Why Taxpayers, and Not Just Public Workers, Likely Contribute to Public Worker Pensions

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Mar 15, 2011

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.

An Idea for Safeguarding Pensioners and Taxpayers

Filed Under (Retirement Policy) by Jeffrey Brown on Dec 10, 2009

In at least one previous post, as well as in other research papers and articles, I have discussed the enormous problems facing the Pension Benefit Guarantee Corporation (PBGC), the government corporation that insures private defined benefit pension plans.  This week, a very talented MBA student at Illinois – Gagan Bhatia – reminded me of a terrific idea that would go a very long way toward providing plan sponsors with economically appropriate incentives for funding their plans.  Right now, plan sponsors lack appropriate and sufficient incentives to fully fund their plan or to choose a portfolio that immunizes the plan funding from market risk.  Sure, the government imposes funding requirements, but they have proven woefully inadequate.

In fairness, while Gagan Bhatia came up with this idea on his own and independently, it is an idea that has been out there, including in some work by Doug Elliot of the Center on Federal Financial Institutions.  Regardless of who gets credit, I think it is a terrific idea.

In a nutshell, the idea is to increase the seniority of pension claims in the event of a bankruptcy.  When a company files for Chapter 11 bankruptcy, the company’s creditors and claimants fall into different pools as per their priority over the company’s assets. PBGC’s obligations fall into the Unsecured Creditors pool which are paid after the Secured Creditors.   

Under this proposal, the PBGC would be moved up the line and be considered a senior, secured claim.  In essence, it would allow the PBGC to get paid first (or at least earlier than under current law) from any assets that the plan sponsor has remaining.

Why does this help?  Currently, creditors have insufficient incentive to consider the funding status of a firm’s pension plan when the firm is issuing debt.  If creditors knew that the PBGC’s claim on the firm’s assets was senior to that of the creditors, then creditors and potential creditors would become powerful enforcers of economically appropriate funding behavior.  Plan sponsors that failed to adequately fund their pension or plan sponsors who failed to engage in asset-liability matching would be considered – appropriately – to be a higher credit risk.  Thus, the firm would have to pay more to borrow.  Firms that funded their pensions and invested them in a manner that mitigated future funding risk would benefit from lower borrowing rates. 

In essence, this approach would harness market forces to achieve a worthwhile public policy goal.  Along the way, both pensioners and taxpayers would benefit. 

 

 

 

The Real Risk to Illinois Public Pension Participants: Retiree Health Care

Filed Under (Health Care, U.S. Fiscal Policy) by Jeffrey Brown on Oct 6, 2009

I’ve noted in prior postings that public pensioners in Illinois have very little to worry about with regard to their pension benefits.  But now the bad news – they do have reason to be concerned about retiree health insurance.

 

As I stated in a previous post, Article XIII, Section 5 of the Illinois state constitution protects pension benefits.  Specifically, it states:

 

“Membership in any pension or retirement system of the State, any unit of local government or school district, or any agency or instrumentality thereof, shall be an enforceable contractual relationship, the benefits of which shall not be diminished or impaired.”

 

That is about as strong of a guarantee as anyone could hope for in this day and age.  Indeed, Social Security offers no such guarantees.  The Supreme Court of the United States has previously (in 1960) ruled that individuals have no inherent “right” to their Social Security benefits (see Fleming v. Nestor).  Congress can alter them at anytime. 

 

But, the above guarantee is limited to the benefits from the retirement system, such as the Statue Universities Retirement System (SURS) or the Teachers’ Retirement System (TRS).  As much as participants might hope that retiree health insurance is a benefit of the retirement system, I (and, more importantly, most of the lawyers to whom I have posed this question) don’t think this argument would stand much of a chance in the courts. 

 

Of course, even in states that do not have explicit constitutional guarantees, retirement benefits are often protected by a contract clause.  And, yes, Illinois has one of those too.  Specifically, the Illinois constitution states:

 

“No ex post facto law, or law impairing the obligation of contracts or making an irrevocable grant of special privileges or immunities, shall be passed.”

 

I have asked a few knowledgeable legal experts about whether this would apply in the case of retiree health care.  The responses are typically consistent – that while contract impairment provisions are sometimes successful with regard to the terms of a retirement system contract, nobody could point to a case where this provision was successfully applied to benefits under an employment contract because employment contracts, by their nature, are temporary.  If you doubt this, just consider the fact that the University of Illinois changed our contracts for the current year to allow the University to require involuntary, unpaid furloughs!

 

Of course, I am an economist, not a lawyer – and I am certainly no judge.  So this is not to say that retired Illinois public servants don’t have a case worthy of court if the state were to eliminate or substantially reduce their retiree health care benefits.  As has been pointed out to me by others, such a case is certainly likely to be given “an attentive listen” by the courts.  But whether that translates into any actual protection of benefits is anybody’s guess.  If I were a betting man (I’m not), then I would best against it.

