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

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

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

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

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

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

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

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

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

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

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

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

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

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

My own research area is environmental and natural resource economics, which others often call “sustainability”.  That’s actually embarrassing, because I don’t know what it means.  For a renewable resource like timber, it seems pretty easy:  you just plant trees, let them grow, cut them down, and then plant trees again.  For a nonrenewable resource like oil, it’s impossible: once a barrel of oil is consumed, it’s gone forever.  The only way to make oil “sustainable” is not to use it, which does not make any sense, because oil has no value at all if it can’t be used.

So, sustainability is either obvious or impossible.  The concept seems to be of no use whatever.  So I turn to people smarter than me, to get some answers.  By “smarter than me”, in this case, I mean (1.) Nobel-Prize winning economist Robert Solow, and (2.) whoever writes for Wikipedia.

Way back in 1991, Robert Solow wrote “Sustainability: An Economist’s Perspective”, in which he says:  “It is very hard to be against sustainability. In fact, the less you know about it, the better it sounds.”   He says he has seen various definitions, but they all turn out to be vague.  So his essay is an attempt to make it more precise.  “Pretty clearly the notion of sustainability is about … a moral obligation that we are supposed to have for future generations.”   But you can’t be morally obligated to do something that is not feasible!  He notes UNESCO’s definition:  “… every generation should leave water, air, and soil resources as pure and unpolluted as when it came on earth.”   But taken literally, that injunction “would mean to make no use of mineral resources; it would mean to do no permanent construction, … build no roads, build no dams, build no piers.”  That is neither feasible nor desirable!

Instead, he suggests that sustainability might be both feasible and desirable if it is defined as “an obligation to conduct ourselves so that we leave to the future the option or the capacity to be as well off as we are.”   In the final analysis, what that means is that we don’t necessarily have to leave all the oil in the ground, if we leave something else of equal or greater value, some other investment that can be used by future generations to produce and consume as we do, and which they can leave to other generations after them.  It is a holistic concept, both simple and operational.  We only need to add the value of all assets, subtract all liabilities, and make sure that the net wealth we bequeath is not less than we inherited. 

We can use oil, but we should not simultaneously be running huge government budget deficits that reduce the net wealth left to our children and their children.  The measure of “net wealth” should include the value of ecosystems, fresh water supplies, biodiversity, and oil, as well as productive farmland, infrastructure, machinery, and other productive assets.   All those values are extremely difficult to measure, but at least the concept is clear.

Has that message been adopted since 1991?  It certainly does not seem to be part of the thinking of the U.S. Congress and the rest of our political system.   What are they using for guidance?

Wikipedia says  “Sustainability is the capacity to endure. For humans, sustainability is the long-term maintenance of responsibility, which has environmental, economic, and social dimensions, and encompasses the concept of stewardship, the responsible management of resource use.”  Okay, well, that’s still pretty vague, by Solow’s standards.  Let’s see if they make it more specific: “In ecology, sustainability describes how biological systems remain diverse and productive over time, a necessary precondition for the well-being of humans and other organisms. Long-lived and healthy wetlands and forests are examples of sustainable biological systems.”

I’m sorry, that kind of specificity does not make it more operational.   They haven’t read Solow.  In fact, the whole entry seems to read like it is intended to maximize the number of times it can link to other Wikipedia entries!

“Moving towards sustainability is also a social challenge that entails, among other factors, international and national law, urban planning and transport, local and individual lifestyles and ethical consumerism. Ways of living more sustainably can take many forms from controlling living conditions (e.g., ecovillages, eco-municipalities and sustainable cities), to reappraising work practices (e.g., using permaculture, green building, sustainable agriculture), or developing new technologies that reduce the consumption of resources.”

Actually, the only phrase in the whole entry that really struck me was “more sustainably.”  Now, I REALLY do not know that THAT means.  Our current trajectory is either sustainable, or it’s not!  If future generations can live forever, how can they live longer than that?  And if not, well, …

Ever since Governor Quinn proposed his plan to reform government employee pensions in Illinois, I’ve been thinking about how to blog about it.  The problem is, my primary opinion is a legal one – that the proposal clearly violates the non-impairment clause of the Illinois state constitution because it threatens current employees with excluding future pay raises from pensionable earnings in contradiction of the “contractual relationship” laid out in the Illinois Pension Code – and I’m not a lawyer.  Better to stick with what I am supposed to know.

