Public pensions are a critical issue especially as baby boomers retire, but they are fraught with confusing technical details. Two new studies shed much light on pensions for citizens interested in public policy.
The first, a report by the Minnesota Taxpayers Association, focuses on specific concerns in Minnesota. When the report was presented to the Legislature last week, some elected officials reacted as if the cat had just dragged in a rotting squirrel carcass. The report, they said, was unduly alarmist, incomplete, funded by groups with an ax to grind, etc.
I am not the only skeptic who thought that the report must be pretty darned good to prompt such a reaction. Read it and judge for yourself. It might not be perfect in every detail, but it does an enormous service to Minnesotans in examining a subject many prefer to be kept under the carpet.
The second study is in the May issue of fedgazette, a quarterly newspaper of the Minneapolis Federal Reserve Bank (www.minneapolisfed.org/publications_papers/pub_display.cfm?id=1351). The Minneapolis district spans five states so its analysis is much broader than that of the taxpayers association’s. Together, the reports provide useful insights into a much-ignored set of problems.
The purpose of this column is not to summarize the reports, but rather to offer general background on public pension issues.
Let’s reflect on why pensions exist. People work because they like to and because they get paid for it. Historically, people worked for 40 to 60 years. They then lived some time after ending full-time work. Over time, higher incomes motivated people to retire earlier and medical technology extended the interval before death.
One somehow has to earn enough from work to provide disposable income over one’s whole life. For millennia, people accumulated money or property while working to support their retirement. Or they put great effort into rearing numerous children to help them in their old age.
Pensions are relatively new.
Pensions are deferred compensation earned while working but paid out only after retirement. Why is such an arrangement preferable — for either the employer or employee — to higher wages during working years? After all, higher wages could be invested for future retirement income and the worker would have more flexibility in choosing when to consume the value earned by their work.
The employee might prefer a pension if the value of the promised amount is higher than expected from managing one’s own investments. The superior investment skills or lower administrative costs of the employer also might provide higher returns.
An employee also might prefer the fact that the employer can absorb some risk in offering a pension. Savings can always run out if the saver lives longer than expected, but traditional pensions pay out for life, however long.
Employers might prefer pensions because they motivate employee loyalty, particularly when they involve a long vesting period or are structured to give disproportionately higher returns to long service.
Employers as well as employees might prefer a pension to higher current compensation if tax laws favor deferred compensation.
Employers and employees look at total compensation — current or deferred — in offering and accepting jobs. Is the present value of the expected compensation enough to attract sufficient workers with the right skills? One can’t look at current pay and pensions in isolation from the other.
The problem is that pensions — corporate or public — are fraught with “moral hazard.” That term describes situations that create incentives for people to do things that harm society as a whole.
Such incentives exist with pensions because those making decisions — hired managers for corporations and elected officials for government — are not making decisions for themselves but as representatives for stockholders or citizens. Often, the short-run interests of decision-makers conflict with the long-term well being of those they represent.
Unfortunately, the deferred nature of pension payments obscures public understanding of important tradeoffs. In the 1960s and 1970s, when General Motors, Ford and the United Auto Workers negotiated higher pension payments in lieu of immediate raises, most stockholders did not understand the long-run impacts on shareholder value.
In the 1990s, a booming stock market allowed elected officials in Minnesota to offer after-the-fact bonus payments to those already retired. Citizens did not understand the negative effects such payments would have on local and state finances over the long haul.
In both cases the promised benefits were clearer to recipients than eventual costs were to those who would foot the bill. But bills always come due eventually. Automakers are seeing those bills now, and local and state government won’t be far behind.
© 2006 Edward Lotterman
Chanarambie Consulting, Inc.