 

So should retirees panic?  Of course not.  We should never forget that we live in a democracy, and most politicians know that the surest way to lose the next election is to do something that makes a large voting bloc – especially seniors – angry, motivated and mobilized.  Politically, I doubt the state will do anything so drastic as to eliminate retiree health benefits for existing retirees or those close to retirement.  But even if drastic changes are out, the reality of the dire long-run budget picture in Illinois would seem to dictate that retiree health care will be an area that legislators look to for future savings. 

 

So, I would much rather that retired public servants enjoy their retirement worry-free.  But for those who want something to worry about, then retiree health benefits are worth a lot more worry than pension benefits.

Do Illinois Pensioners and Taxpayers Know the True Value of Public Pensions?

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Sep 28, 2009

Last week I wrote about the (often misguided) debate over the generosity of public pensions in the state of Illinois.  I ended by noting that it was important to further examine how my previous analysis would change once we account for two under-appreciated facts about the Illinois pension system.    

 

The first under-appreciated fact is that Illinois is one of a small number of states that provides an explicit constitutional guarantee against the impairment of pension benefits.  Specifically, Article XIII section 5 of the Illinois State constitution states that: “Membership in any pension or retirement system of the State … shall be an enforceable contractual relationship, the benefits of which shall not be diminished or impaired.”

 

While Illinois is not alone in providing this guarantee – similar language is included in the constitutions of Alaska, Arizona, Hawaii, Louisiana, Michigan and New York – it should be noted that not all states provide such a guarantee.  In Indiana, for example, the Indiana Court of Appeals (in Haverstock v. State Public Employees Retirement Fund” stated that “pensions are mere gratuities springing from the appreciation and graciousness of the state.”

 

In a paper that I wrote with David Wilcox in the May 2009 American Economic Review, we discuss just how powerful these guarantees have proven to be over the years.  On the basis of that analysis, I am highly confident that Illinois pensioners will receive their benefits.  Unfortunately, with Illinois having one of the worst records of effective governance in the U.S., most other pensioners and participants are not quite so confident.  One way or another, most of them think, the politicians in this state will find some way to renege (at least partially) on these benefits.  (As an aside, what public servants really have reason to be afraid of is that retiree health benefits will disappear – those are not covered by the impairment clause.) 

 

The second underappreciated fact is that the public defined benefit pension plans in Illinois are far too complex for the average (or even the highly sophisticated) participant, taxpayer or legislator to properly value.  There are many reasons for this, but mainly it boils down to the fact that the ultimate benefit depends on a lot of variables that will only be known with certainty many years in the future, such as one’s final average salary.  If that were not complex enough, the legislature has made it even more complicated by having multiple benefit formulas in place.  For example, in the “Traditional” defined benefit plan under the State Universities Retirement System (SURS), participants who joined the system prior to July 2005 received a benefit that was the higher of two approaches.  The first was the standard formula (2.2% times years of service times final average compensation).  The second was a “money purchase” option that essentially kept track of the individual’s contributions, matched them with a state match (at least on paper – we already know the state did not really provide the money), and then credited them with an “Effective Rate of Interest,” or ERI.  Then, at retirement, the “balance” in this largely fictitious account was converted to an annuity using an annuity table that used a rate quite close to the ERI.  If the resulting number was higher than the standard formula, the annuitant gets this higher amount instead. 

 

Confused yet?  If you answered “yes,” don’t feel bad.  Most participants don’t understand all these details.  It is complex stuff that requires a high degree of financial sophistication to truly follow.  If you answer “no,” then let me ask a few extra credit questions.  First, do you know what mean, standard deviation and range the ERI has been in for the last 25 years?  And do you know how the annuity conversion factor compares to market rates?

 

By this point, I suspect very few people know the answer.  Again, don’t feel bad.  I study pensions for a living, and it took me a lot of time and research to find these answers (and, alas, it was too late – by the time I understood all the details, I had already made a sub-optimal pension choice – and it was unfortunately a lifetime irrevocable one!) 

 

Without boring you with details, let me give you a flavor of what I have since learned.  The way the SURS board has historically set the ERI, participants in the DB plan were getting an enormously high return (roughly 8-9%) relative to the risk (as measured by the standard deviation in the ERI, which was tiny over the past 25 years), and this high return was being implicitly guaranteed by the taxpayer.  And the annuity rate?  It is substantially more favorable than even the most attractive private market annuity prices – I’m talking in the range of 50% or more benefits per dollar in the “account,” and in some cases, far more.  These two factors explain why most people retiring from SURS in recent years actually received a higher benefit from the money purchase calculation than the basic formula.

