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Uncapping Social Security payroll tax is hardly a panacea

October 19, 2011, 11:11 am

In a blog item on the Social Security/Ponzi Scheme nexus (which I touched on here), Ezra Klein makes a characteristic pitch for eliminating the cap on earnings subject to payroll taxes:

…Social Security has a funding gap equal to 0.7 percent of GDP over the next 75 years. We could wipe that gap out by lifting the payroll tax cap (right now, payroll taxes only apply to the first $107,000 of income) or by adjusting benefits downwards. Once it’s done, however, it’s done. Stable.

Um, maybe not so done. The chart below shows Social Security’s annual net cash flows – meaning, taxes collected minus benefits paid out – for current law (red line) and if we eliminated the payroll tax ceiling (blue line). Under current law, the system is running small deficits today, will (supposedly) improve over the next few years as the economy recovers, and then head deeper into deficit around 2016 or so. If we eliminate the payroll tax ceiling we get a big inflow of money in the near term, so we shoot up to a surplus of over 2 percent of payroll – that’s around $110 billion. But these new surpluses peak in 2014 and then start heading south. By 2025 the program is once again in deficit.

Now, if you think that those near-term surpluses generated by eliminating the tax max will be saved, then Social Security’s trust fund balance – shown in the green line plotted against the right axis – will be meaningful to you. But even then, it’s pretty clear that this isn’t what you’d call “done.” The new trust fund ratio – that is, the ratio of the trust fund balance to annual benefit payments – would peak in 2024 and decline after that.

If you don’t think the trust fund is meaningful – and there are plenty of reasons not to – then eliminating the tax max creates a short-term glut of cash to be spent on other things and thereafter cuts Social Security’s annual deficits only about in half. That’s not much considering that lifting the cap would raise the total top marginal tax rate – federal income and payroll taxes and state income taxes – to over 60 percent, without having done anything to fix the larger problems in Medicare and Medicaid.

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Categories: Economic Policy, Retirement and Social Security | Tags: Social Security

‘What a Piece of Junk’: Responding to the Economic Policy Institute on Public Employee Pay

By Andrew Biggs

October 6, 2011, 5:30 pm

In the original”Star Wars” trilogy (not those crappy prequels), Luke Skywalker uttered these words when he first saw Han Solo’s ship, the Millennium Falcon: “What a piece of junk.” I had the same reaction to a new policy brief from the Economic Policy Institute (EPI), which attacks my work with Jason Richwine on public sector pay, in particular a recent study for the Ohio Business Roundtable. (I should note that these comments are my own and that Jason is far more polite than I am).

In previous work for EPI, Rutgers University’s Jeffrey Keefe concluded that Ohio state and local government workers receive slightly lower total pay and benefits than similar workers in the private sector. We find, by contrast, that the combined value of public sector salaries, benefits, and job security exceeds private sector levels by roughly 43 percent.

Keefe questions practically every part of our Ohio paper and, trust me, we have answers to almost all of his points. If you read EPI’s paper and are tempted to believe its claims, post a comment and I’ll address it.

But pensions are where the real action is. Once you accept our view of pensions, you could buy pretty much everything else EPI says and still conclude that public employees are overpaid. EPI thinks pay studies should focus on what employers contribute toward pensions while we look at the benefits employees actually receive.

Put simply, EPI believes that government pensions can generate a given dollar of future retirement benefits at roughly one-third the cost of a private sector employer. And it’s true that, for each dollar of guaranteed future benefits, governments actually do contribute about one-third as much as private pensions. These lower contributions are based on aggressive accounting rules that let public plans “discount” their future benefit liabilities using high interest rates of around 8 percent, versus about 5.5 percent for private defined benefit (DB) plans and, implicitly, around 4 percent for 401(k)-type pensions. Based on low employer contributions, EPI concludes that public sector pensions aren’t actually all that generous. We counter that if you look at the benefits employees actually receive, most public employees’ total compensation package is well above private sector levels.

In effect, EPI’s argument rests on you believing that “Public employees are overpaid, but we aren’t overpaying them.” That is, government possesses some magic by which it can pay far higher pensions at far lower costs than the private sector. This claim is doubly wrong.

1) The vast, vast majority of professional economists don’t believe that government possesses such magic. As Keefe himself admits, most economists argue that accounting rules that let public plans contribute so much less than private pensions are simply wrong. Don’t take my word for it, though: Nobel Prize-winning economists, the Federal Reserve, and the Congressional Budget Office all say the same thing. If public pensions followed economically-sound accounting rules, their contribution rates would rise and it would be obvious that public employees receive higher total compensation.

2) Moreover, even if government can magically generate pension benefits at one third the cost, that does not imply that employees should be the beneficiaries of that little miracle. According to the theory of “equalizing differences”—which the Handbook of Labor Economics calls “the fundamental (long-run) market equilibrium construct in labor economics”—government just as well could pay lower wages and use the savings to reduce taxes or increase other government programs.