So, let’s turn to economics.  While the non-impairment clause prevents the state from reducing pensions, it does not affect other benefits.  In particular, the state would seem free to reduce or remove subsidies for retirement health benefits without running afoul of the non-impairment clause.  New research from by Steven Nyce, Sylvester Schieber, John B. Shoven, Sita Slavov, and David A. Wise suggests that doing so might be a way to lower pension costs.  In short, they show that removing the employer subsidy for health benefits for early retirees would cause people to work longer.  And, when people work longer they contribute more toward the pension fund and draw pensions for less time, improving the overall finances of the pension system.

In the new article, entitled “Does Retiree Health Insurance Encourage Early Retirement,” the authors investigate the relationship between employer subsidies for health insurance to retirees.  The paper begins by noting that many Americans delay retirement until they reach age 65 because employment gives them access to health insurance at far better prices than they could receive in the private market (if such insurance is even available).  When an employer offers subsidized health insurance to those who retire before age 65, it makes it possible for people to retire earlier than they otherwise would.  Using newly-available data, the paper finds that retiree health coverage significantly increases retirements among people in their early 60s.  In fact, when employers subsidize 50 percent or more of the cost of retiree health insurance (as the state of Illinois does), retirements increase by “1-3 percentage points at ages 56-61, by 5.9 percentage points (33.7 percent) at age 62, and by 6.9 percentage points (43.7 percent) at age 63. Overall, an employer contribution of 50 percent or more reduces the total number of person-years worked between ages 56 and 64 by 9.6 percent relative to no coverage.”

What does this mean for the state of Illinois?  Take, for example, SURS, the State Universities Retirement System.  In this system, a worker’s total retirement benefit is limited to 80% of final salary.  This means that, after about 36 years of working for the state, the worker’s pension no longer increases with additional years of service.  Further, state law provides that the state will pay 5% of retiree health premiums for each year of service.  (Importantly, the applicable law is not the Pension Code!)  So, a person who started working for the state at age 25 would, by age 62, be eligible for the maximum pension and free health benefits.

Given this deal, it is no wonder that people choose to retire before age 65.  This costs the pension system, since early retirees do not contribute and they draw their pension for longer.  Removing retiree health benefits would have a significant financial impact on early retirees.  Back in 2006, the most recent data I could find in a quick search, the average health insurance premium for an adult age 60 – 64 on the non-group health insurance market was around $360/month.   A family policy would cost about twice that.  Such policies are usually less generous than employer-provided insurance and feature higher deductibles and coinsurance rates.  So, a near-elderly state employee contemplating retirement might face expected monthly costs of $500 – $700 or more if they had to pick up their own health insurance, and even more if they had a dependent spouse or children.

So, suppose the state were to eliminate retiree health benefits.  Faced with such costs, many people would choose to work until age 65 (or at least until age 63.5 when the COBRA law would allow them to continue to purchase health insurance under the state plan until they become eligible for Medicare at age 65).  And, when people retire later, they draw pensions for less time.

Now, I am not necessarily advocating this, and certainly not across the board.  There are strong arguments why for some government employees – in particular police and firefighters –the physical demands of the job make early retirement reasonable.  For other government employees, such as professors, there is no strong reason why the state should be subsidizing early retirement through providing free health benefits after I stop working.

My broader point is that whatever the state does, and it must do something, it must be done in a way that does not violate the constitution.  While the state cannot touch pension benefits, it is free to reduce health insurance.  And, since retiree health insurance makes retirement more attractive, reducing or removing retiree health benefits would seem to be a constitutional and, based on recent research, effective way to delay retirement, which would improve the ailing pension systems’ finances.

ADDENDUM (5/30/12):  Retirees who began working for the State of Illinois before April 1986 (at least in the case of SURS) may not be eligible for Medicare Part A.  In this case, removing health insurance benefits would leave workers exposed to significant financial and health risk even after the age of 65.  Obviously, removing employer-sponsored health benefits is much more complicated and controversial in this case.

The New York Times today says that the Federal Housing Finance Agency is set to sue major U.S. banks such as Bank of America, JPMorgan Chase, Goldman Sachs, and Deutsche Bank, among others.  The U.S. government argues that the banks sold packaged mortgages as securities to investors while ignoring evidence that the homeowners’ incomes were inflated or falsified.  That is, the banks failed to perform the due diligence required under securities law.  When many of those homeowners were unable to pay their mortgages, the securities backed by the mortgages tanked.  Housing and financial crises ensued.

