After a brief absence from the media spotlight, Professor
Joshua Rauh, now a senior fellow at the Hoover Institution, reappeared in
October in an opinion piece for the Washington Post, along with his
frequent collaborator, Professor Robert Novy-Marx. Based on a rehash of their June, 2011,
working paper that purported to calculate the increase in contributions that
will be needed on an annual basis to fully fund public pension systems in 30
years, the article claims that, on average, a tax increase of $1,385 per U.S.
household per year would be required. The
article drew an immediate critical response from Dean Baker, an economist and
co-director of the Center for Economic and Policy Research (CEPR), who exposed
what he called the “tricks” that were used to generate Rauh’s “scary”
projections. The National Institute on
Retirement Security (NIRS) also wrote a letter to the editor that called the
piece an “ivory tower” exercise that “bears no relationship to real world
decisions to fund retirement benefits”
for the public sector. While DB
plans’ calculation of their unfunded liabilities continues to be criticized, the article’s focus on
pension “reform,” including hybrid plans and cost-of-living adjustments, suggests
that the tactics of opponents may be shifting.
[Professor Rauh, whose criticisms of public sector defined
benefit plans are well-known to NCTR members, was formerly an Associate
Professor of Finance at the Kellogg School of Management at Northwestern
University. In 2012, he became a Professor
of Finance at Stanford Graduate School of Business and a Senior Fellow with the
Hoover Institution at Stanford University.
(The Hoover Institution is a public policy think tank located at
Stanford with its own board of overseers.
Its Fellows include well-known conservatives such as Edwin Meese,
Condoleezza Rice, George Shultz, and Donald Rumsfeld.) Professor Robert Novy-Marx continues as Assistant
Professor of Finance at the University of Rochester’s Simon Graduate School of
Business.]
In an opinion piece entitled “The Looming Shortfall in
Public Pension Costs” that appeared in
the October 19, 2012, edition of the Washington
Post, Professors Rauh and Novy-Marx make dramatic projections about the financial
condition of public retirement systems and their effects on state taxes. The article is based on an updated version of
an earlier paper released in June of last year entitled “The Revenue Demands of
Public Employee Pension Promises.” The
paper purports to calculate “how much states have to increase revenues or cut
spending to pay new pension promises to existing employees and pay down
unfunded legacy liabilities over the next 30 years.”
Based on these calculations, the two academics claim that,
on average, “a tax increase of $1,385 per U.S. household per year would be required,
starting immediately and growing with the size of the public sector. “ In the alternative, public-sector budget cuts
of a similar magnitude, or a combination of tax increases and cuts adding up to
this amount, would be required, they allege.
Their paper provides a per-state figure, showing Ohio with the highest
cost per household of $2,553 and Indiana with the lowest, at $237 per
household. These costs would amount to 14.1
percent of every dollar that state and local governments take in for taxes and
fees for services, according to their study, up from the 5.7 percent that they
claim is the current percentage share.
As for offsetting reductions as a result of employee
contributions, Rauh and Novy-Marx dismiss this possibility as unrealistic,
despite the record of recent pension reforms across the United States. They claim that to obtain the amount needed
from employee contributions would require an increase of 24 percent, which they
say is “infeasible and would place a huge burden on younger public employees.” Therefore, they conclude that “some
redirection of taxpayer resources to cover pension obligations seems
inevitable.” Of course, their acknowledgement
of these qualifiers (“some” and “seems”) at this point in their article doesn’t
stop them from nevertheless asserting at the outset of the piece that their
dramatic tax increase calculations “would be required.”
The Rauh/Novy-Marx article was immediately addressed by Dean
Baker, an economist and co-director of the Center for Economic Policy Research
(CEPR). (Dean Baker was also a presenter
at NCTR’s 2012 convention in Tucson, Arizona.)
In a posting entitled “The Washington Post Tries to Scare You on Public
Sector Pensions,” he asserts that Professors Rauh and Novy-Marx use “two simple tricks” to generate their “scary
projections of household liabilities.”
