Why WEP?

Filed Under (Retirement Policy, Uncategorized) by Jeffrey Brown on Aug 23, 2010

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

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

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

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

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

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

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

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

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

Social Security Primary Insurance Amount If No WEP Adjustment Applied

 

Average earnings covered by SS

Average earnings not covered by SS

Average total earnings

Benefit if SS formula applied to covered earnings

Benefit as % of income if no WEP adjustment

Larry

500

0

500

450

90%

Mo

5000

0

5000

1891

38%

Curly

500

4500

5000

450

90%

 

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

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

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

The Laws of Arithmetic and Illinois Pensions

Filed Under (Retirement Policy) by Jeffrey Brown on May 17, 2010

An article on Saturday in the Tribune pointed out the obvious – that there are no easy solutions to Illinois state budget woes.  Lawmakers are not even thinking about how to backfill the enormous pension funding gap that already exists.  Rather, they are spending all their energy trying to figure out how to deal with one piece of it – namely, the $4 billion or so that is due this year.

It reminds me, once again, of former Fed Chairman Greenspan’s remark about Social Security options, and how we only have three options – raise taxes, reduce benefits, or repeal the laws of arithmetic.

The same three options are the only ones on the table for Illinois.  Our ability to reduce benefits is limited.  And as many have pointed out in comments on my prior posts, one can hardly lay the blame for this problem at the feet of the pension participants who paid their share along the way.  That leaves tax increase or borrowing.  But I would hasten to add that borrowing is just a tax increase on future generations of taxpayers.  This being gubernatorial election year in Illinois, I suspect that lawmakers will once again kick this fiscal can down the road …

Pension Reform in Illinois: Why is everyone cheering?

Filed Under (Retirement Policy) by Fred Giertz on Apr 14, 2010

 

What passes for pension reform in Illinois came with lightening speed in late March. The bill (SB 1946) appeared suddenly and was approved by substantial bi-partisan majorities in barely two days and enthusiastically signed by Gov. Pat Quinn. After some preliminary actions on March 23, the Illinois House and Senate took 71 separate actions on March 24, leading to the final approval of the bill.                  

The bill was widely hailed in the editorial pages of newspapers in the state as well as the Wall Street Journal and by politicians as an important step toward addressing the state’s massive budget shortfall by dealing with the pension piece of the problem – the one that has come to symbolize the cause of and solution to the state’s fiscal woes.

Unfortunately, the pension reform process was seriously flawed on procedural grounds. In addition, the new legislation falls far short of effectively dealing with pension funding problems, not to mention the larger state budget issue. 

In a recent News-Gazette commentary, State Sen. Mike Frerichs, D-Champaign, heralded a new day of openness and transparency in the General Assembly. His Taxpayer Transparency Act (SB 3622), approved by the Senate, would “put an end to the practice of last-minute, secret budgets in Illinois.”   Further, it will mandate “that general revenue spending proposals must be available for public review for four days prior to the General Assembly taking a vote.” 

Overcome by this spirit of openness, the Senate passed pension legislation that few members, not to mention citizens, understood. By comparison, the recent national health care debate was a model of openness and propriety. In fact, two weeks after the legislation was approved, no one in Springfield could give a definitive answer to a number of key features of the bill. There were no significant hearings on the legislation, no real input from the state’s pension systems, and no competent actuarial study before the bill was approved. 

It is surprising how the editorial writers and commentators bought into the reform idea. In a Chicago Tribune commentary, Abner Mikva, an icon of Illinois politics, stated: “Gov. Quinn and the legislature deserve a lot of credit for a pension reform that is a substantial piece of any meaningful fiscal restraint program. More than a faint praise, they deserve a loud hurrah.” It is disappointing that the former distinguished judge, noted for his advocacy of proper and open procedures in politics, would be cheering what transpired in Springfield. 

The faulty process might be forgiven if the results effectively addressed the pension problem.  Instead, the new bill can be viewed as business as usual similar to the so-called reforms of 2003 and 2005, where purported savings to be realized far in the future became the excuse for reduced current funding efforts. 

The pension bill imposes a new dramatically lower second tier by severely limiting pension coverage and pension benefits for new employees. This will differentially impact public school teachers and public higher education employees who are not covered by social security. New retirement benefits will only be partially indexed for inflation, and these adjustments will not be compounded. The result is that a retiree would lose around 28 percent in purchasing power during a 20-year retirement with 3 percent inflation and 50 percent with 6 percent inflation. 

To save state funds, pension benefits for new employees will be based on a fraction of the social security earnings ceiling – currently $106,800 per year regardless of the actual employee’s salary. This too will only be partially adjusted for inflation, which will cause the earnings ceiling for a new employee working 30 years to fall to 64 percent of the social security ceiling with 3 percent inflation and to 42 percent with 6 percent inflation. 