Kinda late, isn’t it?  Well, certainly it’s too late this time, to prevent the housing and financial crises of the past few years.  What is the point of the suit, then?  Does the U.S. Federal government really need the money that they can get from these banks, as damages, and will they give it back to all of us who lost money during those years?  The U.S. might sue for around a billion dollars, which is peanuts these days.  Divided by 333 million Americans, that would be about three dollars each.  Why bother?

An important conceptual point here is the difference between ex post liability (after the fact) and ex ante incentives (beforehand).   The point of this suit is not to collect a billion dollars after the fact, although arguments are made about the fairness of those liable to pay for damages.  Rather, the point is to provide the proper incentives to private companies before the next time.  To a private company, a billion dollars really is a lot of money.  If they have to worry about the loss of a billion dollars, for ignoring their legal responsibilities, then maybe next time they’ll be more careful to follow the law.

Government regulation can take alternative forms.  One alternative is to send auditors and inspectors into every bank, every day, to check what they are doing.  That would be very expensive.  A cheaper alternative is to let the banks decide for themselves if they are exercising due diligence, but with the “threat” hanging over their head that they might get sued if they don’t.

The use of “default options” (i.e., an automatic decision on behalf of individuals who fail to make an active choice) has been shown to exert a strong influence on individual behavior in a variety of settings.  Perhaps nowhere has this effect been more powerful than in the arena of retirement savings, where default options have been shown to dramatically increase participation in 401(k) plans and savings rates and to provide better portfolio allocations.

The widespread use of default options, however, has also been accompanied by a deeper understanding of when default options are appropriate tools for improving individuals’ well-being, and when, in contrast, default options are potentially harmful.

The State Universities Retirement System (SURS) of Illinois has, for approximately 12 years, defaulted new employees into the Traditional Defined Benefit pension plan if they fail to choose a retirement plan within six months of employment. Along with my University of Illinois College of Business colleagues Anne Farrell and Scott Weisbenner, I surveyed nearly 5,000 SURS participants who joined the system between 1999 and 2007 to better understand who defaults, why they default, and the implications of defaulting rather than actively choosing a plan.

Some key findings of the research include the following:

• More than half of survey respondents who accepted the default option cite information problems or decision complexity as a primary reason for defaulting.
• One in five respondents believe that because the Traditional defined-benefit plan was selected as the default option, that plan must have been the best option.
• Over one-third (35.2%) of respondents who defaulted into the Traditional plan would choose a different plan if given the opportunity to do so at the time of the survey.  This is more than double both the fraction of individuals who made an active choice who would like to change plans (15.5%), and the fraction of individuals who made an active choice of the Traditional plan who would like to change plans (14.0%).
• Individuals who both defaulted into the Traditional plan and would like to choose a different plan if given the opportunity are substantially more likely to cite information problems.

There are numerous implications of the research, including:

• Because (a) there is no single plan choice that is clearly right for all participants; (b) the choice of retirement plans is highly complex; and (c) plan choice is irrevocable, this is a context in which it is not advisable to rely heavily on a single default option.
• To the extent that the Illinois legislature considers changes to the SURS system, it should consider ways to provide information that enables quality decision-making by participants.  The legislature should not rely extensively on default options to convey such information.
• To the extent that default options are used in the SURS system, consideration should be given to allowing default options to vary by participants’ age or income, or to allowing participants to make a one-time change to their plan enrollments.

Given that the Illinois legislature continues to debate the future of state pensions in Illinois, we think these lessons are timely.

Many public employees and retirees in Illinois are (understandably) extremely agitated by the ongoing discussions about public pension reform in Illinois.  Today, I was forwarded yet another email by someone concerned about recent comments made by Illinois State Treasurer Dan Rutherford. 

In a nutshell, some in the legislature are kicking around an idea to get around the Illinois constitution’s prohibition against “impairing” retirement benefits by offering employees a choice:  pay higher premiums in order to keep existing benefits, or switch into a less generous plan. 

To questions about whether this would or would not violate the impairment clause of the Illinois constitution, there is considerable uncertainty.  Rutherford’s reaction view is (my paraphrase, not an actual quote) – “let’s pass it and then let the Courts sort it out.”

