Jane the Actuary Retirement

Forbes Post, “The Social Security Trust Fund Is Real – But So What?”

Originally published at Forbes.com on May 5, 2018.

 

Stop me if you’ve heard this one before:  “Social Security would be doing just fine if the thieving politicians hadn’t stolen all the money from the Trust Fund that we paid in to earn our benefit checks.”

Or maybe this:  “The Trust Fund is just an accounting gimmick, nothing more, and Social Security is broke.”

Who’s right?

The Trust Fund is real.

Well, sort of.

The Social Security Administration does indeed invest its surpluses, that is, the revenues from FICA taxes, taxes on Social Security benefits, and interest credited to the fund, less benefits paid out, into government bonds.  And if you or I, or, say, a pension fund, happened to exist in government bonds, we wouldn’t consider that investment to be “fake,” or the money to have been “stolen” from us.  It’s real money, and we’d have a real right to that money.  In the same fashion, the Trust Fund will redeem its bonds when it begins to run deficits.

But that’s not the end of the story.

Consider that the trust fund is not a matter of “us” saving for “our retirement.”  There was, to be sure, a real element of building up surpluses during the early years of the program, though not to the degree that would truly make it an advance-funded program, rather than only partially-so.  In any event, the Trust Fund was virtually depleted in 1983, and the system would have been unable to pay full benefits but for FICA contribution increases beginning in 1977 and accelerated in a 1983 bipartisan reform bill, which also raised the retirement age to 67 and otherwise stabilized the system’s finances.   The funds which have built up since then are the moderate excess of revenues over payouts following the tax hike, not a true pre-funding as you’d see, for example, in a private-sector pension plan.  Its function is really just, in principle, to smooth out spending over time.

The trouble is, though, that one can outline what the Trust Fund “is” in terms of accounting and financing, but people tend to look at this in a moral sense.  The Trust Fund is the embodiment of American workers’ conviction that, having paid taxes during their working lifetime, they have a moral right to their Social Security benefits, or, more generally, to a retirement free of financial worry.  And this is not the case.

Consider this alternative:  what if, in the 1983 Social Security reform, rather than building up surpluses, Congress had decided that any surpluses would be become general tax revenues and any deficits would be paid directly through tax revenue?  Functionally, there would have been little difference, other than bookkeeping, between building up a fund, nominally, that is immediately funneled into government spending, and doing so directly, and between bonds being redeemed, in the future, requiring new borrowing to fund the redemptions (or running a budgetary surplus — in some alternate universe, anyway), or just borrowing directly.

Alternately, what if Congress had simply decided that FICA taxes would vary each year, determined by the projected Social Security payouts each year?  We would not be discussing the depletion of a fund, but instead, perhaps, would be complaining at the prospect of our FICA taxes growing ever higher.

What would the economy of the United States have looked like in the past several decades had there not been FICA surpluses used to buy (or “buy” with scare-quotes if you like) government bonds?  Consider that the Social Security Trust Fund (in combination with the Disability Trust Fund), at the end of 2016, “owned” 13% of the total National Debt (the link includes a detailed breakdown of what entities own what portion of U.S. debt).  Did the availability of the Trust Fund as a debt-purchaser, help hold down interest rates, keep government borrowing affordable, and keep the deficit lower than it otherwise would have been?  Or did this simply enable Congress to defer dealing with deficits when they might otherwise have been motivated to make hard decisions?

Or consider our Neighbors to the North.  Canada, after all, has a Trust Fund, but the nature of the fund is radically different:  it is a real investment fund, holding a wide variety of assets,  including private equity and real estate holdings (they fully or partially own Petco, Univision, and Neiman Marcus, for instance).  Their long-term planned asset mix is 55% equities, 20% fixed income securities (largely government bonds) and 25% real estate.  (Readers can learn more at the Canada Pension Plan Investment Board website.)  In addition to providing a higher rate of return over time than the interest credits of the U.S. Social Security Trust Fund, the very nature of the Canadian fund is wholly independent of the government.  What’s more, although the Canada Pension Plan has historically been more-or-less pay-as-you-go just as in the U.S., they have actually just recently implemented a benefit increase, which is being phased in slowly enough to be wholly pre-funded by a payroll tax increase.

