Wednesday, May 16, 2012

How to Fund a Public Sector Pension

Politicians have a bad habit of promising more than they can deliver--especially if the delivery part happens when someone else is in office.  This is particularly true of public sector pension.  In lieu of raising wages to attract talent, which would in turn require raising taxes, politicians raise the public sector pension instead and defer the raising of taxes.

The reason they can get away with this is the discount rate--a dollar twenty years from now is worth less than a dollar now, in no small part because a dollar now would have twenty years to reap returns on investment.  It only makes sense, therefore, that a dollar in twenty years be valued at only, say, 25 cents now.  So a politician can promise a dollar, but only raise 25 cents.  If they use a particularly steep discount rate (most states assume a staggeringly-high, consistent return of 8% from a conservative portfolio), they can underfund the pension scheme even more severely.

The way to get around this problem is to assume that the discount rate does not exist.  Even though it does not make financial sense, it makes political sense.  If a politician promises a dollar in twenty years, he has to put up a dollar now.  If the fund drops below the 1:1 ratio, the fund will hold any investment return until the 1:1 ratio is regained.  If the fund goes above the 1:1 ratio, the excess investment earning would be paid into the treasury.  In effect, you'd have the opposite impact on a politician's preferences.  Promising a pension would have an immediate impact on spending and would benefit his antecedents.

As side benefits, a pre-funded public sector pension, however, would never go broke--the pension would never need infusions of cash--even if it suffered severe losses, it would have time for investment returns to make up the shortfall.  This is particularly helpful since pension fund bailouts happen during financial crises, making them pro-cyclical.  A fully-funded pension scheme, but contrast, would be contra-cyclical to the market, as funds would be withdrawn during the bull markets and invested during the bear market (which has an additional benefit of letting the fund buy low and sell high).

4 Comments:

Blogger Yoel Natan said...

Well, it seems that Medicare, public pensions, etc., are all going into a pay-what-we-can scenario, like what would happen in a bankruptcy. The govt can only raise taxes so much without hurting the economy and investors will only loan so much, so the US or its states might go into selective default. A financial expert said the other day that the US would already being going into selective default right now except that Europe has a cash flow problem, so the US seems relatively safe to investors. Otherwise investors would be eschewing US bonds and the US would be in big trouble. He said that thanks to Europe, by the time the US is forced to resolve its problems, it will be in much worse shape because of the delay, e.g., our debt will be higher. Europe is taking the bullet for us now, but later the US will face a grenade.

Typo: but (by) contrast

3:16 AM  
Blogger Noumenon said...

This matches my approach to investing (don't assume you'll get an investment return, since you might even lose money). It might be too popular with Wall Street since it implies having to buy about double the amount of stocks you actually need, and no pressure to earn a market return.

Corporate pensions face the same issue, just with less accountability. If I imagine applying this same requirement to corporations, they might stop offering pensions. But that would be OK too, since they already tend to dip into the pension returns and leave them underfunded.

7:28 AM  
Anonymous Roger Kovaciny said...

You missed an essential point: as even Roosevelt publicly stated, it should be illegal for public-sector employees to unionize, for the simple and sufficient reason that it puts the union on both sides of the negotiating table. They elect the people they'll be negotiating with, and then conspire together to loot the taxpayers. At one meeting Pennsylvania's Democratic governor jumped up and shouted that "we" would "fight for" what the unions were demanding, forgetting that the governor is supposed to be management. But of course he isn't. He's just a union peripheral.

4:30 AM  
Blogger Octavo Dia said...

First, unionization and public sector pensions are different issues. Non-unionized public sector workers still have pensions.

Second, perhaps it is true for upper, upper management, but as someone who is on the other side of the table, there is little love lost between the two.

6:23 AM  

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