Thursday, November 10, 2011

Public Pensions Are Not the Problem

I hear it all the time: public pensions are a big problem. On TV, I hear that "we" just have a 401(k) plan, why should government workers have a pension plan? I'll answer that question and talk about the real problem that public pensions have been made to become.

Understand as I write this that I am a fiscal conservative by nature. While there is a place for some benefits that are more socialized than some others might think, I don't, for example, espouse that our employers, public or private, should be responsible for our entire welfare.

That having been said, let's consider a young potential worker, Kelly (I figured I would use an androgynous name because I haven't decided yet if I want to make Kelly male or female, or if I even care). Kelly is considering two job offers, one with a private employer and one with a public employer. This may not be an unusual scenario.

The private employer offers Kelly a nice package to start with. It includes all this:

  • $60,000 base pay
  • 2 weeks paid vacation and 10 paid holidays
  • A consumer driven health plan (Kelly doesn't know what that means, but does know that it is a health plan) where the employer pays 75% of the total cost
  • A 401(k) plan with a match of 50 cents on the dollar for the first 6% of pay that Kelly contributes
Assuming that she (I decided to make Kelly female) elects the health plan and defers at least 6% of her pay to her 401(k) plan, the total annual employer cost of the package being offered to Kelly is approximately $60,000 (base pay) + $4,615 (paid time off) + $4,500 (health plan) + $1,800 (401(k)) = $70,915.

The public employer offers Kelly a very different package. It includes all this:
  • $50,000 base pay
  • 3 weeks paid vacation and 15 paid holidays
  • A traditional indemnity health plan for which the employer pays 90% of the total cost
  • A defined benefit pension plan that if funded ratably over a full career for Kelly will cost the employer (on average) about 5% of pay
Again, assuming that she elects the health plan, the total annual employer cost of the package is about $45,000 (base pay) + $5,769 (paid time off) + $9,720 (health plan) + $2,500 (pension plan) = $67,989.

NOTE: I have taken fairly wild guesses on the costs of the health plan. They should not be used as representative of any particular plans nor should the be used as representative of the costs of any particular plans.

The values of the two packages are close enough that Kelly may have some career and lifestyle choices to make. But, we will leave Kelly for the moment as her career decision does not really matter to us.

The first thing that does matter, however, is that the two potential employers have similar costs of employment, however, they choose to allocate those costs very differently. The second thing that matters is the pension plan. Note that I said that the public employer was going to fund that benefit ratably over a full career. When this is done on a percentage of pay basis, it typically comes from an actuarial cost method known as (Individual) Entry Age Normal. In this case, the 5% of pay is what is known as the normal cost, or the annual cost of the benefits being allocated to the present year.

Wow, that was an earful. I'll slow down the technical stuff.

My point is that a public pension plan, at least in every jurisdiction of which I am aware, can be funded rationally. As part of that rational funding, the plan sponsor (whoever represents the sponsor) must first allow the plan's actuary to choose reasonable actuarial assumptions, including those for discount rate, salary increase rate, rates of termination, disability, retirement, and death, and any others that are appropriate to the plan and its population. Second, the plan must be funded using an actuarial cost method that takes into account future pay increases and is reasonable in its allocation of benefits to an employee's past service, current service, and future service with the employer. Third, regardless of the leeway allowed by the law, the sponsor must ensure that the plan is funded rationally every year. The cost is the cost. You don't take a year off from funding so that you can build a new skate park, especially since the mayor's son is a competitive skateboarder. 

The problem is that most public plan sponsors have not taken this approach. They have been neither reasonable nor rational. Much like the US government, especially under the last two presidents, public plan sponsors have taken the approach of running up obligations that perhaps could have been paid for as they were accrued, but were instead left for a future generation.

Therein lies the problem. The public pension is only its face.


  1. John,

    Not sure your example is on point (the numbers seem arbitrarily chosen, and I wonder what 5% of pay, using risk-adjusted return measures, buys you as a pension compared to what actual plans out there cost):

    The larger issue though, IMO, is the ability of narrow interests (public sector employees and government officials) to conspire to defeat the general interest (taxpayers) with obfuscatory compensation practices. Deferred compensation (pensions, retiree health care) are the ideal vehicles for executing this conspiracy. Better governance and accounting rules in the private sector have been much more effective at protecting shareholders than what taxpayers have enjoyed.

  2. Brian,

    The numbers were arbitrarily chosen and intended to be illustrative. And, I do agree that the FASB [and SEC], for example, have done a far better job at helping to protect shareholders than the GASB has done with respect to taxpayers and bondholders.

    However, that was not my point, or at least I didn't intend it to be. Rather, I was taking the viewpoint that regardless of accounting and governance rules, both private employers and public employers have a pool of money that they are willing to spend on an employee or a group of employees. Simply that public employers today are more likely to spend it on defined benefit plans than are private employers is not reason enough to condemn public employers, despite the overly voiced opinions of the media that they should be condemned.

    Backtracking some, had the GASB served the public pension world as I (and I think you) believe it should have, public employer stakeholders would have had a far better idea of the obligations that they faced at a far earlier point in time. I would still contend, however, that if public pensions were funded rationally (reasonable discount rates and other assumptions AND reasonable actuarial cost methods) that what we would be looking at is a small current underfunding (due in large part to the continued decline in discount rates), but not the systematic decline that we have seen.

    To look at the other side, someone that I am close to is a firefighter. To paraphrase him, [I] work at a dangerous job for relatively low pay and my life expectancy, even if I do not have a severe work-related injury, is shorter than most. Why would I take a job like this if I didn't get superior benefits for my family and me?

    So, I repeat, each employer is willing to allocate some specific number of dollars to each employee. How they choose to do it is part of the deal between the employer and the employee.