Underfunded State Pension Plans

http://www.futureofcapitalism.com/2010/10/underfunded-state-pension-plans

By now the notion that underfunded pension plans for state and local public employees are a "problem" has become conventional wisdom on the center right. See, for example, this Manhattan Institute Civic Report, "Underfunded Teacher Pension Plans: It's Worse Than You Think," or this white paper from the campaign of New York's Republican candidate for state comptroller, Harry Wilson. In this context, a new paper from the National Bureau of Economic Research titled "Should Public Retirement Plans Be Fully Funded" comes as a welcome challenge to some of the unstated assumptions that surround this issue.

The paper, by Henning Bohn of the University of California, Santa Barbara, says the optimal funding level for public pension funds is zero, or at the very least, "less than full." From the paper:

because funding is costly and full funding is usually suboptimal, regulations that impose full funding would undermine employer incentives to offer DB plans. Most private employers phased out their DB plans after costly funding and insurance requirements were imposed in the 1970s. If current anxieties about public retirement plans lead to excessive funding requirements, the effects may prove similarly destructive.

Depending on where one stands politically, such destruction could either be a good thing or a bad thing. In other words, the campaign on the center-right for full funding of pension plans with very cautious assumptions about returns may be a tactic for achieving the replacement of defined benefit plans with a defined contribution plan.

But Professor Bohn's argument that full funding is suboptimal is not limited to the prospect that requiring it could destroy the plan. He makes at least two other arguments. The first is that since most voter-taxpayers have debt, requiring full funding means the voter-taxpayers are essentially borrowing money now to give to the government to invest in the financial markets to fund public employee pensions. Here is how he puts it: "contributions to a public pension fund require taxes. Taxpayers who are in debt must borrow to pay taxes. If the borrowing rate exceeds the return on fund assets, taxpayers are better off if pensions are left unfunded and if taxes are deferred until the pension payments are due." Or, even more directly: "Put simply: Why should taxpayers vote to accumulate assets in a public retirement plans that buys Treasury notes yielding, say, 2% when they are paying 15% interest on their credit cards and 7% on car loans?"

The second is that some level of pension funding less than full funding may make sense because it allows the government to decrease its total compensation to employees.

The paper is interesting, as well, for its discussion of taxes and pension plans:

The tax argument is straightforward. Compensation paid in form of a pension is taxable only when the pension is paid out. Hence deferred compensation means deferred taxes. Assets in funded plans compound without being taxed repeatedly. Not surprisingly, pensions—both private and public—became popular after WWII, at a time of high marginal taxes on regular, non-sheltered savings.

by Ira Stoll  |  Oct 4, 2010 at 10:13 am Related Topics:  Education, New York, Politics, State-pension-fund capitalism receive the latest by email: subscribe to the free futureofcapitalism.com mailing list