The surplus that generated the Trust Fund were a missed opportunity.

To be fair, there have been worries about the prospect of the government of the United States managing a sovereign wealth-type fund of such a massive size.  Could an investment board truly make decisions impartially?  Would the government be too heavy-handed, attempt to micromanage the companies in which it invested — for example, by monitoring executives’ salaries for “fairness” or requiring a sufficient number of female or ethnic-minority board members?  Maybe.  But there would have been an alternative — the time would have definitely been ripe for an alternate Social Security system, in which the pre-funded component from those surpluses could have been in the form of individual accounts or pooled but nongovernmental funds (hmmm . . . where have I heard that before?).  Such a system would have allowed for the buildup of real advance funding for retirement, rather than leaving us worried about the future.

But the “Real-ness” of Trust Fund is a bit academic.

The bottom line is that whether the Trust Fund is “real” or just a fiction on paper, in the end, doesn’t matter.  Whether the Trust Fund uses its assets to pay retirees, and the federal government has to borrow, to pay back that debt, or whether the government has to pay those benefits directly, it’s still the case that money has to be found — and the amount of money which will have to be found, for retirement benefits, Medicare, and other expenses, is forecast to grow dramatically.  A January paper from the Brookings Institute provides some very sobering numbers:  due to the aging of the American population, federal spending on the elderly is forecast to grow from the current (2017) level of 20.5% of GDP, up to 29.4% in 2046 — and that’s not 29.4% of government spending, but 29.4% of our total economic output.  And this isn’t just a temporary “hump” due to the Baby Boom.  The author states:

Although we often talk about aging as arising from the retirement of the baby boomers, that is somewhat misleading. The retirement of the baby boomers represents the beginning of a permanent transition to an older population, reflecting the fall in the fertility rate that occurred after the baby boom and continued increases in life expectancy. Because aging is not a temporary phenomenon, we can’t simply smooth through it by borrowing. Instead, it is clear that population aging will eventually require significant adjustments in fiscal policy—either cuts in spending, increases in taxes, or, most likely, some combination of the two.

What should the policy response be to future impact of an aging population?  The paper acknowledges that such forecasting is uncertain, and offers various options but does not promise any easy solution — because there is no easy solution on offer.

 

December 2024 Author’s note: the terms of my affiliation with Forbes enable me to republish materials on other sites, so I am updating my personal website by duplicating a selected portion of my Forbes writing here.

Jane the Actuary Retirement

Forbes post, “So, Hey, Why Not Just Remove The Social Security Earnings Cap?”

Originally published at Forbes.com on April 28, 2018.

 

Am I stuck in a rut and giving every article a rhetorical question title?  Maybe.  But I wanted to address a basic “fixing Social Security” question that one hears regularly: “the fix for Social Security is simple; all we need to do is remove the earnings ceiling and we can not only pay for Social Security as it is, but even build in enhancements.”

And, in fact, that’s the standard funding mechanism of Democrat-sponsored Social Security proposals.  As referenced in an earlier article, in 2017, Senator Bernie Sanders has introduced not-going-anywhere legislation to tax wages and investment income above $250,000 and direct the proceeds to Social Security to extend solvency and boost benefits.  Now, as of last week Monday, Senators Chris Van Hollen (D-Md.) Richard Blumenthal (D-CT) introduced legislation, the “Social Security 2100 Act,” the text of which appears to be modeled off earlier legislation which applies Social Security taxes to income over $400,000 (with no apparent inflation adjustment) with trivial benefit accruals.  (The proposal also includes other changes including setting a minimum benefit at 125% of the single individual poverty line, that is, $18,825, for a 30-year working lifetime with average-wage increases afterwards, increasing employer and employee contributions by 1.2 percentage points in a graded fashion, and merging the Old Age and Disability Trust Funds into a single Trust Fund.)