It is obvious why this is not satisfying to public employees – after all, it is their benefits that might get cut, or their contributions that may go up. But setting aside all the questions about what we “should” or “should not” do, I think there is tremendous logic to having the legislature pass a law in order to get a more definitive ruling on what the state “can” or “cannot” do.  Yes, I agree that it is really unfortunate that we may have to pass a law to find out exactly where the limits of the impairment clause are, but that appears to be the hand we have been dealt.  But figuring out where Illinois Courts will draw this line is exceedingly important.

Why?  As I have noted before, when employers provide employee benefits, they are not doing so just to be nice.  They are doing so to attract, retain and motivate employees.  In short, it is one component of the compensation package.  In an environment that is disciplined by market forces, employers will only offer employees pensions if the average employee values the pension at more than it costs the employer to provide.  Otherwise, both would be made better off by paying cash.  As I have also written, however, it is not clear how well this market discipline works for public employees.

The major problem we have in Illinois is that we may be in the worst of all worlds, namely, one in which the pension benefits are indeed fully protected by the constitution, but where the perception of political risk means that employees value them far less then they will actually cost to provide.  If this is the case, then nobody wins!  Taxpayers are on the hook for the full cost, but employees do not value the benefits fully.  So the total cost of providing public services goes up!

We would all be better off to have legal clarity.  If the state courts rule that the benefits are protected, then public employees and retirees can go back to valuing their benefits at full value (which will help with recruitment, retention, and general happiness), and the state can move on to figuring out how else to manage its serious fiscal problems.  If the court rules that forcing higher contributions does not violate the contribution, then we can hopefully have a sensible conversation about what the optimal mix of wages and benefits are going forward. 

Either outcome would be far preferable to the current situation.

So, the State of Illinois is at it again, talking about reducing pension benefits for current state employees.  Let me get one thing out on the table right from the start:  I believe that the Illinois Constitution is clear on this point: benefits to current employees cannot be reduced.  The plain language of the Constitution is clear, and legal opinions to date support the view that the Constitution guarantees that benefits promised to employees by the Illinois Pension Statute at the time they were hired cannot be “diminished or impaired.”  (Note: I do have ideas for things that can be diminished or impaired without violating the Constitution, but that is a blog for a different day.)

I understand that the state is in a downward fiscal spiral, but that is part of a general problem – for years the state has spent more than it can afford.  Two things.  First, the pension problem is a symptom of that, not a cause.  For decades the state has opted not to make the statutorily required contributions to the public pension systems.  Instead, it has chosen to spend the money on current goods and services or to keep taxes lower than they otherwise would need to be.  There’s nothing wrong with that, but to blame the pension system for the state’s financial problems is like blaming Bernie Madoff’s victims when his Ponzi scheme went bust.  (To be fair, to the extent that state pension systems are overly generous, that’s a problem.  It could be that, due to lack of competition, the strength of labor unions, and difficulty making comparisons for public jobs like police, firefighters and teachers that have no clear private counterpart, state and local employees are overpaid in general and in terms of their pension benefits.  But as I’ve argued before, the best studies I’ve seen show that overall compensation to state and local employees consisting of wages, pensions and other benefits, is pretty competitive with the private sector.)  Second, even if the pensions are overly generous, they are guaranteed by the Illinois Constitution and state employees have held up their end of the contract.  It sets a terrible precedent that the state should be able to ignore its contracts and violate the Constitution when things get tough, especially because the reason why things look so bad for pensions is that the state has not made prudent funding decisions.  It is exactly for this reason that the guarantee is in the Constitution, and “we’ve refused to pay into the pension fund for so long that now there is no choice but to renege on our obligations” seems just crazy, like telling your child that since they didn’t clean up their room for a month you’re going to clean it for them.  It is no way to force a government that has trouble facing fiscal realities to do so.

But, set that aside, and suppose just for a minute, that the State succeeds in breaking its promises to its employees and violating the Illinois Constitution.  Suppose that the current system is replaced by a choice between less-generous defined benefit package (like current pensions but lower benefit and higher cost) and a less-generous defined contribution system, a 401k-like system where employees and the state make contributions to investment accounts that grow or not along with the stock market.  How do we expect state employees to react, given that they had been planning on a more generous retirement package?