First, Dr. Baker notes that the study assumes that pensions
will receive what he calls “impossibly low” returns on their assets, namely
annual returns of 2 percent above the rate of inflation. However, as Baker points out, it is “almost
impossible to construct scenarios in which stock returns will come in much
below the levels assumed by [public] pension funds” unless Rauh and Novy-Marx
want to dispute the official economic growth projections of the Congressional
Budget Office (CBO) and other official forecasters. With a current ratio of stock prices to trend
earnings that is close to the historic average of 15 to 1, “real returns of 7
percent are very reasonable,” Dr. Baker explains.
The other “trick,” according to Dr. Baker, is that Rauh and
Novy-Marx “implicitly compare averages to medians.” For example, the two professors calculate
that even if public plans “continue to make massive bets that the stock market
will bail them out” and even if the market were to perform as well over the
next 30 years as it did over the past half-century -- “an unprecedented bull
market,” they call it -- then the required per-U.S. household tax increase
would still amount to $756 per year.
However, Baker suggests that some context should be provided
for that number. First, he notes that there
are a bit less than 120 million households in the country, which means that the
average income per household is around $120,000 a year. “This means,” Baker explains, “that the
unfunded liability from public sector pensions will cost an average household a
bit more than 0.6 percent of their income.”
For a family making $60,000 a year, this would amount to slightly under
$400 a year.
“Does that still
sound like a lot?” Baker asks. He
suggests a couple of comparisons:
- At their peak, the wars in Afghanistan and Iraq were costing an average family about 2 percent of their income or around $2,400 a year in the current economy.
- The patent protection that is provided to drug companies costs the average family around $1,800 a year in higher drug prices.
- The implicit subsidy that the government gives large banks by protecting them against failure costs an average family around $500 a year. “This is in effect the money that we are being taxed to help the struggling CEOs and top executives at the major banks,” Baker goes on to explain.
Dr. Baker concludes by reminding readers that workers did
work for these pensions. “This was part
of their pay package,” he stresses. It
is “more than a bit bizarre,” he says, “that we should therefore rip off the
workers who are counting on these pensions.” If governments enter into contracts with
private sector businesses, and then don't put aside the money to pay these
contracts, would it makes sense to tell these contractors “to get lost,” he
asks.
The National Institute on Retirement Security (NIRS) also
weighed in with a letter to the editors of the Washington Post. In it, Diane Oakley, NIRS’ Executive
Director, criticizes what she refers to as “the authors’ ivory tower exercise
that values public pension liabilities at a ‘riskless’ investment rate.” As she points out, determining funding costs
based on such a rate that is far below expected investment returns of governmental
plans would “distort funding policy decisions and waste government dollars by
over-funding pensions.”
Ms. Oakley goes on to note that the Governmental Accounting
Standards Board (GASB) has made it clear that there is a “definitive
separation” between financial reporting of pension liabilities and funding
decisions, and that moving to fund public pensions based on a riskless rate has
not been a policy consideration of those governmental officials responsible for
developing stable and sustainable pension funding policy.
The NIRS letter concludes by warning that switching from
pensions to 401(k) accounts is not a solution either. With the median balance of401(k)accounts at
$44,000 according to recent Federal Reserve data, Ms. Oakley suggests to the Washington Post
that “Perhaps an economic analysis of
the real retirement crisis facing Americans lacking pensions would better serve
your readers? “
Although NCTR and NASRA did not produce formal responses to
the Washington Post op-ed, press inquiries were directed to a joint
issue brief prepared in July of last year in response to the release of the
original Rauh/Novy-Marx paper. This
brief, entitled “More Faulty Pension Analysis Unhelpful to State and Local
Recovery Efforts,” charges that the two professors used “underlying assumptions
that understate revenues, inflate costs, and ignore other available public
policy options. “ Consequently, the
brief stresses that their paper’s conclusions “bear little resemblance to the
actual practices of most state and local governments, or their pension plans,
and again have limited application for policymakers wishing to address the
financial impacts of the Great Recession.”