 

What do these two points – the constitutional guarantee and the complexity of the benefit formula – have to do with each other?  Put simply, they have conspired to put an enormous pension funding burden on taxpayers without providing commensurate perceived value to state workers!

 

Let me explain.  As a result of a complex benefit formula that hides the true value of the pensions – combined with the fact that most participants view the DB pension promises as being at some risk of not being honored – means that most public pension participants do not value the pensions at their full economic value.  This fact partially mitigates the point I made last time because this means the “compensating wage differential” will not be dollar-for-dollar. 

 

However, the fact that participants discount their benefits in this way does NOT mean that the state is not actually incurring the full economic costs.  Indeed, the constitutional guarantee means that the states’ taxpayers ARE on the hook for the full economic cost of these benefits.

 

In essence, we have the worst of both worlds.  Public employees are earning a valuable benefit, but because our legislators have (i) created a needlessly complex system, (ii) created a complete lack of confidence in the security of these promises, and (iii) have provided us with a constitutional guarantee that the benefits will be paid, the participants don’t fully value the benefits even though the state bears the full costs.

 

If any private company did this – providing a costly benefit that was valued by employees at less than the true cost to the employer – that company would soon be bankrupt.  But this is Illinois state government.  So, instead, we continue to build up enormous funding liabilities that will simply be passed on to the next generation of Illinois taxpayers.  It may be “business as usual” in Illinois.  But it’s also a real shame.

 

Public servants and taxpayers of Illinois deserve better.

 

Are Public Pension Plans in Illinois Too Generous?

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Sep 22, 2009

The Chicago Sun Times has recently had a series of articles about public pensions in Illinois.  One of the recent ones – “Public pensions, fat retirements” – focuses on the 4,000 retired government workers that receive pensions of at least $100,000 per year.  The article quotes several people saying things like “it’s both illogical and extraordinarily expensive” to provide such pensions and noting that public pensions are “extremely generous.”

 

There is no question that public pension funding in Illinois is in need of serious attention.  For those that have not yet noticed, Illinois pension obligations are enormous – and this is primarily the result of many decades of irresponsible budget practices on the part of Illinois politicians who have consistently chosen to underfund pensions.  In essence, the State has a history of not paying its pension bills, and future Illinois taxpayers will eventually have to ante up in a big way.  This is an enormous problem, and one that needs to be addressed.  I will focus more on the fiscal strains of pensions in future posts.

 

For this post, I simply want to comment on the debate about whether public pensions are really “too generous.”  What exactly does this mean?  (The short answer is that such statements are largely vacuous … read on).

 

Some people make such statements on the basis of comparing Illinois pensions to those of retirees in the private sector or in other states.  This leads to a whole host of arguments from critics and defenders, such as the fact that Illinois public workers do not participate in Social security.  

 

At the end of the day, however, none of these arguments are the least bit helpful in answering the question at hand.  The reason is that pensions are only one part of the total compensation package.  To the extent that labor markets in Illinois and the US more broadly are reasonably competitive, then workers are trading pension benefits against other forms of compensation, including wages. 

 

Most economists believe that workers bear the cost of employee benefits in the form of lower wages.  Let’s suppose a newly minted PhD has been offered positions as an assistant professor at the University of Illinois and at the University of Michigan.  The academic labor market is pretty darn competitive, so the University of Illinois will only be successful at hiring this person if the total compensation package is competitive.  The pension is one piece of that package, but there are numerous other factors at play as well.  If we were to offer an individual a less generous pension, then the University would almost surely have to compensate this person in other ways, such as higher pay, more generous health benefits, more time off, or something else.

 

So when pensioners say the earned their benefits, they are right.  Not only did they pay their own contributions into the system, but the state contributions (yes, the ones that never actually got made!) were also funded by these very same employees in the form of lower wages.  In essence, state employees accepted lower wages in return for a promised future pension benefit.  

 

If we believe we have the mix of compensation wrong, then let’s adjust this mix for future workers (we have to focus on the future because the impairment clause of the state constitution restricts our ability to do so for current workers).  But let us not be so naïve as to think that we can cut pension benefits while holding all else equal. 

 

So at the end of the day it really makes little economic sense to suggest that pensions are “too generous,” given that the pensioners paid for these benefits throughout their careers.  The problem is not pension generosity – the problem is the politicians who could not keep their hands off the money. 

 

In future posts, I will discuss in more detail how the above analysis changes when we consider two important factors.  First, that in spite of a constitutional guarantee of pension benefits, participants don’t have complete confidence in the inviolability of their benefits.  Second, that the complexity of the pension benefit calculations means that very few participants, taxpayers or policymakers truly understand the true economic value or costs of the benefits that are being provided.  Stay tuned …