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Pensions Aren't the Problem, cont.

3:27 PM, Mar 28, 2011 • By DANIEL HALPER
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Andrew Biggs and Eileen Norcross write this letter to the editor in response to Eli Lehrer's "Pensions Aren't the Problem," which appeared in the March 28 issue of THE WEEKLY STANDARD:

In “Pensions Aren’t the Problem,” Eli Lehrer unfortunately comes to a series of inconsistent conclusions in his assessment of public employee pension funding. All of these errors can be traced to his acceptance at face value of flawed arguments made by pension plans and the interest groups that support them.

In recent years, economists have increasingly argued that public employee pensions significantly understate their liabilities and overstate their funding health because they ignore the risk of pension investments. If public sector pensions were required to use the same accounting standards as private plans, they wouldn’t be 80 percent funded on average but closer to 45 percent funded. And public pensions’ unfunded liabilities wouldn’t be $500 billion, as they report, but somewhere north of $3 trillion.

Lehrer argues that public sector pensions aren’t that big of a problem, citing data and arguments made by the plans and rejecting the almost universal view of economists, conservative and liberal alike, that pension shortfalls far exceed reported values.

For instance, Lehrer notes that, in Illinois, pension costs equal only 3.4 percent of the state budget. But this ignores the fact that Illinois has been meeting only around two-thirds of its funding requirements even under public pension’s own lax accounting standards, and that using market accounting Illinois’s contributions should make up more than 14 percent of the state budget. Similar figures apply for California, New Jersey, and other poorly funded states. Yes, pension funding is a small burden if you don’t fully fund your pension, but that’s hardly a reason to be sanguine.

Lehrer also understates what can be done to reduce pension costs. He is correct that most states offer constitutional protections for accrued pension benefits, but he mistakenly infers that states are unable to alter formulas by which current employees earn future benefits. In some states this is the case, but in most it would be legal to reduce the rate of future benefit accruals while honoring benefits already earned. Indeed, a number of states have already proposed doing so.

Lehrer also uncritically accepts the rejoinder by public pension interest groups that government is inherently superior to the private sector at providing pension benefits, a claim that few economists find credible. In effect, states and localities have since the 1980s set themselves up as hedge funds, hoping to maintain low contributions by funding trillions in guaranteed benefit liabilities using far smaller amounts of increasingly risky assets. When these assets fall short, it is the taxpayer – not “the government” – that bears the risk.

In sum, if you accept weak evidence from public sector pensions and the interest groups that support and benefit from them, you are likely to accept their conclusions as well. To get on top of pension financing, we first need to know how big the funding gap is and what steps will help address it. This reiterates the need to get pension accounting right.

Andrew Biggs and Eileen Norcross are the authors of The Crisis in Public Sector Pension Plans: A Blueprint for Reform in New Jersey.

Eli Lehrer responds:

I'm not sure if Andrew Biggs and Eileen Norcross understand where I was coming from. In fact, I'd dispute each of their three major points.

First, contrary Biggs and Norcross's statement, there is no "universal view" amongst economists that the Government Accounting Standards Board measures that state governments use to determine pensions are seriously flawed. The assumptions are used widely by governments for a variety of purposes. Almost all major pension funds make return assumptions in the neighborhood of 8 percent. This is the same type of assumption that most private pension funds and 401(k)s assume. (The plan that my employer offers among them.) These are not "hedge fund" like returns but, rather, the returns that any well managed diversified investment portfolio can and should realize. If these returns aren't achieved—it's true—then big funding gaps will emerge. But, if these huge gaps do exist then it will reflect overall economic and stock market performance that indicate serious hard economic times overall. And other concerns—paying for core government services—will then be relatively more important than pensions.

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