NCTR and NASRA were particularly critical of the paper’s use
of a much larger estimate of liabilities based on a theoretical value using
current low interest rates instead of the accounting and actuarial standards
that use long-term expected government costs.
The op-ed’s rehashing of this approach to measuring pension costs seems
to fit with a shifting of attention on the part of opponents of public pension
plans.
Previously, the focus
was on recalculating the liabilities of public plans using the so-called “risk-free”
rate of return. The argument was that
this would increase the “accuracy” of the measurement based on the theory of
financial economics, and would also provide for better comparability among
plans.
Indeed, at a Ways and Means Oversight Subcommittee hearing
in May of 2011, Congressman Devin Nunes (D-CA), the author of the “Public
Employee Pension Transparency Act” (PEPTA), said that all the fuss over the
discount rate that his bill required was unwarranted, and that the real point
was to achieve comparability: “You
can't get off this fixation about 3 percent, 4 percent, 5 percent,” he said at
the time. “The truth of why the rate was
picked is what I said earlier to Mr. Buchanan, is so that you would have a
conservative ability to compare public employee pensions across the line” Nunes
insisted.
Furthermore, financial economists generally agree that the discount
rate should be based on the nature of the liabilities irrespective of how those
liabilities are funded. In fact, the
Nunes legislation (HR 567) actually contains a provision that would make it
clear that nothing in the bill “shall be construed to alter existing funding
standards for State or local government employee pension plans or to require
Federal funding standards for such plans.”
Now, however, the focus of opponents does appear to be shifting
to the actual funding of these liabilities.
In short, moving to fund public
pensions based on a riskless rate, as NIRS described it.
This lies at the heart of the Rauh/Novy-Marx paper and op-ed
piece. Their “legacy liabilities” are
measured using the risk-free rate, and they then assume that the funding of
those liabilities will be accomplished using portfolios of risk-free
investments that return only inflation plus 1.7 percent.
The potential funding of these liabilities by the Federal
government is also at the heart of the increasing attention in recent days on
the potential for a Federal bail-out of public pensions and the “winners and
losers” among states if such a bailout resulted, as recently calculated by the
Illinois Policy Institute. The new
“restated” liabilities (whether by Moody’s, or Rauh, or PEPTA) are presumed as
the basis of the “cost” of public pensions that the taxpayer or the Federal
government might have to pay.
One other item of note:
Rauh and Novy-Marx conclude their article by suggesting that states should
“consider introducing mixed defined-benefit and defined-contribution plans for
all employees, not just new hires.
Cost-of-living adjustments along the lines of those adopted in Rhode
Island “should continue to be reexamined across the country, and new designs
should also be considered.”
This is somewhat of a change in tune. In earlier writings and presentations, Rauh
has insisted that states should stop making new defined-benefit promises and start
up defined contribution plans. One of
his earlier proposals would allow states to issue Federally tax-subsidized
pension funding bonds for the next 15 years, but only if they agree to close
defined benefit plans to new hires and offer instead a defined contribution
plan similar to the Federal Thrift Savings Program, as well as accept universal
Social Security coverage.
(Interestingly, Rauh -- not States or local governments -- is the only
real proposer of a “Federal bail-out.”)
Now, in the op-ed, Professor Rauh is speaking more generally
of reforming current DB plans. He speaks
favorably of hybrid plans with a smaller defined-benefit component,
contributions to individual accounts and higher retirement ages. It is interesting that this change in tone is
coinciding with a number of recent studies and conferences examining the
growing role of DC plans in the public sector.
Are these shifts real or only perceived? Are they a reflection of a changing world, or
part of the push to accomplish such changes?
In any case, public pension opponents have shown themselves to have a
remarkable ability to change colors and directions in order to accomplish their
goals.
To paraphrase, the price of real retirement security for
public employees may be eternal vigilance.