For a public/private pay comparison, what we want to know is whether that offset has taken place. By measuring the pensions people will actually receive, along with their salaries and other benefits, we can accurately compare total compensation packages between the public and private sectors. And, based on these actual benefits, it is unequivocal that public employees in Ohio, and in most other states for that matter, receive higher total pay than private sector workers.

Other public sector pay studies—such as from the (hardly conservative-leaning) Center for State and Local Government Excellence, which EPI cited in its highly-misleading blog post on our paper—note that, “the public sector contribution under-states public sector compensation,” for exactly the reasons we describe. (We have other issues with the CSLGE study, but on this point they’re correct).

So to accept EPI’s arguments regarding pensions and overall public sector compensation, you have to reject the views of both the vast majority of financial economists and the vast majority of labor economists. Nice going, EPI.

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Categories: Economic Policy, Retirement and Social Security | Tags: Federal Employee Pensions

How Generous Are Federal Employee Pensions?

By Andrew Biggs

September 30, 2011, 10:27 am

USA Today reports that “retirement programs for former federal workers—civilian and military—are growing so fast they now face a multitrillion-dollar shortfall nearly as big as Social Security’s.” USA Today’s figures include both pension and retiree health costs and are inclusive of military programs, so it is a broad figure. Nevertheless, it raises an interesting question: how did retirement costs for a small segment of the population grow to rival Social Security, a program designed to cover nearly all Americans? One big reason is that federal pension benefits are simply very generous relative to typical private sector plans.

How generous? To check, I took a stylized worker and ran his annual salary through both the federal pension programs and a typical plan offered to private sector employees to see the difference in how much they would end up with at retirement. Since federal workers receive higher salaries than the average private sector worker (more on that here) I assumed the employee earned 150 percent of the average wage each year; that would put his earnings this year at a bit over $60,000. I assumed he entered the workforce at age 21 and worked until age 65; in reality, most people take some time out of the workforce and most federal employees have held other jobs, but for these purposes that doesn’t matter too much.

Most current federal employees are covered by two pension plans: a defined benefit (DB) program known as the Federal Employees Retirement System (FERS) and a defined contribution (DC) program called the Thrift Savings Plan (TSP). For a federal employee who retires at age 62 or older and has 20 or more years of service, his basic FERS benefit will equal 1.1 percent of his highest 3 years of average earnings, multiplied by his years of service. For FERS, most federal employees contribute 0.85 percent of pay, with the remaining costs covered by the government. The Thrift Savings Plan functions similarly to a private sector 401(k) plan. Federal employers contribute 1 percent of worker wages to the TSP regardless of whether individuals participate. In addition, the federal government matches employee contributions $1.00 per $1.00 for the first 3 percent of earnings contributed and $.50 per $1.00 for the next 2 percent of earnings. A federal employee contributing 5 percent of earnings to the TSP would receive a total employer contribution of 5 percent of earnings. Most current federal employees also participate in the Social Security program.

In the private sector, a typical pension plan today is a defined contribution 401(k) program, which is generally funded with a combination of worker contributions and employer matches. The most common matching formula is $.50 per $1.00 of contributions, up to the first 6 percent of pay. Around one-third of employers offering matching 401(k) plans use this approach, so we’ll follow it here. DB plans still exist in the private sector, but they’re shrinking fast: only 13 of the Fortune 100 companies now offer a traditional DB plan to newly hired employees. Some offer so-called “hybrid plans”—which are themselves shrinking—while the remainder offer 401(k) plans.

For both 401(k)s and the TSP, we need to make the risk of the benefits they offer comparable to the guaranteed benefits from a defined benefit plan; otherwise, investments in riskier assets like stocks will seem like “free money.” To do that, I follow the Congressional Budget Office’s approach of assuming that DC plans invest in government bonds, which I assume to have a 4 percent yield. That’s higher than the roughly 2.5 percent Treasury securities are currently paying but lower than the historical average, so you can adjust up or down as you see fit. Once people retire, I convert their DC accounts to a joint and survivor annuity using rates published by the TSP. For both workers, I assume they contribute enough to receive the maximum employer match to their DC account; but in comparing benefits I use only those generated by the employer match, not from the worker’s own contributions.

In both federal and private sector employment the worker would receive the same annual Social Security benefit of around $21,656. At retirement, the worker’s highest three years of earnings average at $60,368; with an assumed 44 years of service and a 1.1 percent replacement factor, that generates an annual FERS pension of $29,218. In addition, the annuitized value of the employer match to the TSP generates another $6,960 in annual benefits, for a total retirement income of $57,834. In addition, the federal employee would have whatever income his own TSP contributions generated.

The private sector worker would have a Social Security benefit of around $21,656, plus an annuity payment drawn from his employer’s 401(k) contributions of around $4,175 per year. The total retirement income would be around $25,832, plus whatever he received through his own 401(k) contributions. To make things simple, $25,832/$57,834 = around 45 percent, so the private sector worker clearly is receiving far less.