To be sure, neither of these proposals stand much of a chance of being taken up by the Republicans but it seems relevant to address this issue sooner rather than later.  And, to be fair, the math does work, more or less.  The amateur Social Security reformer can take a look at the Social Security Game, put together by the American Academy of Actuaries, which reports that eliminating the ceiling solves 88% of the gap.

A few international comparisons

To begin with, readers should know that the idea of an earnings ceiling is nearly universal and that the relatively high American ceiling is an outlier.  Interested readers can find summaries of Social Security provisions at Social Security Programs Throughout the World, at the Social Security website.

Our nearest neighbor, Canada, has a ceiling of CAD 55,900 (USD 43,400).

Germany’s ceiling is EUR 74,400 (64,800 in the former East Germany, USD 90,000/78,422) as of 2016.

Sweden, SEK 478,551 (USD 55,000)

The Netherlands, EUR 33,715 (USD 40,800).

In the United Kingdom, there isn’t a ceiling but there is a breakpoint at which employee contributions drop to a much smaller level (from 12% to 2%); that’s GBP 43,000 (USD 59,470).

And, to be sure, there are other countries in which the system is funded rather differently:  Norway and Ireland, for instance, each collect payroll taxes on one’s entire income.  Australia funds its (means-tested) system wholly from general revenues, and the first of Canada’s two parts in its system is also funded from general tax revenues.  Heck, even my own pet proposal for Social Security reform funds its flat first-tier benefit from general revenues, and, to be perfectly honest, my cynical expectation is that the most likely resolution of the future Social Security funding gap will simply be for the federal government to pick up the difference with general tax revenues.  But to remove the ceiling while keeping other elements of the system unchanged would be a deliberate choice that would take the United States outside of mainstream practice, not bring it into the mainstream.

Are Social Security benefits earned?

The longstanding argument for the existence of a cap in the first place is that Social Security is not a welfare program but an insurance system; it happens to be run by the government, but, just like participating in a private sector insurance system, you earn your benefits and receive your fair share, in terms of retirement income and protection against such events as disability or the death of a provider.  If the cap were removed, it would be plain to see that this is just another government benefit, with higher earners subsidizing lower earners by virtue of the lower benefit accrual for above-bendpoint wages, just as already it’s becoming acknowledged that single workers subsidize low-earning married workers.  Would this be the deathknell of support for Social Security?  Not if Medicare is any indicator — despite the removal of the FICA ceiling for Medicare in 1994 and the addition of the Obamacare taxes in 2013, Americans still hold the firm conviction that they have earned their Medicare benefits, fair-and-square.  (See Does The Medicare Payroll Tax Still Make Sense?)

But are we willing to be honest about the impact of removing the cap in our public discourse?  If someone earning greater than $127,000 annually pays taxes on their whole salary, then they’re subsidizing lower earners.  (Even without discussing the mechanics of Social Security, it’s plain to see that there’s a subsidy, or else simply increasing income subject to tax would grow the program overall but wouldn’t improve its sustainability.)  And if they are doing the subsidizing, then other recipients are, in fact, not earning their benefits fair-and-square, but are receiving subsidies. Maybe we’re still OK with that, and maybe we can recast it as, “the rich subsidize the poor and we, the middle class, pay in what we get out.”

But if that’s the case, then why stop with removing the ceiling?  These proposal amount to raising taxes by 12.4% on wages above $127,000, or $250,000 or $400,000.  Why not, then, apply the tax to investment or other non-employment earnings?

And, more importantly, however much we’ve decided that funding retirement income for the elderly is an important objective, there are multiple other competing objectives.  Without trying to start an argument on fair taxation levels, it’s plain to see that you can’t spend the same money twice.  If we are to discuss increasing marginal taxes by 12.4%, is there really a national consensus that it should all be directed to Social Security?  What about healthcare?  Education?  Daycare subsidies?  Parental leave?  Infrastructure?  Affordable housing?

