What do Newt Gingrich and Public Pension Accountants Have in Common? A Belief in a Free Lunch

Posted by Jeffrey Brown on Jan 10, 2012

Filed Under (Finance, Retirement Policy, U.S. Fiscal Policy)

Given that current Presidential candidate and former House Speaker Newt Gingrich has long been an outspoken critic of government bureaucrats, it may surprise readers to learn that his Social Security reform plan shares an intellectual flaw with public pension accounting.   Namely, a belief in a “free lunch” from the stock market.

Let me explain.  It is widely understood that the U.S. stock market has performed quite well over long time horizons in comparison with other assets, such as bonds.  Nearly all economists agree that the reason stocks have higher expected returns is because stocks are riskier.  Investors need to be compensated for bearing this extra risk.

Most people intuitively understand that stocks are inherently risky, especially after they have witnessed the volatility of the past few years.  On the other hand, many people mistakenly believe that stocks are not risky as long as one is willing to hold them long enough.

This is a great fallacy, and acting upon it is financially reckless.   While there is a long-standing debate in the economics literature about whether stock returns are “mean-reverting” (i.e., somewhat less risky) in the long-run, no serious financial economist would ever suggest that the risk of stocks is zero, even at an infinitely long time horizon.

What does all this have to do with Newt Gingrich and public pension accounting?

Gingrich has offered up a Social Security reform plan that would replace the existing system with a system of personal retirement accounts.  There are many reasons to like personal retirement accounts.  But the most important thing to understand about personal retirement accounts is that they are NOT a substitute for raising revenue or cutting benefit growth to restore fiscal sanity to Social Security.  Newt and his advisors mistakenly think they are.

Gingrich’s campaign policy white paper extols a central virtue of the Chilean system and the old Ryan-Sunnunu reform option by noting that “the government guarantees that all workers with personal accounts will receive at least as much in retirement as they would under the current Social Security system” (emphasis added).

It is the guarantee that is problematic.  Newt seems to believe – in the face of all theory and evidence to the contrary – that a multi-trillion dollar shortfall in the Social Security system can be eliminated by investing contributions in stocks.  He is so confident that it will work, that he is willing to guarantee the return required to provide the same benefits as under the current Social Security formula.

This is a recipe for fiscal disaster.  As has been noted by numerous economists – including a number of pro-accounts conservative economists – a government guarantee of investment returns imposes a potentially enormous unfunded contingent liability on taxpayers.  To paraphrase a quip I once heard:  rather than reducing our entitlement state, Newt Gingrich appears content to become the portfolio manager for the entitlement state.

But Newt Gingrich has plenty of company.  Government accounting standards for public pension plans allow public sector DB plans to engage in this same economic deception.  And, ironically from a political perspective, this approach is eagerly defended by liberal think tanks and labor unions – strange intellectual bedfellows for candidate Gingrich - who want to hide the true cost of public sector pensions.

Let’s take my state of Illinois, home to three of the ten worst funded public pension plans in the nation.  Reform efforts here are severely hampered by the existence of a state constitutional guarantee against the impairment of retirement benefits for public workers.  Newt proposes providing similar guarantees to Social Security recipients.

As I have written elsewhere, the Government Accounting Standards Board (GASB) standards allow states and localities to assume they will benefit from the high returns of having part of their portfolio invested in equities, without accounting for the increased risk.  This allows public pensions to hide the true cost of public pensions from taxpayers, contributing to the massive pension funding crisis which we now face in the U.S.

Newt’s plan and GASB rules are both the direct result of a failure to accurately account for risk when valuing financial guarantees.

Taxpayers are not well-served by government accounting and budget-scoring rules that allow politicians to grow government without being honest about how we will pay for it.  The public should insist that government guarantees be accounted for accurately and honestly.

In the meantime, I look forward to seeing the mental gymnastics performed by both liberal and conservative pundits who try to defend one position while criticizing the other.

One Response to “What do Newt Gingrich and Public Pension Accountants Have in Common? A Belief in a Free Lunch”

  • Camilla A. Berger says:

    After a 31 year mostly stay-at-home marriage raising four kids, I was widowed and went to work full-time as a librarian at age 52 and earned a government pension, retiriing at age 70. In retirement I lost my entire widow’s social security benefit under the GPO and was left with only $144/month on my own minimal social security earnngs (10 years) after the WEP was applied. Yet if I had worked 30 years under SS and then got a government job I would have had no offset under the WEP. What a put-down for women who sacrificed to stay home with their children. Those who think women have equal rights should take a another look at this legislation..