Tuesday, November 6, 2012

Rauh Resurfaces; Refocuses on “Costs” of Unfunded Liabilities

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.  

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