To paraphrase a certain former president, “It’s the opportunity cost, stupid.”

 

December 2024 Author’s note: the terms of my affiliation with Forbes enable me to republish materials on other sites, so I am updating my personal website by duplicating a selected portion of my Forbes writing here.

Jane the Actuary Retirement

Forbes post, “Is This Longevity-Annuity Social Security Proposal The (Retirement) Holy Grail?”

Originally published at Forbes.com on April 18, 2018.

 

Pretty much anyone who hangs up their shingle as a “retirement policy expert” is busily trying to solve two issues:  increasing the level of savings before retirement, and increasing the degree to which that savings is transformed into retirement income that is secure and reliable.  About the former I’ll have more to say in later articles, but for today I want to address the latter issue, in light of a recent Pew issue brief, “Auto-IRAs Could Help Retirees Boost Social Security Payments.”

Here’s the background:

It’s widely acknowledged that continuing to work for some additional length of time beyond the initially-expected retirement age can add substantially to one’s retirement benefits, and one of the pieces of advice that’s floating around at the moment, with respect to retirement, is to delay collecting your Social Security benefits as long as possible.  Typically that’s meant to be accomplished by means of continuing to work, but the good folks at Pew propose something different, to the extent that state-managed auto-enrollment IRAs result in more people having modest amounts of retirement savings.  These retirees, they suggest, shouldn’t try to spread their savings out over the course of their retirement years to supplement their Social Security check, but instead spend down their savings right away in order to defer collecting Social Security and boost their benefits.

The logic here is unassailable:  regardless of whether one’s “full retirement age” is the age 65 of the past, age 66 for those now at retirement age, or age 67 for year-of-birth 1960 and later, the parameters for retirement age adjustments still works the same:  one may choose to collect Social Security benefits at any age between 62 and 70, but that benefits check increases for every year that one waits.  And despite the increase in the age at which the full benefit formula applies without reduction, people still think of the old Social Security normal retirement age (and still the Medicare eligibility age) as “Retirement Age,” and think of the earliest eligibility of 62 as another reasonable choice — hence, these are still the most common ages to commence benefits even with the full retirement age nominally now age 66.

But there is a substantial benefit to waiting until age 70.  Let’s look at the numbers.

The Social Security website helpfully provides both the maximum benefits, as if a worker earned wages greater than the “wage base” for each of 35 years of employment, and an example which is based on a worker with average wages (approximately $54,000).  Separately, they provide the rate at which benefits increase for each year beyond Full Retirement Age that one delays benefits:  for everyone born 1943 or later, benefits increase 8% per year after Full Retirement Age (FRA) up until age 70.  In addition, for each year before the FRA, benefits are reduced by 6.7% (for the first three years) or 5% (more than three years).

Here’s what this looks like, as a percent of pay at retirement for an average worker (with certain simplifications):

Retire at age 62, collect 30% of pay.

Age 66:  40% of pay

Age 70:  53% of pay

And while 53% of pay isn’t spectacular, it’s a heck of a lot better than 30%.

So far, so good, right?  What’s more, Social Security checks are guaranteed lifetime income, with built-in COLAs, without the high cost of having to go out and buy an annuity from a salesman.  That’s pretty hard to beat.

But let’s take it a step further:  what if the Social Security Administration, via a legislation change, allowed this late-retirement benefit boost to continue beyond age 70, up to 75 or even beyond, as far into retirement as one could manage to continue to support oneself on retirement savings, a part-time job, or income of whatever sort?  It would be a game-changer in terms of providing the lifetime income that everyone is looking for.  Waiting until age 75 to collect Social Security, based on the same late retirement increases as exist in current law up to age 70, would increase pay replacement percentages from Social Security alone up to 70% for the average worker.

