Edward L. Glaeser

How to fix the pension mess

By Edward L. Glaeser
December 16, 2010

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CAN THE federal government help states solve their pension problems? Earlier this month, three Republican congressmen— Paul Ryan of Wisconsin with Darrell Issa and Devin Nunes, both of California — proposed an innovative approach to promote transparency in state and local pension plans. If their bill becomes law, then bonds issued by states or localities that fail to plainly report their pension obligations will lose their federal tax-exempt status.

Our public pension problem is a fiscal tsunami in waiting. Economists Robert Novy-Marx and Joshua Rauh estimate that “the present value of the already-promised pension liabilities of the 50 US states amount to $5.17 trillion,’’ and that “as of December 2008, state governments had approximately $1.94 trillion set aside in pension funds.’’ That leaves a horrific $3.23 trillion shortfall. This problem also exists for municipal pension plans, which Novy-Marx and Rauh estimate have a $574 billion funding shortfall.

They also estimate that in mid-2009 Massachusetts state pensions had $32.7 billion in assets and a liability of $86.9 billion for pensions already promised. These numbers imply that the state system is only 38 percent funded, which is far below the state’s official estimates. The key difference is that states typically assume that their portfolios will earn an 8 percent return, while Novy-Marx and Rauh instead estimate future returns using the Treasury bond rate.

The bill also requires that pension funds assume Treasury rate returns, which makes some sense because pension funds only beat the Treasury rate by taking on extra risk. That risk is ultimately borne by taxpayers. Our recent asset market bust certainly suggests that 8 percent is overly optimistic, which makes underfunding worse than official figures suggest.

How did we get into this mess? The problem is not that state workers are overpaid, but that they receive too much of their compensation in generous pensions and too little in current compensation. This pro-pension tilt reflects the ease with which pension liabilities can be understated on the balance sheet.

When a city or state pays its workers more today, those costs enter immediately as spending. When a city or state offers more generous pensions, those costs get hidden because governments don’t typically set aside enough money to cover pension costs. By assuming that pension funds will earn extraordinary returns, it looks like pensions cost taxpayers far less than they actually do. This ability to obfuscate creates a strong incentive to skew compensation away from current wages toward future pensions.

It’s not just taxpayers who lose from this arrangement; public employees also suffer. Policemen and teachers are hardly rich and plenty would rather get more cash up front. The system ensures that they only get to see the fruits of their labors when they retire.

The transparency bill understands that unobservability lies at the heart of the pension problem and tries to make pension costs more obvious to everyone. It is a good, creative bill that Congress should support, but true pension reform must go further. Defined benefit plans should be replaced with defined contribution plans for new employees. The costs of contributing to defined contribution plans are immediately apparent, which is one reason why so many private companies have switched from defined benefit to defined contribution plans. To ensure a minimum retirement income for public workers, they should also enter the Social Security system.

Although the transparency bill could have required states and municipalities to switch to defined contribution plans in order to receive tax exempt status on their bonds, it would have required a breathtaking transfer of power from states to the federal government. This week’s big legal news — the Virginia attorney general’s victory against a federal mandate to buy health insurance — is a reminder that courts don’t always look kindly on aggrandizement of federal power. It is probably wise that the bill requires only transparency, not a wholesale change in the structure of state pensions.

Yet looking ahead, if Massachusetts wants to preempt future, more intrusive federal attempts to ensure state pension system solvency, it should begin the transition from defined benefit to defined contribution plans today.

Edward L. Glaeser, a professor of economics at Harvard University, is director of the Rappaport Institute for Greater Boston. His column appears regularly in the Globe.