These are only two of several punitive measures that will reduce future pension benefits. The fallacy of this approach is that it assumes that there will be no adjustment necessary in the hiring costs for new employees who are offered drastically reduced benefits compared to current employees. Can new, highly skilled employees be hired with such meager benefits? This can only be done by paying higher salaries to compensate for the lower benefits or through the establishment of supplementary retirement systems to make up for the deficiency. What the state saves in lower pension costs will be partially offset by higher wages and new supplementary benefit costs. 

Rather than using the new pension savings as a means of setting the state on a path to solvency, the new pension bill is used as an excuse for the state to continue its reckless ways by reducing scheduled pensions contributions. What is overlooked in this discussion is that the budget problems facing the state are really the result of excess spending over several decades where deficits have been partially funded by shorting the state’s pension systems. For example, had the state made timely payments (based on actuarial costs of slightly more than 10 percent of payrolls) to the State Universities Retirement System, SURS would be fully funded with assets of around 106 percent of liabilities rather than its actual level of around 50 percent. 

No reasonable observer can deny that pension reform as well as a careful evaluation of non-pension post-retirement benefits such as health insurance needs to be part of a general solution to the state fiscal mess. However, these changes must be accompanied by greater fiscal discipline as evidenced by spending austerity and enhanced revenues. Unfortunately, the General Assembly appears to view its version of pension reform as a substitute for such discipline.

 Giertz is professor of economics at the University of Illinois and an elected member of the State Universities Retirement System Board of Trustees. The views expressed here are his and not necessarily those of these institutions.

  

Misguided Reform Rhetoric Around Illinois Pensions

Filed Under (Retirement Policy) by Jeffrey Brown on Mar 31, 2010

Illinois pensions are in the news yet again.  Last month, the Pew Center on the States reported that Illinois was once again the poster child for everything wrong with the funding of state pensions, noting that we had the worst funding ratio of any state in the country.

 

Last week, Illinois House Speaker Michael Madigan decided – finally – to take some action.  He secured a House vote to change pension benefits for future Illinois state workers.  Specifically, this proposal would raise the full benefit age to 67, cap the maximum pension income at a bit over $100,000, limit cost-of-living increases, and so on.  In short, the package amounts to benefit reductions for not-yet-hired future state workers.  

 

Why this option?  To put it simply, there are only two options for fixing the funding problem. 

 

Option one is increase revenue to the system.  In other words, make additional contributions.  But this would require that Illinois lawmakers raise taxes or cut other state spending, neither of which is politically popular.  

 

Option two is to reduce the liabilities.  But as I have written before, the impairment clause in the state constitution prohibits benefit reductions to existing retirees and existing employees.  So the only way to reduce liabilities is to cut benefits for future workers – those that have not yet joined the system.  And that is precisely what Madigan pushed through the House.

 

[By the way, the only “option three” is to, in the words of Alan Greenspan when discussing Social Security, is to “repeal the laws of arithmetic.”  I am pretty sure that most state governments would choose this option if they could!]    

 

As a fiscal conservative, I have no real objection to the decision to reduce future liabilities in the way that the House has chosen to do.  But two issues that have come up in the debate that I think are worth a bit of analytical clarity.  

 

First, estimates of future savings are almost surely inflated.  There are two reasons for this.  One is that some of the estimates appear to have simply looked at undiscounted dollar flows, which implicitly assumes a dollar saved in 2050 is the same as a dollar saved in 2020.  This is obviously not the case, since a dollar saved earlier has a much higher present value.  A second reasons is that – as I have written before – pensions are part of the overall compensation package.  If we reduce future retirement benefits, our ability to attract top faculty members, for example, will be reduced unless we increase compensation in some other way.  None of the cost savings estimates account for this.    

 

Second, there is clear confusion about the source of the funding problem.  Much of the rhetoric around this legislation focused on the level of benefits.  The Champaign News-Gazette is a typical example, stating:

“A big part of Illinois’ horrendous budget problems can be traced to the high costs for the lavish pensions many public employees enjoy. They are far more generous than those available to workers in the private sector, and that’s a big reason why state public pensions are underfunded to the tune of an estimated $80 billion.”

This is wrong for several reasons.

First, the real source of the funding problem is not level of benefits.  It is the fact the Illinois legislature has consistently failed to make the annual contributions that are called for under standard funding formulas.  My colleague Fred Giertz has done some calculations suggesting that if the legislature had made its required contributions every year, the Illinois system would be slightly over-funded, not under-funded.  In short, don’t blame the pensioners for the lack of fiscal discipline on the part of our politicians.

Second, the comparison of public pensions to private pensions is misleading.  One reason is that the public pension replaces both Social Security and a private pension.  Social Security costs roughly 12% of payroll today.  Private employers who offer pensions typically contribute several percent more.  On that basis, Illinois public pensions are not “lavish.”  A second reason is that – yes, I am repeating myself – this is part of an overall compensation package.  So any comparison needs to account for the value of all salary and benefits, not just a single piece of it.

 

 

 

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 …