It’s almost too good to be true.  And, yes, in view of full disclosure, there is a catch.

The catch is this:

it wouldn’t be actuarially fair.  Yes, to begin with, it’s plain that a figure as round and level as 8% could only ever be an approximation of actuarially equivalent adjustment for delaying benefits, and I’m not going to claim I have the tools at hand to calculate the “correct” adjustment factors.  But consider that a sad fact of life is that not only are those workers with relatively more money advantaged in various ways compared to those with less, but their life expectancy is also higher.  And it’s precisely this group that would have the ability to defer collecting Social Security checks, so a calculation of adjustment factors based purely on actuarial tables, rather than taking into account the motivation that healthier people would have to try to increase their benefits by deferral, would be doubly unfair, because unequal benefits would be going to those who are both healthier and wealthier, on average, than the norm.

That being said, even if the increase factor is less dramatic when a proper actuarial equivalence calculation is performed, I’d suggest that this proposal nonetheless has a lot to recommend it.  Consider that, in response to worries about outliving income, one common existing proposal is to promote the idea of “longevity insurance,” a type of annuity that is lower-cost because it only pays out if you beat the odds and live to age 80 or even 85.  But individuals still fear annuities because of their image as being offered by shady commission-seeking salesmen.  If the federal government is going to undertake the provision of COLA-adjusted annuities to all Social Security participants in any case, why not consider this “extended late retirement” as a way to make this work as effectively as possible?

 

December 2024 Author’s note: the terms of my affiliation with Forbes enable me to republish materials on other sites, so I am updating my personal website by duplicating a selected portion of my Forbes writing here.

Jane the Actuary Retirement

Forbes post, “Does The Medicare Payroll Tax Still Make Sense?”

Originally published at Forbes.com on April 16, 2018.

 

Happy Tax Day! — or, rather, Tax Day Eve, or the day after Tax Weekend.

For some Forbes readers, it’s a day like any other, if you filed your taxes as early as possible to get your refund, or if your tax advisor is doing all of the heavy lifting.  But others of you are, like me, wading through a thick pile of forms and muttering to yourself, “file your taxes on a postcard – ha!”  And for some of you, two of those forms, Form 8960, for the Net Investment Income Tax, and Form 8959, for the Additional Medicare Tax, have been making your life just a little bit harder since Obamacare/the Affordable Care Act was implemented.  (Yes, given the income thresholds required before those taxes come into play, those unaffected may not feel too much sympathy, or may not even be aware of them, depending readers’ degree of nerdiness about tax and health care topics, but bear with me.)

Let’s review how Medicare is funded:

Parts B (outpatient/doctors’ services) and D (drugs) are funded via a combination of funds from general federal revenues as well as premium payments, not unlike other federal programs.  But Part A, hospital services, that is, the original Medicare program, is funded via payroll/FICA taxes of 1.45% for employer and employee.  Originally the tax was capped in the same manner as Social Security still is, but in 1994, the ceiling was removed.  Also, as part of the Affordable Care Act, in 2013, two additional taxes were instituted.  For households with income over $250,000, an increase of 0.9% was added for that marginal income in the Additional Medicare Tax, for a total tax rate of 3.8%, and, in addition, for those same households, investment income was taxed at 3.8% as well.

These taxes feed into a Trust Fund, similar to the Social Security Trust Fund, and, like the Social Security Trust Fund, it’s projected to be exhausted, in this case in 2029, at which point, Medicare Part A will nominally be able to pay 88% of benefits.  But unlike (or perhaps, just as with) Social Security, there is no real concern that benefit checks will be reduced by 12%, or that Medicare will pay for 88% of its usual benefits coverage.  Instead it is generally presumed that the same sort of adjustments to provider reimbursements, efforts at coordination of care, and effectiveness initiatives that have been ongoing, or, failing that, another tax hike, will continue to defer this Doomsday.

