The Political Underbelly of the Pensions Crisis: What Broke the System, and How Do We Fix It?

02/25/2014 04:09 pm ET | Updated Apr 27, 2014
  • Rob Johnson Executive Director, Institute for New Economic Thinking

The following is adapted from the author's forthcoming paper on the public pensions crisis.

Since the beginning of the Great Recession, policymakers and reporters have spoken of a growing crisis in public pensions. Many state and local governments are struggling to meet their obligations to retirees, and the easiest explanation is that government workers are overpaid and their pensions are unaffordable. But the evidence suggests that the pensions crisis is both less pervasive and more complex than that. Beyond the economic crisis, which put enormous pressure on state and municipal budgets, a range of factors including poor decision-making and the influence of big money interests has led to the underfunding of some state and city public pensions. With a clearer understanding of the problem, we can begin to take steps to solve it and keep our promises to public workers.

Contrary to public perception, pension underfunding is not a widespread issue. There is wide variation in pension performance across states, and underfunding is concentrated in particular states (for example, Illinois and Kentucky) and cities (Chicago and Providence). Where underfunding does occur, it seems to stem largely from the internal problems of those governments, which existed well before the recent economic crisis put additional pressure on their budgets.

There is also little basis for the conclusion that state and local employees are significantly overcompensated. On the contrary, pay is comparable at lower skill levels, and private-sector employees are significantly better paid at higher skill levels. According to Alicia Munnell, Director of the Center for Retirement Research, "Pension and retiree health benefits for state and local workers roughly offset the wage penalty, so that total compensation in the two sectors is roughly comparable." There are surely examples of extreme individual pension obligations that warrant scrutiny, but they do not appear to contribute significantly to the total level of underfunding reported by analysts.  

The evidence suggests that pension underfunding is at times associated with choosing an unreasonably high discount rate. The discount rate is the expected rate of return on invested pension funds. A lower discount rate means governments must provision more now in order to meet future liabilities. Politicians tend to prefer a higher discount rate, which reflects a better "expected" yield on assets in the pension fund, since it allows them to justify provisioning less for pensions now. Unfortunately, a higher yield also means more investment risk. If the pension fund loses money, the pension liability does not go away; instead, taxpayers are forced to make up the difference or the government defaults on its obligations. This approach may help to mask the true cost of providing public services, but it is the public financial equivalent of the Hail Mary pass in football: you score a touchdown or you lose.

This may explain why governments are increasingly attracted to investment alternatives that have a record of substantial returns and are not closely correlated with the stock indices. Alternative asset investments (primarily hedge funds, venture capital funds, and private equity) averaged just below a combined 5 percent share of U.S. public pension funds' portfolios between 1984 and 1994, but they averaged nearly a 20 percent share from 2008 to 2011. These more volatile assets may provide substantial benefit, but in times of stress, it is unclear if "reaching for yield" is a prudent strategy or simply reflects desperation. It also raises ethical concerns due to a lack of transparency and the potential for "pay to play" schemes, in which placement agents offer financial incentives, such as campaign contributions, to the people responsible for making decisions about pension fund allocations. This appears to be a system prone to abuse, and significant reforms must be enacted to realign the incentives of pension officials with the incentives of taxpayers and pensioners. This could include immunizing some pension investment boards with financial compensation, requiring disclosure of all outside income, and prohibiting individuals and firms that manage assets for a particular government from making campaign contributions to local representatives.

Even when there is no direct corruption, big money can have a powerful influence over pension funding decisions. It becomes very difficult for the political process to defend the common interest when ambitious politicians are under pressure from concentrated interests. Policymakers may be reluctant to adequately provision for pensions if doing so requires them to raise tax rates on high-income individuals, cut corporate subsidies, or otherwise drive away capital. Just look at the case of Detroit, where restructuring pension obligations is on the table at the same time the state is approving money to build a new hockey arena. This is not antiseptic technocracy at work; this is politics.

Relief could come from reforms in the political systems to lessen big money's influence and empower small donors. To accomplish this, states could establish systems of public campaign financing. Maine, Arizona, and Connecticut already have such systems, as does New York City, and New York State is on the cusp. Though the mechanics differ, all of these systems would change incentives to make candidates responsive to average people, not just big donors. As a result, policy is more likely to be oriented to the public interest.

The pensions crisis has far-reaching implications for the future of the U.S. economy: the state and local government sector is about 14 percent of the American workforce. Failure to uphold the promises we've made to current workers and retirees would create a brain drain in the public sector, drive down private-sector wages, exacerbate inequality, and lead to more economic volatility. The good news appears to be that there are a large number of pension plans that are solvent thanks to prudent management. The real problem rests with the governments of a few states that have historically failed to provision adequately for their pension obligations and are increasingly turning to riskier investment assets. These problems can be solved, but it will require substantial reform and swift and collective action.

Originally published on Next New Deal