The Hidden Economic Logic Behind the “Take it to the Courts” View on Illinois Pensions

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on May 23, 2011

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.

Our Annual Entitlement Check-Up: The News is Not Good

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

On Friday, the Trustees of the Social Security and Medicare trust funds issued their 2011 report on the fiscal status of these programs.  The annual Trustee’s Report has long been considered the authoritative and official guide on the health of our largest entitlement programs. And the prognosis – yet again – is not good.

As background, there are six Trustees – the Secretaries of Labor, Treasury and Commerce, the Commissioner of SSA, and two public trustees (one Democrat and one Republican).  This is the first report since 2007 that has been signed by the two Public Trustees, as it took years of political wrangling to finally get those positions filled after the terms of the former Trustees expired.  The new public trustees – Robert Reischauer and Chuck Blahous – were confirmed just last Fall,and they are, by the way, absolutely fantastic choices.  (If you will allow me a bit of personal history, I was myself nominated by President Bush for one of the positions in February 2008, but I was never confirmed because the Bush White House and Senate Majority Leader Harry Reid could not come to agreement over who the other nominee should be.  My nomination expired unconfirmed when Bush left office, and so the whole process had to start again.)

Those of use who have been reading these annual reports for years tend to comb through them looking for subtle changes in emphasis and language as well as to understand the differences in assumptions that drive the size and timing of the future deficits.  But despite the year-to-year fluctuations in these measures, the over-arching story has been largely unchanged for decades.  The main message has consistently been that these programs are on unsustainable fiscal paths, and we have to take meaningful steps to reform the programs.

If you want to read all the specific numbers, and depress yourself by looking at the impressive charts of just how bad things can get, you can read the summary of the report by clicking here.

But if you just want to get an overall sense of the main theme, then allow me to quote from the text written by the two Public Trustees.  I think they pretty much nailed it with these few sentences:

“Notwithstanding the updates that will take place in the future, certain fundamental conclusions are inescapable and will almost certainly remain so as long as current policies continue unchanged. The most important of these conclusions is that both the Social Security and Medicare programs face substantial financial shortfalls that will require significant legislative action to address. A corollary of this finding is that the longer such legislative corrections are delayed, the more adverse the consequences will be for those who will bear the costs of closing these imbalances. The remainder of this message addresses the causes, severity, and certainty of these shortfalls — and the costly consequences of further delay.”

Translation?  These programs are in deep trouble, and the longer we wait to fix them, the worse it is going to be for everyone affected (including taxpayers and retirees).

Just like the physician who warns her patient every year at the annual physical that continuing to eat fatty foods while living a sedentary life is a sure road to a heart attack, the Trustees play a useful role in annually warning us of the fiscal heart attack awaiting our nation.  Let’s just hope Congress and the President start heeding the advice.

How Generations of Seniors Were Framed …

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on May 13, 2011

I had planned to post a blog discussing my research about how the way the Social Security Administration framed the benefits claiming decision may have led generations of seniors to claim benefits earlier than they otherwise would have.  But the U.S. News and World Report beat me to writing about my own research.  So I will simply link to their blog here.  Enjoy!

Founding Fathers on the Social Security Trust Fund

Filed Under (Retirement Policy, U.S. Fiscal Policy, Uncategorized) by Jeffrey Brown on May 1, 2011

We found some amazing old footage of President George Washington and President Thomas Jefferson discussing the Social Security Trust Funds.  Enjoy!

Pension Discounting: The Brits Have It Wrong Too

Filed Under (Retirement Policy) by Jeffrey Brown on Apr 27, 2011

Today’s Financial Times has reported on a letter signed by me, my Illinois colleague George Pennacchi, and 21 other pension experts in the U.S., the U.K., and Australia explaining why the Chancellor of the Exchequer needs to re-think how pension discounting is done in the U.K.  It seems the U.S. is not the only nation having trouble grappling with basic financial economics.

Illinois Teachers’ Pensions Increase Allocation to Alternative Investments in Order to Do the Impossible

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Apr 21, 2011

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.”