For Social Security, there are reasonable grounds for a payroll tax, since benefits accrue based on wages, not on total income, and accrue to individuals, not to households.  But for Medicare, there is no relationship between the amount of tax one has paid and the benefits one receives upon retirement.  To be sure, as with Social Security, there are eligibility requirements; one must contribute into the system for ten years, or, alternatively, have been married to a spouse who contributed.  But this effectively functions as a residency requirement to exclude comparatively recent immigrants, and, in turn, a more relaxed requirement permits the purchase of Part A benefits with five years of residency in the country.  There’s no reason why a FICA tax, per se, is needed to implement these requirements.

So, to go back to the question I asked in the title of this brief column, why not fund the system through general revenues, and increase tax rates by the equivalent amount to do so?  It would, after all, be a small step toward tax simplification.

There are two potential answers.  One is cynical, the other pragmatic.

Readers may recall the claims that anti-Obamacare townhall protesters demanded, “Hands off my Medicare!,” for which they were mocked by Affordable Care Act supporters who deemed this proof that the government was perfectly well able to run large health care systems.  More recently, Democrats/Progressives have taken their turn with this “hands off” rallying cry, in response to Republicans again raising the issue of entitlement reform.  Consider these words from an opinion column from Robert Reich from this past February,

Americans pay into Social Security and Medicare throughout their entire working lives. It’s Americans’ own money they’re getting back through these programs.

Preserving Medicare funding via FICA taxes maintains the fiction that Medicare benefits are not merely a manifestation of society’s obligation to care for the elderly, but earned in an almost contractual way.  It gets the job done, in terms of galvanizing public support, but it’s deceptive, because a percent-of-pay contribution for medical care inevitably means that higher earners subsidize lower earners.

On the other hand, “if it ain’t broke, don’t fix it.”  As much as the public perception of Medicare may put up roadblocks for modernizing the system, the separate stream of funding may at least have the advantage of forcing attention to Medicare costs instead of leaving it ignored as just one more piece of the deficit.

 

December 2024 Author’s note: the terms of my affiliation with Forbes enable me to republish materials on other sites, so I am updating my personal website by duplicating a selected portion of my Forbes writing here.

Jane the Actuary Retirement

Social Capital in Retirement – looking for stories

Megan McArdle, Washington Post columnist, wrote about a recent study showing that the amount of “Social Capital” — defined as ” the network of personal and community bonds that help humans and communities function effectively” — varies dramatically by region.

In the meantime, not long ago, I revisited a theme I’ve written about in the past, “I’m sorry, but ‘aging in place’ is still is a piece of *@!%,”  in which I carp about the stubborn refusal of the elderly to get with the program and move into housing that better meets their needs rather than causing their kids to worry (yeah, OK, I have some personal gripes here).

So here’s a request:  please share with me your stories — from your own life or older people you know.  Do they have “social capital” and how does it affect their experience of aging?  And did a move to a retirement community enrich or dismantle their social capital?

Jane the Actuary Retirement

Forbes post, “Why Public Pension Pre-Funding Matters (An Explainer)”

Originally published at Forbes.com on April 3, 2018.

 

In the news lately:

“Puerto Rico gov defies board, rejects reform, pension cuts,” April 2, 2018, ABC News (AP).

The powers of a federal control board overseeing Puerto Rico’s finances could soon be tested as the U.S. territory’s governor on Monday defied its calls to implement more austerity measures amid an 11-year recession.

Gov. Ricardo Rossello rejected demands that his administration submit a revised fiscal plan to include a labor reform and a 10 percent cut to a pension system facing nearly $50 billion in liabilities.

“Kentucky teachers to skip work after lawmakers’ ‘bait and switch’ on pension reform,” March 31, 2018, CNN.

More than 20 Kentucky counties had schools close Friday after the state Legislature approved changes to their pension the day before.

Educators, who are furious over the pension issue, called out of work sick or requested substitutes in protest.

