Thinking Waaaaaaaaaay Outside the Box on Public Pensions

Filed Under (Other Topics, Retirement Policy) by Nolan Miller on May 16, 2012

I’ve written over the past couple of weeks about public pensions in Illinois.  Short version: they’re a possibly-unfixable mess.  Since the state constitution forbids reducing promised benefits for current employees (or increasing contributions) and the state has failed to plan for their pension promises in a timely manner, the state is stuck between the proverbial rock and a hard place.

With this in mind, over the past few days I’ve been trying to think of unconventional ways in which the state can save money.  This is a bit tricky, since in the case of public employees the state pays their salary when they’re working AND their pension when they retire.  It’s the overall cost that matters.  So, for example, when the University of Illinois had an early retirement program last year, the University stopped paying them and SURS, the state university retirement system, started paying them.  But since both are ultimately using state dollars (but less-so in the case of the University, whose state appropriation as a fraction of overall cost has fallen drastically in recent years), this is really just a reshuffling of which pocket the money comes from.  The state is still on the hook.

Thinking outside the box leads to some crazy ideas.  And here’s one of them.  I make no promises about whether it will work in practice.  But it does point to some of the strange features of state finance.

Here’s the idea: to help the state’s pension system’s finances, the state should pay its workers more as they near retirement.  That’s right.  More.

As I started to play around with the idea, I had a dim recollection of reading something related.  It turns out that a couple of weeks ago, Andrew Biggs wrote in the Wall Street Journal about how cutting the Social Security payroll tax for workers nearing retirement could actually help the system’s finances.  The idea is simple: if older workers get to keep more of their wages, they’ll work longer.  And, if they’re working, they’re not collecting Social Security.  Lowering the payroll tax pushes back retirement, and this helps the system’s finances.  The idea is also related to my post from two weeks ago, where I discussed research showing that retiree health benefits induce early retirements.  If the state can’t pay retirees less and can’t ask them to contribute more, the only thing it can do to reduce pension costs is induce them to retire later, and it needs to do so in a way that costs less than the potential savings from delayed retirement.

So, how does it work?  Consider a worker near retirement age who has been working for the state his whole career, or at least long enough to reach the earnings cap on the state’s retirement system.  This worker, let’s call him Charlie, will earn 80% of his final salary after retirement.  And, assuming this worker was actually fulfilling a necessary function (e.g., teaching students finance), that worker will have to be replaced after retirement by a new worker.  Let’s call him David.  New workers tend to earn less than senior workers, so David will earn less than Charlie did.  Maybe David earns 80% of Charlie’s final salary.  But, essentially, after Charlie retires the state will be paying both Charlie and David – two people – to do work that could be supplied by one person.  While the state paid 100% of Charlie’s salary for that work before retirement, it pays 160% of Charlie’s salary after retirement!

So, the state has the potential to save a lot of money overall – 60% of Charlie’s salary per year – if it can induce Charlie to delay retirement.  Due to the non-impairment clause, a lot of the ordinary ways of doing this such as increasing the full retirement age are off the table.  One thing the state can do is increase Charlie’s salary.  This could be done through an actual wage increase or, as Biggs suggests, by reducing the 8% of wages that Charlie must pay into the retirement system as he nears retirement.

It is easy to see how it might be worth it to the state to spend more money on Charlie’s wages in order to delay his retirement.  But, let’s make up some simple numbers.  I’m going to ignore things like the fact that pension payments increase 3% per year and other details of the retirement system. They don’t change the basic insight, and the uncertainty involved with the other numbers that I’M JUST GOING TO MAKE UP is a much bigger deal than details like this.  I’m illustrating – not proposing policy.

So, suppose that increasing Charlie’s wage by 10% per year leads him to delay retirement by 3 years.  Suppose Charlie makes $50,000 per year and has maxed out his service so he’ll earn 80% of that ($40,000) after he retires.  Assume that David will earn $40,000 after he’s hired.

There are two things that should be taken into account.  If Charlie’s wage goes up, the basis for his pension will go up as well.  Roughly speaking, pensions are based on average earnings over the last four years of work.  Over these years, Charlie earns 50,000 for one year (the year before he gets the raise) and 55,000 for three years (after he gets the raise).  His final pension is 80% of the average, or 0.8 * 53,750 =  $43,000 per year.  Again, there are subtleties to the formula, but too many details obscure the main idea.  And, if Charlie works additional years, he will pay an additional 8% of salary into the pension system.  This would seem to be money that the state gets back.  But, as far as I can tell, these “excess contributions” are refunded to the employee at retirement.  So, in the case of a worker who has maxed out his pension, there would be no additional benefit to the state.  (For a worker who has not maxed out their pension, the state would receive additional contributions from the worker who delays retirement, but it would also have to pay an additional 2.2 percent of final earnings for each additional year of work, so it is unclear that this would benefit the state.)

