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

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 …

While all eyes were on the public flogging of Tony Hayward on June 17, you may have overlooked something.  A small story in the Wall Street journal titled, “Pension Bombs Need Spotlight”.  It’s the Governmental Accounting Standards Board ”Preliminary Views on Potential Improvements to Pension Standards”.   When you couple this with the excellent article, “Pension Roulette?” by Alexandra Harris at Northwestern’s Medill School of Journalism (a MUST READ) you’ll be able to paint a not so pretty picture. 

First brush stroke; watch the state’s lobbyists try to keep GASB from requiring these changes, for as the first paragraph of the public notice states in part, “The purpose of the document is to obtain comments from constituents on those views before developing more detailed proposals for changes to existing accounting and financial reporting standards”

 Second brush stroke; watch so many exceptions get into the final standards that it becomes (like most financial regulation) a burden for those who play by the rules and a gaping hole that lets the largest violators flow right through. 

Third brush stroke; the State of Illinois’ financial statements become too embarrassing for even S&P, Moody’s, Fitch, et.al.to maintain the current rating. 

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.

With government budget deficits rising across the country, there has been much ado lately about whether government employees are overpaid.  In many cases, attention has been focused on a few unusual cases – football coaches, university presidents, retiring public employees drawing large pensions, etc.  This is fun, and it fans the fires during a period of growing anti-government sentiment, but it doesn’t do much to clarify the question of whether public sector employees are overpaid.  After all, if you are going to look at the highest-paid public employees, shouldn’t you compare them to the highest-paid private ones?  And, compared to a typical hedge fund manager, the salaries earned by football coaches and university presidents is tiny.

 No, the right question is not whether there are a few public employees that are paid a lot.  There are.  And, arguably, there’s nothing wrong with a person being paid a lot.  What would be wrong is if the person is paid dramatically more in the public sector than he or she would be in the private sector due to inefficiency or corruption in the public system.  And, if it were true that the average public employee’s total compensation were higher that could be received in the private sector, this would suggest there are problems with the entire system.  Despite the occasional highly-paid private employee, there seems to be little evidence that total compensation for public employees, on average, is higher than total compensation for those workers were they employed in the private sector instead.

 Two recent stories have pushed the idea that government workers are overpaid.  The first was a USA Today story from earlier this spring that argued that, focusing on occupations that exist both in government and the private sector, in 2008 the average federal employee earned $67,691 while the average private sector employee earned $60,046.  Benefits for the average federal employee were $40,785 per worker while private sector employees received $9,882 per worker on average.  So, federal employees earned a higher salary and more benefits, and total compensation for a typical federal employee was about $38,500 higher than in the private sector.

A BLS report released last week tells a similar story regarding the gap between state and local worker total compensation and that of the private sector.  The report finds that total compensation for state and local workers averaged about $39.81 per hour (in March 2010), while private worker total compensation averaged about $27.73 per hour.  So, the total cost of an average state/local worker is about $12 more per hour than a typical private worker.

Of course, these comparison cannot possibly be right.  It simply doesn’t pass the smell test.  I’ve known people who left the private sector for government work, and they never did so for higher salary.  Shorter hours, yes.  Better benefits, yes.  More job security, yes.  But better pay?  If the average federal employee got almost $40,000 more in total compensation each year than he or she could earn in the private sector, we should expect to see people clamoring to leave their private sector jobs for federal jobs.  The same is true for state/local workers.  We should see a line of private-sector workers trying to move into lucrative government work.  We don’t really seem to see either of these.

The most likely cause of the suspicious numbers is the fact that government employees, as a group, are different than private sector employees.  If government employees are, on average, more educated and more experienced than private sector employees are, on average, then this could account for the difference.  To take a concrete example, suppose the private sector and public sector each hire 10 employees.   Ignore benefits cost to make things simple.  The private sector pays lawyers $120,000 and clerks $40,000 each and hires 3 lawyers and 7 clerks.  The average cost of a private employee is $64,000.  The public sector, on the other hand, pays lawyers $100,000 and clerks $30,000 and hires 5 lawyers and 5 clerks.  Despite the fact that the government pays lawyers less than the private sector and clerks less than the private sector, the average cost of a government employee is $65,000 per worker in this example.   Even though the government pays both high-skill (lawyers) and low-skill (clerks) workers less than the private sector, the average compensation cost in the public sector is higher due to the fact that it employs a greater proportion of high-skill workers!

The previous paragraph illustrates a phenomenon known as Simpson’s Paradox.  I first learned of Simpson’s paradox in the context of airline delays.  To take a simplified version, compare two airports, Seattle and Phoenix.  (I’m making all these numbers up.)  Suppose that when it rains in Seattle the typical flight is delayed 15 minutes and when it doesn’t rain the typical flight is delayed 0 minutes.  In Phoenix, on the other hand, when it rains the typical flight is delayed 30 minutes and when it doesn’t rain the typical flight is delayed 5 minutes.  Now, suppose I were to tell you that the average flight out of Seattle is delayed longer than the average flight out of Phoenix.  How would you make sense of that?  Your response might be “well, that’s because it rains all the time in Seattle!” and that would be the right answer.  Suppose it never rains in Phoenix.  The average delay is 5 minutes.  If it rains 2/3 of the time, the average delay in Seattle is 10 minutes, and 10 is more than 5.  In fact, as long as it rains more than 1/3 of the time, average delays in Seattle will be longer than average delays in Phoenix, despite the fact that Seattle has shorter delays both on days when it rains and days when it doesn’t rain!

Enough for today.  Next time I’ll write about this report, which does a better job with the data and claims to show that government workers are underpaid.  It isn’t perfect either.