The bill, which overhauls the state’s pension, passed mostly on party lines and heads to Gov. Matt Bevin, who supports reforming the system. State leaders say it’s critical to fix the pension crisis, which ranks as one of the worst in the US.

“Court strikes down Chicago Park District pension plan,” April 2, 2018, Chicago Tribune.

Chicago Park District pension fund overhaul that Mayor Rahm Emanuel once held up as a model of city-union cooperation has been struck down by a judge, in a ruling that could produce more vexing financial challenges for both the mayor and taxpayers.

Circuit Court Judge Neil Cohen ruled that a January 2014 state change to the district’s pension system was unconstitutional because it diminished benefits by raising the retirement eligibility age and reducing both cost-of-living increases and disability benefits.

Cohen then ordered that the district return to workers the higher retirement contributions they’ve made as a result, with 3 percent interest tacked on. He also ordered the district to make payments covering reduced disability payments, plus interest.

Three separate news items, each a reminder of the perils of underfunding public pensions.  But let’s backtrack a bit.

Years ago, as an actuarial student, preparing for actuarial exams, I learned the ins and outs of pension plan funding methods and funding requirements, and I have a vague memory of reading about public pensions, which were not a part of my day-to-day work.  I remember pretty much two items:  first, the eye-popping idea that state constitutions promised state and local employees that they could keep their existing benefits, not just for past service accruals, but for all future years of employment; and, second, the notion that it was generally accepted for public plans to be un- or underfunded because, after all, unlike private employers, whose very real risk of bankruptcy was highlighted by the Studebaker plan failure that was the motivation for the Erisa pension funding legislation of 1974, public employers posed no such risk to their employees since state and local governments would always be around.

Now, that particular reading has long since been consigned to the recycling bin, so I can hardly cite chapter and verse on that statement.  Did the author say, “It’s perfectly fine for public pension plans to be unfunded” or maybe just “It’s not as bad a problem as for private employers” or even “Some people might claim that it’s OK”?  I don’t know. In any case, the idea seems antiquated in 2018.

But these various recent news items suggest that now is as good a time as any to actuary-splain a bit: Yes, it matters that public pensions are funded, and, no, it’s not just a matter of greedy pension-cutters using underfunding as an excuse to destroy pension benefits.

 Legacy costs

One key assumption underlying the explicit acceptance of underfunded pension plans, or the indifference to remedying the situation, is that, in fact, public employers will always be there.  Yes, they might declare bankruptcy, either by name or in practice by defaulting on bonds, but no city or state is just going to shut down like a factory closing.

But the first new article above is an instance of this very thing occurring:  the population of Puerto Rico peaked in 2000 at 3.8 million, then declined slowly in the first decade of the 21st century, then precipitously through 2016.  The long-term effects of Hurricane Maria aren’t yet known, but one economist, Lyman Stone, has presented forecasts of population declines in which the population is halved by 2060.

And this is, of course, what has already happened with the city of Detroit:  from a peak of 1.8 million residents in 1950, it has now dropped to less than 700,000 (estimated) in 2016.   It is plain to see that whatever cost of pensions one might consider affordable for a tax base of 1.8 million, cannot possibly be so for less than half the population, nor is it possible to predict whether one’s one state or municipality will be booming and prosperous or shrinking and struggling — at least not with enough time to plan ahead.

Fiscal responsibility

We know the story of what happened with Detroit, or, at least, a brief search brings up the denouement:  retirees took a 4.5% cut in pensions, new employees were moved into hybrid plans, and the major foundations in the city came to the rescue of pensioners and the Detroit Institute of Arts, the collection of which was at risk of being liquidated to pay creditors, in a “Grand Bargain.”

But why did it get that bad?  Here’s the Washington Post, in 2013 (quoting the Detroit Free Press to which it links with an invalid link):

Detroit officials have also made a habit of convincing unions to accept pension sweeteners — shorter terms of employment required, more generous multipliers, or a “13th check,” essentially an annual bonus — rather than pay increases.