• The decrease in retirement benefits might cause current workers to demand greater compensation, most likely in the form of higher wages.  [Note: I can also come up with reasons why it might not.  For example if current workers think they’re never going to get a dime from the state under the current system, then moving to a system that has a higher likelihood of delivering a smaller payment might actually be a good thing for them.  Of course, wages are unlikely to go down in response.]
• Decreased faith in the state government as an employer that honors its commitments might make talented people less likely to go to work for the state, or make them demand higher wages if they do.  [Same note as above applies.  Maybe people have so little faith in the state right now that improving their short-term finances would make them more willing to work for the state.  For more on that point, read on.]
• Good employees with outside opportunities could demand higher wages in order to continue to work for the state.  Again, this could either increase wages or reduce the effectiveness of the current workforce.  To the extent that high wages for stars pull up wages for similar employees, this could put pressure on wages across the board.
• Even as good employees leave the system, “bad” employees with limited outside opportunities will continue to work for the state.  This phenomenon, which economists call “adverse retention” could result in a rapid deterioration of the quality of the state’s workforce.
• Mid-career employees that had planned on a more generous pension might postpone retirement.  To the extent that more experienced employees have higher wages, this could result in higher wage bills for the state.  To the extent that some jobs, like police and firefighters, require physical strength that wanes with age, this might result in reduced capability or the need to hire more workers to do the same amount of work.  This is even true in academia, where younger scholars are often more in touch with the latest-and-greatest developments in the field than older ones.
• If workers lose confidence that the state will continue to fund even the reduced defined benefit  pension system in the future, they may move toward the defined contribution system because in such a system the state is forced to make contributions to the employee’s account every year, so that the employee can start investing that money.  Now, one of the nice things about defined benefit plans from the state’s point of view is that the state has had the option (which it has used) to delay making contributions to the plan in order to use the money for current purchases.  If pension reform drives employees toward defined contribution plans, the state will lose this option.  It will have to come up with all of the cash immediately, and given how bad the state’s financial system is right now, it seems like transforming the pension obligation from a future liability to a need to come up with large amounts of additional cash immediately may actually make the state’s short-term liquidity problem even worse than it currently is.  Sure, it will force the state to adopt a more realistic approach to budgeting, but there will be definite costs to doing so.

There are more, but you get the idea.  Policymakers often focus on the “intended consequences” of a policy change.  In this case, reducing pension benefits will reduce the amount the state has to pay into its pension system.  That’s clear.  Economists, on the other hand, like to think about the “unintended consequences” of policy changes.  In the case of reducing pension benefits, the unintended consequences could include higher wages, later retirements, and a general decreases in the quality of the state’s workforce.  In my mind, the last bullet point above is especially important.  If pension reform pushes workers into the DC plan, the state might find itself needing to come up with a whole lot of cash in a serious hurry.  There are probably more, but what seems clear is that in the rush to find a short-term solution to a long-run problem whose scope is much larger than the pension system, nobody is really thinking about to what extent the unintended consequences of pension reductions could offset the intended ones.

Just a short note today (which I learned from reading Institutional Investor) to point out that the Illinois Teachers’ Retirement System on April 8 approved a change in portfolio allocation.  Specifically, they are going to increase by 5 percentage points the fraction of the pension portfolio going to hedge funds and private equity.  The increase is coming primarily from a reduction in domestic equities from 26% to 20% of the portfolio.

What I find ironic (indeed, it would be amusing if the stakes were not so high) is the statement by the Chief Investment Officer that they are doing this to “minimize risk and maximize returns.”

There is a major problem with this statement.  Namely, it is impossible to do both.

It is possible to minimize risk, while holding the return constant.  Or one can maximize returns, while holding the risk constant.  Indeed, these are two different ways of – in financial economics lingo – to get to an “efficient” portfolio.

But it is impossible to do both simultaneously.  In financial markets increased market risk and increased expected returns go hand-in-hand.  As Frank Sinatra said about love and marriage, “you can’t have one without the other.”

Many academic economists, including me, often weigh-in on public policy issues.  One of the things we quickly learn is that academic discourse and political debate can be quite different.  One example of this is that academics are quite good at isolating specific questions (e.g., “holding all else constant”), while political debates often combine issues in an attempt to “spin” the discussion for or against a certain idea.