It’s an old expression.  But, ARE you worth your weight in gold?  New record-high gold prices on Tuesday – along with Nolan Miller’s column on gold – inspired me to take another look.

On the face of it, valuing an average life sounds like a morbid, if not impossible task.  However, governmental agencies at all levels use a concept called the Value of Statistical Life (VSL) when making many different kinds of safety and regulatory decisions.  At its heart, the VSL tells us how much society should be willing to pay to reduce mortality risks over an affected population.   For example, guardrails make highways safer, yet they only appear on curved sections of road, because the extra cost of installing rails along the rest of the highway does not justify the relatively few fatalities averted.  In other words, we have NOT found it worthwhile to spend what would amount to $20 million to save one more life! 

Different agencies and regulatory bodies use different VSL numbers, calculated using different methodologies.  But a new study by Kniesner, Viscusi, and Ziliak (2010) estimates that what we ARE willing to spend to save an average American life is between $7 million to $8 million (2001 dollars).  THEY are not making a moral judgment, they are just reporting the moral judgments that actually get made.  The estimated value of statistical life (VSL) is $7-8 million.

To be clear, when it comes to a specific life, not a statistical one, we often are willing to pay any price.  For instance, when Baby Jessica fell down a well in Midland, TX, no one asked how much it would cost to save her.  The U.S. military takes this principle one step further with their doctrine of “leave no man behind”, which effectively places an infinite price on saving a comrade’s life and retrieving the fallen.

This brings me back to the original question, are you worth your weight in gold?  In short, yes!  An average adult American’s life is valued at more than TWICE his or her weight in gold on the open market.  The Center for Disease Control (CDC) reports that the average American adult (male and female), ages 20-74, weighs approximately 175 lbs.  At its high nominal price on Tuesday of $1245 per troy ounce, that 175 lbs of gold would sell for about $3.16 million.  (Note: 14.583 troy ounces per pound.)  Compared against Kniesner, Viscusi, and Ziliak (2010)’s VLS estimate, humans seems quite valuable relative to gold!

Just wanted to note that as of a few days ago, Illinois has once again been downgraded by the rating agencies. This time, it was Fitch, who stated that “The rating downgrade, to ‘A’ from ‘A+,’ reflects the continuing unwillingness of the state of Illinois to take action to address its significant budgetary problems.”  This comes on top of the June 4 downgrade by Moody’s.   Lest you think such things do not matter, a lower rating raises the rate at which the state must borrow - thus further exacerbating our fiscal problems.

One of the key dividing lines between liberals and conservatives in the U.S. is the extent to which people believe that individuals should have the freedom to make their own choices, even when those choices appear to be “bad” for the individual.  Just think about the debates we have had over motorcycle helmet laws, seat belts, and smoking.

The standard libertarian perspective is that individuals should be free to make their own choices.  After all, we might think that it is really stupid for someone to ride a motorcycle down the highway at 70 miles per hour without wearing any protective gear, but perhaps the person doing it feels differently.  Thus, debates over such policies often hinge on the extent to which the policy helps prevent negative “externalities” – in other words, we restrict your behavior because we are trying to protect other individuals from the side-effects of your actions.  So the anti-smoking crusaders focus on “second hand smoke” while the mandatory-helmet proponents often focus on the costs to society of providing medical care to the uninsured motorcycle rider. 

In recent years, there has been much debate related to the food we consume.  There is no question that the U.S. is suffering from a rise in obesity, and that this trend has costs not only for individuals but also for society as a whole (e.g., rising costs of publicly provided health care).  Still, many of us recoil at the notion that the “food police” will tell us what we can and cannot eat.  After all, if I want to eat a half-pound hamburger with a side of fries while I am on vacation, it is hard to see why that should be the business of anybody but me and the restaurant.

Even in the absence of externalities, public health advocates will often argue that people do not make good eating choices because they do not have good information.  If true, then the best policy approach would seem to be to provide such information (rather than, say, outlawing half pound hamburgers!)  But does providing such information really make any difference?

In a new NBER working paper, three economists provide compelling evidence that posting calorie information affects behavior. Specifically, the studied food and beverage purchases at Starbucks stores in New York City (where calories are posted), as well as the purchases of Starbucks stores in other locations (where calories are not posted). 

The long and the short of it is that they found that mandatory calorie posting reduced calories per transaction by 6% (from 247 to 232 calories).  Intriguingly, they also found that commuters who lowered their calories per transaction while working in New York City during the week also lowered their calories while buying from Starbucks outside the city on weekends (where calories are not posted).  This suggests that the information sticks with people and causes them to change their habits.  Interestingly, all the reduction came from food, not from the beverages.  I guess true Starbucks aficionados are really there for the coffee, not the cakes.  (Of course, as my colleague Nolan just pointed out to me, a 15 calorie reduction is probably within the margin of error of how much milk the typical person puts in their coffee!)

This research is of much broader relevance than just Starbucks.  As part of the March 2010 health care reform bill, chain restaurants nationwide will have to start posting calorie counts sometime in 2011.  While such a regulation is certainly not cost-less for the restaurants, at least it is nice to know there is some evidence suggesting that this policy may actually have the desired effect.  That is not sufficient to suggest that this policy passes a cost-benefit test, but at least it is a start!

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. 

The third installment of the Brett Arend’s Wall Street Journal series on gold is out.    Its advice on how to tap the upside potential of gold without the risk:

One way …  is to buy call options on the GLD exchange-traded fund. Call options give you the right to buy the fund at a later date if prices rise further, while letting you walk away with only small losses if they tank.