 

The Odd Political Calculus of Social Security Arithmetic

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Apr 18, 2011

One of the many lessons I learned from working in the White House and from serving as an outside adviser to a Presidential campaign is that – as totally backwards as this sounds – sometimes the best way to preserve options for solving policy problems is to have politicians not talk about solutions.  Publicly, that is.  Especially during a campaign season (and, these days, when is it not campaign season?)

Why do I say this?  Well, put simply, when politicians take public positions on controversial issues, they often state what they are against, rather than what they are for.  Think “no new taxes.”  And once politicians take a public stand against an issue, they are loath to change positions for fear of being labeled as a flip-flopper.  (Indeed, the very fact that you can think of times when politicians have said one thing and done another is evidence of this very point: people pay attention – and remember – when politicians do this!)

This may be the silver lining to the fact that the silence on Social Security is deafening.  Neither President Obama’s impassioned speech nor Republican Congressman Paul Ryan’s politically bold plan for deficit reduction provided any specifics on Social Security reform.  Of course, Congressman Ryan has issued very specific Social Security proposals in the past that have included personal accounts, progressive price indexation, and increases in the retirement age.  But his latest plan did not get into specifics.

To read a bit more about it, there is an incredibly insightful piece by Laura Meckler of the Wall Street Journal that was just posted.  It highlights several key facts:

  1. By remaining relatively silent, both sides have left some room to negotiate.
  2. Compromise remains tricky, however, particularly in light of Sen. Harry Reid’s position that Social Security should not even be on the table.  (A view that is consistent with his past irresponsibility in stating that he believes Social Security is fine for decades to come).       
  3. Fortunately, there are a few Democratic Senators (apparently including Dick Durbin) who seem to understand the need for change.
  4. Republicans are also split on the issue, particularly around whether personal accounts are a “must have” or a “nice to have” as part of any negotiations.  And, of course, whether payroll taxes are on the table.

While it is easy to be pessimistic about the political prospects for reform, I am comforted in what appears to be a growing awareness and acceptance of the fact that we are on an unsustainable course, and that “everything” ought to be on the table.  My hope is that extreme positions – such as “absolutely no changes to Social Security” or “absolutely no revenue options on the table” – will become marginalized as more and more people understand the need to make difficult choices to solve these problems.

When Measurement Gets Politicized: The Case of Public Pension Liabilities

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Apr 13, 2011

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.

What are the Policy Consequences of Delaying Social Security Reform?

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Mar 28, 2011

Much has been written about the financial consequences of delaying action on Social Security reform (click here for one such report, notable for the fact that it is genuinely bipartisan).  Most of what has been written deals with the straightforward “mathematics” of delay.  In short, the longer we delay, the bigger the changes that will be required when Congress finally does act.  Regardless of whether you prefer that we return Social Security to financial sustainability via benefit reductions or tax increases, the point is that the longer we wait to do so, the bigger those benefit reductions or tax increases will have to be.  This is well-documented by policy experts across the political spectrum (even if the facts are somehow ignored by many of those that must run for re-election).

Today, though, I want to focus not on the simple mathematics of delay, but rather on what delay means for the politics, and what those politics, in turn, mean for the policy outcome.  In recent years, I have heard two very different views on the subject.  I am not sure which will prove to be correct, so let me just set them out here and invite comments if you have strong feelings on the subject.

The first view, which I first heard in a conversation that I had with a well-known and well-respected policy expert on the Democratic side of the debate (whose name I will not use simply out of respect for the fact that this was a private conversation) who pointed out that the longer we wait to address Social Security, the more likely it was that solvency would be restored through tax increases.  His political calculus was that the bigger the benefit cuts required, the less likely that the political will would exist to make such cuts, particularly given the clout of organizations like the AARP.  This particular individual viewed this as a desirable outcome, as it made it more likely we would keep the current benefit structure in place. 