And this is the story that’s repeated over and over again.  Pensions are made more generous — with high accrual rates, low retirement eligibility ages, generous cost of living provisions — as a means of providing more generous compensation to state and local employees, without actually needing to pay anything from the current year’s budget.  Costs are deferred until well after current legislators have themselves retired.

Fundamentally, that’s what’s going on in Kentucky: the state’s governor, Matt Bevin, has now recognized the importance of funding pensions, and is maybe a bit embarrassed at the state’s tied-for-last-place pension funding status, but because the past generosity of pensions had been effectively borrowing from future generations, even if without the explicit label of “debt,” there is no money available to shift into better present-day compensation instead.  (See this extensive backgrounder for more.)

And pension debt is even worse than ordinary state debts, for instance, bond issues for building up infrastructure.  Pension debt is nothing other than borrowing to pay for present-day employee salaries.  And, worse, legislators can pick and choose when and whether to “pay off” the debt or allow it to grow (that is, by making, or failing to make contributions to the pension funds).

Sound governance

Third, pension funding is fundamentally a matter of good governance.  The Chicago Tribune article on the Chicago Park District pension reform attempt is just the latest development in the Illinois Tale of Pension Woe.  In fact, it’s actually it’s a counter-example to the usual case in Illinois, in which individual municipalities, school districts, and the like, determine their teacher compensation and pay the corresponding percent-of-pay contribution requirements to the appropriate pension funds, and have no further obligation, with the state taking on the obligation to make up for any underfunding, whether due to failure to make the state’s own contributions, or due to investment losses, or losses due to unfavorable actuarial experience.  Only in Chicago does the city bear full responsibility for deficits — a responsibility which produced, on the one hand, in the case of the Park District, a union agreement for pension reductions, as touted in the above article, and, on the other hand, a lawsuit by the city against the state with the claim that the state’s picking up the underfunding for non-Chicago pensions was “separate and unequal” system of funding.  (What happened in the end?  The usual horse-trading.)

But Illinois has long been dogged by issues of pension spiking, by all of the other government entities who bear no further responsibility after their contributions are made.  As the Chicago Tribune reported back in 2015, the state passed a law as far back as 2005 to counter the regular instances in which teachers received substantial pay increases (e.g., 20%) to boost their pensions at little cost to the local schools; from then on out, local schools were required to pay the additional actuarial cost of the increased pensions resulting from high late-career pay increases in excess of 6%.  But, as the Tribune reports,

The Teachers’ Retirement System of the State of Illinois, known as TRS, used legal exemptions to waive almost 75 percent of penalties for local districts across Illinois, a Tribune investigation found. The waivers shifted the cost of those penalties to taxpayers statewide.

What’s more, at a time of low inflation, the 6% cap still provides a lot of room, and local school boards are maximizing the advantage they take, as reported in 2017, by giving teachers the maximum pay raise in the years preceding retirement, to boost their pension, however much it exceeds that of younger teachers.

It’s a no-win:  if the local government that sets pay levels is the one that bears responsibility for the cost of future pension obligations, the risk of legacy costs overwhelming a town’s budget increases; if the state government is liable, they’re at risk of skyrocketing costs when others game the system.

Finally, I titled this article, “Why Public Pension Pre-Funding Matters,” and, in fact, a well-funded plan goes a long way toward remedying the risk of legacy costs — if the funding valuations and asset allocations are based on assumptions that are sufficiently conservative so as to minimize the risk of future adverse experience.  But it’s not an easy solution to the problem of a legislature that too easily succumbs to the temptation to defer funding, or local school boards that are too eager to game the system.  And pension funds can themselves be at risk of further problems, when the state uses the funds to dole out political favors by means of investment choices or management firms.  But I’ll save for another day the debate about what retirement provision for state and local workers should look like in the first place.

 

December 2024 Author’s note: the terms of my affiliation with Forbes enable me to republish materials on other sites, so I am updating my personal website by duplicating a selected portion of my Forbes writing here.