The public pension debate is a prime example.  There are at least four very important – but conceptually distinct – issues that often get discussed.  Three of these are areas where there are legitimate grounds for disagreement.  The fourth, however, is a pure issue of measurement over which there is virtually no disagreement among academic economists (regardless of ideology).  But others have succeeded in politicizing the issue, and the implications of this are important and unfortunate. 

What are the four issues?

Question 1:  Should public sector workers continue to be offered Defined Benefit plans, or should they be offered Defined Contribution plans instead? 

Question 2: If we continue to offer DB plans, should we fully pre-fund them?

Question 3: Assuming we do at least some pre-funding, how should the assets be invested?

Question 4: What is the value – in today’s dollars – of the future pension benefits that we owe?

These are all distinct questions.  Two people could completely disagree on whether public workers should be offered DB or DC plans, but they might still agree that if a DB is offered, it ought to be fully funded.  Or they could agree that they both like DB plans, but then disagree on the optimal portfolio allocation.  Indeed, for each of the first three questions, there are a number of intellectually defensible answers, and smart, well-educated, good-intentioned individuals can disagree simply because they place different weights on different factors.   Fair enough.

But question 4 is unlike the other three.  Question 4 is not a question about values or weights or the perception of pros and cons.  Question 4 is a measurement issue, pure and simple.  Financial economic theory – and centuries of experience with financial markets – provide clear principles on the right way to discount future pension liabilities.  Namely, you pick a discount rate that reflects the risk of the liabilities themselves.  Every academic financial economist I have ever asked (and there are many, including several Nobel Laureates) agrees on this point (and this is true regardless of their personal political ideology).  Furthermore, they agree that the right answer to this question is *completely* unrelated to how a plan invests its assets (question 3), or whether the plan pre-funds (question 2), or whether the individual prefers a DB or a DC plan (question 1).  They agree that it is a simple measurement issue.   Just like 1+1=2, and this is true for both liberals and conservatives.

Unfortunately, a large number of non-academics – ranging from the Government Accounting Standards Board to some plan administrators to some ideologically-motivated “think tanks” – have managed to turn a clear measurement issue into a muddled ideological and political issue.  In essence, they have begun to argue that 1+1 is actually equal to 1.5, not 2.  And they further imply that those who say 1+1 is equal to 2 are just out to destroy DB plans. 

They do this by saying that those who would discount public pension liabilities the correct way (using a risk-adjusted discount rate -which results in an estimate of about $3 trillion of under-funding in public plans – rather than the intellectually vacuous but “official” estimates of about $1 trillion) are just out to make DB plans look “more expensive.”  They accuse scholars of trying to inflate the costs of DB pensions for some political reason, such as a desire to privatize the system.    

All of this is nonsense.  Many of these same economists disagree on the answers to questions 1, 2 and 3, but we all agree that we ought to at least start with an accurate measurement of the size of the pension liability. Whether one believes DB plans are the greatest human invention of all time, or the worst sin ever committed, should have no bearing whatsoever on how we calculate the present value of our future pension liabilities.  It is also true that how we invest our assets has no bearing on the size of the liability (after all, a dollar invested in stocks today is still worth the same as a dollar invested in bonds today). 

Unfortunately, this politicization of a fundamental economic principle is not merely an intellectual frustration to academic financial economists.  Understating the true economic costs of future pension promises has real consequences.  It distorts decision-making.  It artificially stacks the debate in favor of some reform options and against others.  It promotes excessive risk-taking.  And, perhaps worst of all, it disguises the true cost of government to current taxpayers.

David Cay Johnston of Tax.com wrote a piece that appears to have gone viral on Facebook.  In it, he makes a well-reasoned case that public workers in Wisconsin have paid for their own benefits by accepting lower wages.

The key to his argument is this statement:

“The fact is that all of the money going into these plans belongs to the workers because it is part of the compensation of the state workers. The fact is that the state workers negotiate their total compensation, which they then divvy up between cash wages, paid vacations, health insurance and, yes, pensions. Since the Wisconsin government workers collectively bargained for their compensation, all of the compensation they have bargained for is part of their pay and thus only the workers contribute to the pension plan. This is an indisputable fact.”

This argument is one that economists clearly understand.  In fact, I agree that this view is the right starting point for analysis.  But that does not mean it is the right ending point.  In this case, I think Mr. Johnston has over-played his hand.  Indeed, there are compelling reasons to think that taxpayers do pay for part of these pensions – although not for the naïve reasons that Mr. Johnston blasts the press and politicians for touting.

