Now, you might say, there is a big difference between simply decreeing the existence of money, and having actually saved the money through past surpluses. This is correct. If those past surpluses added to national saving, then presumably the higher saving rate spurred investment, and the economy is larger today than it otherwise would have been.

Here is an analogy. Suppose I divide my household expenditures into “mine” and “my wife’s.” Suppose that in the “mine” account, my income exceeds my expenditures by $10,000 per year. In “my wife’s” account, her income falls short of expenditures by $15,000 per year. So rather than me sticking my $10k in a bank, I loan it to her. This means I am running a $5k surplus in the “min” account, she is running a $15k deficit in her account, and our combined household is running a “unified deficit” of $5k.

Suppose we do this every year. So by the time I reach retirement, I have “saved” $250,000 in accumulated surpluses and interest in the form of I.O.U.’s from my wife. I call this my trust fund. But this means my wife owes me $250,000 (in addition to the $125,000 she would owe to other creditors.)

It might make me feel good to say that I have a quarter million in savings. But my wife and I are not exactly well-prepared for retirement, are we?

The question becomes, am I better off having saved $10k per year? Well, it depends. If my wife would have run $15k deficits whether I saved or not, then, yes, we are better off. But if the fact that I was saving $10k per year means she ran deficits of $15k per year instead of $5k per year, then we are no better off.

And, either way, we still have to come up with money to pay off our debt and feed ourselves in retirement. That money has to come from somewhere …

So it is with the government. Social Security saved all this money for the past 25-30 years. The rest of government spent it. Now the treasury owes Social Security trillions of dollars. It is fine to say that the treasury must pay it. But where does Treasury get the money?

Empirically, nobody can say for sure whether those Social Security surpluses were saved in an economically meaningful way. Republicans tend to argue that none of it was saved – that every dollar of Social Security surplus was spent on massive deficits elsewhere in the government. Democrats say those “on budget” deficits would have existed whether or not Social Security ran a surplus, and therefore the Social Security surpluses still increased national saving (or reduced dis-saving.)

Ultimately, it is an empirical question whether the surpluses added to saving or not, but unfortunately it is an empirical question we cannot really answer because we never get to observe the counter-factual world in which we hold everything constant except the size of the Social Security surpluses. This has not stopped researchers from trying, and they have found mixed results with some saying it has contributed a bit, other saying not at all. Nobody has claimed empirically that it was all saved.

Bringing this back to Krugman. He is clearly taking one side in this debate. By arguing that the only date that matters is when the trust funds are exhausted, he is implicitly arguing either that (a) 100% of the surpluses were saved, or (b) that he does not care about the broader economic impact, but only about government accounting rules. Either way, it is rather strange to take such a view and then claim that the other side is thinking like a Zombie …

I have written before that SURS – the public pension system in Illinois covering most workers in higher education – is a highly complex system, and that this complexity often “hides” some of the generosity of the system from both participants and taxpayers.  (I put “hidden” and “hides” in parentheses because SURS does disclose the information - it is just that one needs a pretty high level of knowledge and financial sophistication to make sense of the fiscal implications of what is being disclosed).

Today, I want to talk about one very specific taxpayer “subsidy” to retirees that I do not think many people realize exists. This subsidy comes in the form of excessively-generous annuitization rates.

I will try to spare the unnecessary details, but a bit of detail is required. Individuals in the SURS defined benefit plan have their retirement benefit calculated in multiple ways, and then the participant gets the higher of these amounts. One of those approaches is the “money purchase” formula (which was eliminated for those hired after July 1, 2005). When I was doing some research on this issue a few years ago, I learned that – at least at the time – the majority of SURS retirees were receiving the highest benefit using the money purchase option.

I have written before about the problems I have with the way the Effective Interest Rate is set that is used to accumulate the value in the money purchase calculation, and I will not revisit that accumulation issue here.

Rather, the hidden subsidy I want to discuss today is with regard to how the accumulated account balance is converted into an annuity.

On page 17 of the SURS Traditional Benefit Package guide, it shows that someone retiring at age 65 and 0 months will get $1 per month in income for every $110.40 in accumulated “money purchase” account value. Thus, if your account is calculated to be worth $100,000, SURS will convert that to $905 per month for the rest of your life (=100,000 / 110.404).

For comparison, if one goes to www.annuityshopper.com and look up the price for a single life income annuity with no payments to beneficiaries for a 65 year old male resident of Illinois (as of 6/21/10), you will find that a $100,000 account would buy you only $633 per month in benefits. If you are a woman, it would buy you only $579 per month (because women live longer).