Total 10 year cost if Charlie retires now:

Charlie’s pension payments: 10*40,000 = 400,000
David’s wages: 10*40,000 = 400,000
Total Cost:   $800,000


Total 10 year cost if Charlie retires in 3 years:

Charlie’s wages (years 1 – 3): 3*55,000= 165,000
Charlie’s pension (yrs 4 – 10): 7*43,000= 301,000
David’s wages (yrs 4 – 10): 7*40,000= 280,000
Total Cost:   $746,000


So, the total savings over 10 years from my COMPLETELY MADE UP numbers is $54,000, or 6.75% of the cost under the current system.  And, this savings occurs in the first three years from not having to pay David.  Although I’ve ignored the time-value of money to keep things simple, the fact that the savings come up front would favor giving Charlie the raise if there were a positive interest rate.

Whether a scheme like this could actually save money would depend on a lot of things.  Among them are how much more near-retirees need to be paid to delay retirement, how long the delay retirement for, the relative cost of replacement workers, the length of time over which retirees draw pensions, and the time-value of money. Again, for the purposes of illustration, I COMPLETELY MADE UP THE NUMBERS ABOVE.  Economists invest a lot of time and energy in estimating quantities like these, though, and they’d need to do so before anything like this could go forward.

One crucial factor would be how well the state can target workers who are really on the margin of whether or not to retire.  While a wage increase across the board would be extremely unlikely to save the state money, one that is targeted at workers who are thinking about retiring and induces them to delay retirement just might.  One thing’s for sure: it wouldn’t run afoul of the non-impairment clause!

The Public-Private Wage Gap, Part II

Filed Under (Uncategorized) by Nolan Miller on Jul 7, 2010

This week, I’m following up on my earlier post regarding the gap between the wages earned by public and private sector workers.  Given the financial problems faced by state and local governments across the country, the idea that overpaid public employees are, in part, responsible for these problems (and that, by extension, lowering their compensation should play a part in solving the problems) has gotten a lot of attention lately.  However, the best evidence we have on the point, not to mention common sense, suggests that the main factual claim underlying this argument – that state and local employees are overpaid on average – is wrong.

The issue of comparing wages across sectors is complicated.  Fortunately, a recent report from the National Institute on Retirement Security provides a nice introduction to the difficulties of the analysis and a comparison of the compensation earned by state/local workers to that of the private sector that paints a very different picture than the one that has been in the newspapers lately.  To be sure, the NIRS study is not without a point of view, and I think that the analysis is off in places, but it is certainly closer to correct than the naïve figures driving the headlines.

First and foremost, we must recognize that government jobs are different than private sector jobs and government workers are different than private sector workers.  In many cases, public jobs (e.g., police, fire fighters) have no private counterparts and vice versa. It is impossible to compare what a police officer earns in the public and private sectors, since there are no private police officers.  In addition, even when jobs have the same basic title, government jobs often have very different responsibilities than their private sector counterparts.  This results in, for example, almost 54% of state and local workers having college degrees, compared to only about 28% in the private sector.

These differences suggest that comparing average wages across sectors, as is done in the USAToday and BLS studies I cited last time, is likely to get the answer wrong due to differences in the composition of the two workforces.  An alternative approach, and the one that is used in the NIRS study, asks the question “given a person’s age, education, experience and other demographic factors, how much more would he or she be paid in the private sector than he would be paid in the public sector?”  Using this “people-based” approach, the analysis comes up with the answer that a typical public employee’s wage is about 11% lower than it would be if that person were employed in the private sector, reversing the basic finding of the newspaper analysis.  (In Illinois, the difference is more like 12 – 13%.)  Even when the study takes into account that public sector employees earn more in benefits than private workers, the gap is still about 7%.  So, the study’s basic finding is that state/local employees have, on average, lower total compensation than private-sector workers.

The NIRS study does a lot to dispel the idea that average state/local employees are earning more than they would in the private sector – getting fat off the taxpayer, as it were.  However, it is not without problems of its own.  The first, which the paper recognizes in a technical appendix, is that the analysis should also take into account that the mix of jobs done by state/local workers differs from that of the private sector.  Controlling for this shrinks the wage gap somewhat.  The second, which Jeff has written about, is that typical government accounting methods undervalue benefits, in particular they undervalue pension benefits.  Properly valuing pensions would further erode the gap.  In the end, I suspect that the gap between state/local (and federal for that matter) workers and private sector workers is quite small and is not systematically either positive or negative.  In other words, markets probably get things about right.

As a final note, here are a couple of economist “smell tests” for wages.  First, when our department tries to hire someone, we are competing against other public and private employers.  When we succeed in hiring someone, we have negotiated to the point where they are willing to accept our offer when compared to their alternatives.  So, almost by definition, the value they place on total compensation at the two places (relative to the demands of the job) should be pretty close.  Of course, since they chose to come here, they must like our packages somewhat better, but if we did a decent job of negotiating, not too much better.  Second, if total compensation in the government sector is systematically higher or lower than those of the private sector, we should see massive flows of workers in one direction or the other.  The fact that we don’t see this suggests that people are, by and large, happy with the jobs they have.  This, again, suggests that the market has wages about right.