As background, let me explain how economists like me tend to think about these things by starting with the case of a simple per-unit tax on a good.  One of the first lessons of public finance is that it generally does not matter whether this tax is levied on the buyers of the good or the sellers.  Why?  Because in a competitive market, prices will adjust so that the net-of-tax prices paid by the buyer and received by the seller are the same under either scenario.  We refer to this as the “economic incidence” of the tax (i.e., who really pays the tax in the sense of bearing the economic burden of the tax).  This is separate from the “statutory incidence” of the tax (i.e., who is responsible for writing the check to pay the tax authorities).  This is a key lesson from the economics of taxation and it has broad implications.

An example of this is the Social Security payroll tax.  Up to a cap, individuals pay a 6.2% tax to support Social Security, and their employer pays another 6.2%.  But most economists who have studied the issue believe that, given the characteristics of the labor market in the U.S., it is likely the workers who bear most of (perhaps the entire) 12.4% payroll tax burden.

An example helps.  Suppose you earn $100,000 and you and your employer each pay $6,200 to the government.  If the entire 12.4% tax was shifted onto the worker, and the employer did not have to pay any at all, the idea is that in a competitive market, your salary would rise so that your after-tax income would be unchanged.

In a similar vein, Mr. Johnston is making the observation that public employees negotiate over pension benefits as part of an overall compensation package, and that, therefore, every dollar (in present value) of future pension benefits requires that an individual worker give up a dollar of salary today.

As I noted above, this is the natural starting place for any economist when thinking about labor markets.  Indeed, I have made similar points myself in this blog when discussing changes to the Illinois pension system.

Thus, if Mr. Johnston wrote this piece for my undergraduate economics class, he would receive an A.  However, if Mr. Johnston wrote this piece for an advanced course in economics, he would probably get a C for massively overstating his case and extrapolating beyond what evidence suggests.

My main concern is his claim that “only the workers contribute to the pension plan. This is an indisputable fact.”  Because despite everything I have said so far, this claim IS disputable.

How?

The theory above works well in a competitive labor market in which all of the actors are operating with perfect information.  It implicitly assumes that public workers value the pension benefit at its full cost, and that politicians and union leaders are negotiating a deal that approximates a market outcome.

There are many problems with this.

For starters, there IS evidence that workers tend to under-value future pension benefits (or at least discount future benefits at a rate far surpassing market rates, which has the same effect: see, for example, Warner and Pleeter 2001).  Indeed a recent study by Fitzpatrick (2011) using the DB plan of Illinois teachers provides evidence that teachers value future pension benefits (at least on the margin) at only about 18 cents on the dollar of present value!  How can this be?

For one thing, the federal tax preference for pensions relative to wages creates an incentive to provide compensation in the form of tax-preferred pension benefits even if they are valued less than dollar-for-dollar.  If someone is in, say, a 25% marginal tax bracket, they might prefer pensions over wages even if they value the pension at only 80 cents on the dollar.

But even this cannot explain the entire discrepancy.  More likely, we are observing the fact that union leaders and legislators are not operating in a perfectly competitive market environment.  This is not a case of employees negotiating with employers over a pool of profits, in which the employers are accountable to shareholders through the board.  This is a case in which unions help elect the officials with whom they are negotiating.  And they are not bargaining over profits, they are bargaining over tax revenue, which the government can require a third party – the taxpayer – to pay.  Now, of course, the non-public-employee taxpayers can theoretically hold the legislature accountable, but this is easy to circumvent by a) pushing the real cost of the increased pensions onto future taxpayers and b) hiding behind government accounting rules that disguise the true cost of providing the pensions.  So Mr. Johnston is holding the size of the overall compensation package fixed in his analysis – when in reality the size of the compensation package may be inflated by the bargaining process that is partially protected from market forces.

In sum, there are legitimate reasons to think that public employees may not have paid for their entire pension.  If so, then in Mr. Johnston’s own words, this could be considered a “serious crime” because it is “the gift of public funds rather than payment for services.”

Unfortunately, we really do not know the extent of this “crime” because we lack a careful empirical study of the Wisconsin situation.  But if I were a betting man, I think the odds are quite good that taxpayers have borne (or perhaps more accurately, future taxpayers will bear) at least a sizable part of the cost of public pensions.