The second view was explained last week in an op-ed published in the Washington Post.  Chuck Blahous, who is one of two Public Trustees for Social Security (he is the Republican trustee who spent 8 years in the Bush White House, although he was nominated to this current post by President Obama), argues that delay could result in the undoing of the program.  He says:

“Faced with a choice between wrenching benefit cuts and/or payroll tax increases vs. tearing down the wall between Social Security and the rest of the budget, legislators will tear it down. And that would be the end of Social Security as we know it. No more special parliamentary protections. No longer would benefit payments be shielded from the chopping block by the rationale that they were funded by separate payroll tax contributions. Social Security would be financed from the general revenue pool, and its benefits would thereafter have to compete with every other federal spending priority. The irony would be that the program was done in by its supposed defenders.”

These are two very different views from two highly respected experts on Social Security politics and policy.  Sadly, given the reluctance of Congress and the Obama administration to make Social Security reform a priority, we may be given the “opportunity” to find out which view is right.  That is unfortunate, as the better outcome would be to fix the program sooner rather than later, and leave the “what ifs” as a purely intellectual exercise.    

I’d be interested in what the readers think (and you can post your comment by clicking the link below) — does delay make it more likely that we will shore up the program by raising payroll taxes, or does it make it more likely that we will have to desert the 75+ year history of having the program financed by a payroll tax, or does it make it more likely we will have to cut benefits?  Or something else?  Thoughts welcomed …

The Pension Non-Impairment Clause of the Illinois 1970 Constitution

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Nolan Miller on Mar 23, 2011

As a challenge, I tried to come up with the most boring title for a blog.  The winner, “The Pension Non-Impairment Clause of the Illinois 1970 Constitution,” is actually of deep importance to those of us who are state employees.  For those of you who haven’t followed the debate, the short version is:

(1)    Illinois’ public pension systems are woefully underfunded due to a long history of the state failing to make necessary contributions to the system.

(2)    The need to make up for past underfunding is putting a huge amount of pressure on the state’s finances.

(3)    As a means of alleviating this problem, some have argued that we should revamp the pension system for public employees.

(4)    Last year, the state passed a law that reduces benefits for newly hired employees.

(5)    Whether pension benefits can be reduced for current employees depends on the legal interpretation of the non-impairment clause of the Illinois constitution.

The constitutional clause in question is Article XIII, Section 5:

SECTION 5. PENSION AND RETIREMENT RIGHTS

    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.

(Source: Illinois Constitution.)

 (At least) three interpretations of the non-impairment clause have been proposed:

(1)     Once a person becomes a member of a state pension plan, the terms of the plan that were in effect at the time of membership (as defined by Illinois statute) cannot be changed.

(2)    Once a person becomes a member of a state pension plan, accrued benefits cannot be changed, but the terms of the pension going forward can be changed.

(3)    Once a person retires, the terms of a state pension plan cannot be changed, but they can be changed up to the point of retirement.

There is also a related issue of whether pension benefits are guaranteed by the state or by the pension plans only.  Which of these interpretations holds is critical for determining the extent to which pension reform can play a part in solving the state’s budget problems.

I’m no expert (but I play one on the web).  However, a recent analysis of the relevant law by the Illinois Senate Democrats compellingly argues that the correct interpretation of the non-impairment clause is (1).  In this case, pension benefits for state employees are highly protected, and pension reform will play a relatively small role in fixing the state’s problems.  (That is, unless as Jeff has argued pension participants can be induced to voluntarily agree to changes to the pension system.)

Of course, even if the Senate Democrats are right about the interpretation, there is still considerable uncertainty about the future of state pension benefits in Illinois.  Among the open questions:

Even if pension benefits are constitutionally guaranteed, if the state doesn’t have any money, pension checks might be significantly delayed in the same way vendors are currently being paid only after long delays.

What happens if in some future decade the Illinois Constitution is amended to remove the ono-impairment clause.  Will the future state be bound by the promises of a constitution that is no longer in effect?

As a non-lawyer, I have no idea what the answer to the second question is.  If you do, why not leave a comment?