Friday, January 12, 2018

Solving the Pension Debt Problem

Back before government grew so big that it became a real, long-term economic problem, many boneheaded decisions were made by lawmakers and governors. One of them was to create a pension system with basically an open-ended taxpayer liability. Obviously, government workers need a retirement plan, just like everyone else, but too many governments have made far too generous promises, somehow expecting future generations to simply pony up the money and honor their promises. 

Wyoming is in better shape in this regard than most other states. Nevertheless, we do have our fair share of commitments to future retirees that from a strict fiscal viewpoint - with no moral preference involved - are excessive. The problem is not just a matter of accounting, but also of government finances. At that point, it becomes a budget problem, i.e., a fiscal policy problem. As such it eventually affects the entire state economy - in other words, it has macroeconomic repercussions. 

I have a suggestion for how to solve this problem, but before I present it, let me delve a little bit more into the nature of the problem. 

Good old economists Arthur Cecil Pigou and John Maynard Keynes argued for years about what role private and public debt play in the economy. It is an enjoyable exchange, but for those who are not political-economy nerds, the take-away from their debate can be summarized in three quick points:

1. A debt is nominal, in other words once contracted, it will retain its nominal monetary value over time regardless of what happens to the economy around it. By consequence, debt payments also retain their nominal value.
2. When an economy grows, its businesses, families and taxpayers see their incomes grow. As a result, all other things equal, the cost of debt declines.
3. When an economy goes into a recession, the same mechanisms increase debt burden. 

These three points may seem trivial, but they have been ignored by our politicians for decades. A pension debt, with its open-ended taxpayer liability, violates the first point: it does not keep the debt burden nominally constant over time. 

This in itself creates a problem relating to the second point: in order to make debt more manageable over time, it is no longer sufficient that the economy grows. The very nature of a public pension debt is that it as already accounted for a minimum growth rate; it is now up to future generations to secure economic growth of the rate accounted for in the pension system, or else the system's future liabilities will become an increasing burden on future generations.  

In short: our public pension systems are built in such a way that X percent economic growth will keep the service cost of the pension debt from rising over time. If we want to grow more prosperous while also honoring our pension debt, we need to make sure our economy grows at more than X percent over time. 

Our problem, in Wyoming, is with the growth rate. While our historic growth record has been good, in the last few years we have had a stagnant-to-shrinking state GDP. With Taxmageddon on the horizon, we are looking at a scenario where - to return to the Keynes-Pigou debt debate - we could have a long series of stagnant-to-shrinking state GDP. If we do, we end up in point three above: even if we froze our pension liabilities, their service costs would still eat up an increasing share of our incomes.

The real trouble here is that even if we stop Taxmageddon and its $475 million in higher taxes, we still have the problem in point two: some of our future economic growth is already accounted for by the pension system. Since we are going to need every fraction of a percent of growth to rebuild Wyoming as a thriving, prospering state, we should consider some out-of-the-box solutions to our pension debt problem.

A solution must comply with two seemingly contradictory conditions:

a) Those who have been promised retirement security must get their retirement security; and
b) Future taxpayers must be relieved of one of the biggest threats to their personal finances.

Unlike most other states, we are in a situation that allows us to solve this problem, in one of two ways. Both of them rely on us using our state's considerable savings.

The lock-in solution

This solution begins with a cut-off date, beyond which the state no longer accumulates future pension payment responsibilities. Every pension payment made after that date goes into a 401(k) style retirement account; the taxpayer's only responsibility is the current, paycheck-to-paycheck compensation of the employee, including the regular retirement account deposit. 

When the employee retires, the state owes him no future payments under the new system. Some employees will have pensions under the new and the old system, but the state's liability will first cap out, then slowly decline as the new system gradually replaces the old. 

However, given the status of our state's economy, it would be wise to make sure that the old system - even though it is capped - does not become a fiscal problem at some point during its now-finite existence. Therefore, the state should set aside a portion of its wealth to honor all future pension payments under the old system. This is not as difficult as it may seem: once the new 401(k) style system is in place the cost of the old system is locked in, and we can relatively easily calculate its net present value. 

There is no doubt that this would require a significant reform, and a sizable commitment of our state's savings. However, there is no better way to use those savings than as an investment in a smaller, leaner and fiscally more sustainable government. A reform that protects the pensions of government workers while making it easier for future legislatures to budget, is a reform worth spending money on.

The buyback solution

This is a more radical solution. It starts off like the lock-in model, with a cut-off date and a shift to a 401(k) style program for future retirement benefits. The difference is that in this case, there is no set-aside of state savings to cover future pensions for the remainder of the old system's obligations. Instead, the state pays each state worker a lump sum equal to the present value of their pensions under the old system, and puts that money into the new 401(k) style system. 

For example, Hackensack Jack is 40 years old and is a salaried, full time employee of the state. He started working for the state 15 years ago and has 25 more years to go before retiring. During those years, the state will make regular payments in to his new retirement account, but he also has 15 years' worth of retirement benefits already paid into the old system. 

At the cut-off point, when the new system goes into effect, the state estimates the net present value of Hackensack Jack's pension entitlement under the old system. That estimate calculates how much his old-system pensions will be worth as a lump sum, 25 years into the future, then present-values that amount and deposits that amount into his new retirement account. 

Effectively, the state buys back the retirement obligations it has accumulated over the first 15 years of Hackensack Jack's employment. 

The advantage of this system over the lock-in model is that there are no future cash flows involved, except retirement benefits to current employees. 

The disadvantage, from an employee viewpoint, could be the uncertainty that is associated with having your retirement savings be entirely dependent on the future performance of our stock market, our debt market or wherever we choose to invest our money. On the other hand, that is the world most of us private-sector employees live in.

There are, of course, significant legal problems associated with either reform model. I am not a legal expert, and therefore I will leave it to those who are to sort out which model would be more appropriate. However, as a political economist I would suggest that we treat the legal hurdles are merely that: it is imperative that we do everything we can to solve our state government's fiscal problems (and, by extension, do the same for our local governments). It is the job of the legal expertise to find the appropriate solutions. 

I sometimes hear from those with legal training that some policy reforms are "impossible". There is no such thing as an "impossible" reform of something that is man made. The pension debt problem is man made, therefore man can make a solution to it. 

The real problem is whether or not we can muster the necessary political fortitude. 

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