This is an absolutely enormous subsidy relative to private market annuity prices. The SURS annuity conversion rate is 43% higher than the best annuity price available from the private market for men, and a 56% bonus for women.

Now, the sophisticated among you might argue that there are two reasons that SURS can provide better pricing than the market. The first is that SURS does not suffer from adverse selection like in the private annuity market (the phenomenon in which only longer lived people buy annuities, thus driving up the price). But research has shown that adverse selection can account for about a 10% reduction in payouts in the private market. The second reason is that SURS may have lower administrative and marketing costs. These are estimated to be about 5-10% of the value of an annuity in the private sector. So, at best, these two factors can account for about 20 percentage points – less than half — of this difference.

Where does this enormous subsidy come from? It comes from the fact that SURS is pricing these annuities assuming that it will continue to earn about 8% per year in its investments going forward. (That distinguishes it from the use of the ERI to accumulate account balances based on past performance of the SURS funds).

To guarantee 8% going forward is financial insanity. In essence, SURS is promising annuitants the expected rate of return on a stock portfolio, but leaving all the risk with the pension fund (and ultimately either future taxpayers or future pensioners).

Were SURS a private insurance company, pricing annuities in this way would be a pretty good way to ensure a “junk” rating from the rating agencies.

At the bottom of the table on page 17 of the SURS material, it states “this table is determined by the SURS actuary and is subject to change based on the actual experience of SURS.” Because SURS has disclosed that it is subject to change, then SURS ought to be able to invoke more realistic pricing assumptions without violating the impairment clause. Of course, it is probably limited in doing this only for those that have not annuitized yet.

Of course, it is worth noting that the 43% and 56% numbers above would apply only to the income generated under the money purchase approach. In reality, making this change would likely result in benefits being higher under the standard formula (2.2% of final average compensation for each year of service). So the good and bad of it is that neither benefits to annuitants nor the cost savings to the SURS system would be as large as this suggests because the other formula acts as a floor.

In closing, I am not necessarily saying we should cut benefits -  I will leave that to the politicians to decide. But if we want to subsidize our annuitants, let’s make a conscious decision to do so and be very transparent about it so that both they and the citizens of Illinois know we are doing it. It is not good for a democracy to hide the subsidy behind actuarial complexity where we can pretend it does not exist.

Mark Guarino of the Christian Science Monitor published a piece yesterday (“States cap workers benefits to reduce shortfalls: Is your pension fund at risk?”) that discussed the status of state pension funds.  

Most of the article discusses points that I and others have made on this blog before, such as large size of the shortfall, the fact that it is politically difficult to fix, and the State of Illinois’ efforts to reduce costs by cutting pensions on future workers.  

There was one thing in the article, however, that struck me as new and, quite frankly, frightening.  I am not sure if this is purely “academic” (and as an academic myself, I do not use the term disparagingly) or whether this is something that has any real practical potential.  But Amy Monahan of the University of Minnesota law school points out in the article that states have “police powers” which “given them fundamental rights to protect the welfare of their citizens in a crisis, which in this case would allow a legal ‘out’ in providing benefits.”  The use of this power to cut constitutionally protected benefits is an idea that has never been tested in the courts, but even so, there are two aspects of this possibility that are disheartening. 

The first is obvious – namely, that perhaps the constitutional guarantee of benefits may not be as strong as participants would like or expect.  Although, in reality, I think it is still clear that the constitutional provision is still the strongest guarantee that one can find anywhere – stronger than unfunded promises from Social Security, and stronger than underfunded promises from a private employer that are guaranteed by an underfunded PBGC.  So, as scary as it sounds, I am still not inclined to believe it more than an extremely remote possibility.

The second aspect is more subtle, but also more pernicious.  As I have written in earlier posts, in a competitive labor market, the perceived value of future pension benefits serve as a substitute for other forms of compensation.  Thus, the more employees have a perception that the Illinois public pension benefits are not secure, the less value employees will place on those benefits.  As a result, either taxpayers must pony up more cash to pay these employees in another form (e.g., higher wages), or many of them will take jobs elsewhere.  

The worst situation from a state’s fiscal perspective is one in which the benefits are actually inviolable, but that nobody believes this to be true.  In that situation, the states’ total compensation costs go up in the short-run – we have to pay employees more to make up for the perceived risky pension – but do not come back down in the long-run if the pensions actually end up being paid.