Recently, Atlanta’s City Council voted unanimously to address a $1.5 billion public-pension liability by increasing worker contributions and reducing benefits. Florida also increased public-worker contributions.
These are steps toward solvency, but the structural forces that create our public-pension problem remain in place.
The best way forward is for the public sector to follow private companies and switch from defined-benefit plans to defined-contribution plans. The reason: Among the states’ biggest problems is an unfunded pension liability, which economists Robert Novy-Marx and Joshua Rauh calculate at more than $2.4 trillion.
When states estimate the size of their pension liabilities, they typically assume an 8 percent or higher rate of return on existing assets.
Novy-Marx and Rauh argue that a more sensible approach would be to discount future liability using the U.S. Treasury bill rate, because only Treasury bills offer the security to meet presumably fixed pension liabilities.
They compare the projected cost of financing under different scenarios and find that “the difference between assets and liabilities is therefore $1.26 trillion under taxable muni discounting and $2.49 trillion under Treasury discounting.”
The problem with public pensions isn’t that teachers or firefighters or police officers are overcompensated. The problem is that public workers get too little of their pay while they work and too much when they retire.
According to a new paper by Maria Fitzpatrick of Stanford University: “Schools and other public-sector employers contribute nearly three times as much per hour worked to the pension benefits of their employees as their counterparts in the private sector.”
In 1998, Illinois upgraded the pensions that teachers would get on future earnings and gave these employees an opportunity to increase their pension payout based on past earnings. Teachers had the option of making a one-time payment equal to 1 percent of their salary per year of service prior to 1998, up to a maximum of 20 percent.
The returns of taking the deal were quite high, Fitzpatrick wrote. “The average price of the upgrade offered to employees with 25 years of experience in 1998 was $15,245, while the expected costs of providing them with the extra retirement benefits if they all purchased would have been $94,166.”
This work suggests that we should offer cash to public workers in exchange for giving up some of their future benefits. If public workers really only value their pensions at 30 cents on the dollar, then a deal where we paid workers 65 cents today to reduce the net present value of their benefits by a dollar, would essentially make both public workers and taxpayers 35 cents richer.
Our defined-benefit system also means that undercompensated, state-appointed investment officials are managing multibillion-dollar portfolios, often driven by political concerns. Rauh co-wrote a study with Yael Hochberg that examines the private-equity investments of public pensions and finds that they display a substantial home bias.
For example, 23 percent of Tennessee’s public-pension investments in private equity go to in-state firms. Out-of-state public pensions place less than 0.2 percent of their funds in Tennessee. The net internal rate of return for out-of-state private-equity investments is 4 percent; the return for in-state investments is 0.4 percent.
Moving forward, the natural solution is to switch to defined-contribution, 401(k)-style plans. The biggest virtue of these plans is that their cost is immediately obvious.
Because many public employees don’t have Social Security, we might need a hybrid system that provides them with some base benefit. But beyond that, there is no reason why public workers shouldn’t have the same type of retirement benefits as private workers. •
Edward Glaeser is an economics professor at Harvard University.
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