Now, we can haggle about some of these assumptions. Maybe private sector workers who are comparable to federal workers in terms of education or other skills receive more generous pensions. But even if we assume that the employer matches 6 percent of pay rather than the more typical 3 percent, that brings the private pension benefit up to only 51 percent of the federal level. And bear in mind that these percentage differences are reduced by the inclusion of Social Security; if I looked only at employer-provided pension benefits, the private benefit would be only around one-tenth the federal level.

Put it this way: federal employees have a more generous defined contribution pension than most private sector workers, and on top of this they have a defined benefit plan for which they pay less than 1 percent of salaries. State and local workers who participate in Social Security usually have more generous DB plans (a replacement factor of around 1.9 percent of final earnings versus 1 or 1.1 percent for federal employees, according to the Public Plans Database), but they pay far more for their benefits: almost 5 percent of pay versus less than 1 percent for federal employees.

In addition, federal employees are also eligible for retiree health coverage, which is very valuable for early retirees but which in the private sector is shrinking even faster than DB pensions. Based on CBO figures, Jason Richwine and I estimated that eligibility for retiree health coverage is worth around an extra 6 percent of pay for federal workers.

In simple terms, the federal employment package is a great deal for federal employees, and as a former federal employee I was happy to get it. But if you wonder why costs are so high, now you know.

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Categories: Retirement and Social Security | Tags: Federal Employee Pensions, Social Security

How Much Do D.C. Teachers Value Job Security?

By Andrew Biggs

September 20, 2011, 5:47 pm

In my work on public sector pay with Jason Richwine, we’ve attempted to place a monetary value on the extra job security that government employees receive. Job security is like an insurance policy against unemployment. Also, it can protect a position that pays a salary or benefits premium relative to the private sector. We find that the baseline value of protection against unemployment is worth an extra 2 to 3 percent of pay.

Job security is an area where our critics have taken our work the least seriously. Other studies on public employee pay, such as those from Jeffrey Keefe and the Center for State and Local Government Excellence, make no real attempt to value job security. Others have simply scoffed, such as the Ohio Public Employees Retirement System, which placed the phrase “job security” in quotes, as if to deny that public employees actually do have greater job security.

This morning’s Washington Examiner reports that growing numbers of elite teachers in Washington, D.C., are willing to trade higher salaries for lower job security. Looking at who was eligible for the raises, how much job security they would give up, and how many took the deal can give us an idea of how public employees value job security.

Under D.C.’s Impact Plus program, teachers who are rated “highly effective” two years running are eligible for annual raises of up to $20,000, in exchange for which they give up the right to stay on the rolls and seek retraining and other options if their teaching position is eliminated. Importantly, under the teaching contract signed under former Chancellor Michelle Rhee, layoffs are now at least partially performance based. As Washington Teachers Union head Nathan Saunders has said, “Excessing is the new teacher firing.” If so, elite teachers presumably have much less to fear compared to layoffs based solely on staffing needs and seniority.

Two-hundred and ninety teachers were eligible for the raise, the top 7 percent of the district’s teaching force. The district illustrates the scale of the salary increases using a teacher who holds only a bachelor’s degree and has a salary level of $51,716. That teacher’s salary would immediately rise to $69,132, a 34 percent increase that puts the teacher at the level ordinarily granted to a teacher on Step 7 of the master’s degree scale.

Of the eligible teachers, 80 percent accepted the raise. This has been interpreted as a positive sign for the program (and it probably is). But look at it this way: one-fifth of the very highest rated teachers turned down a one-third increase in pay to avoid reducing their job security. Presumably, the average teacher would have given up an even larger raise, since he’d have more to fear from a loss of job security. And all teachers would likely give up larger raises if the trade-off had taken job security fully down to private sector levels, where there is employment “at will.”

Now, public employees are more risk averse, and therefore may value security more, than the typical private sector employee. And there’s also the chance that some of the teachers turned the raise down for philosophical reasons; if we can obtain better data on which teachers accepted and which refused, we can get a better handle on that aspect of things.

But all of this tells me it’s worth our while to put a dollar value on job security.

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Categories: Education, Retirement and Social Security | Tags: Job Security

How Private Health Insurance Slashed the Uninsured Rate for Americans: Health Fact of the Week

By Christopher J. Conover

September 16, 2011, 10:55 am

The latest Census figures show the United States now has 49.9 million uninsured, an increase of nearly 1 million over the preceding year. Both in terms of absolute numbers and the percentage of Americans without coverage, this is the highest figure recorded since the Bureau began asking questions about health insurance in its annual survey three decades ago. If fully implemented, the Affordable Care Act is expected to cut this number by more than half. But this is a pittance compared to the dramatic decline in the number of uninsured that occurred before the introduction of Medicare and Medicaid in 1966. This is not unlike the dramatic decline in the poverty rate that occurred before the nation officially declared a war on poverty in the 1960s.

Over 70 years, the uninsured rate has declined by more than 80 percent (figure 6.6). It is noteworthy to see just how much of this decline occurred before the government got heavily involved in providing coverage during the 1960s. In 1940, approximately nine of ten Americans lacked health insurance coverage. By 1960, this had fallen to 25 percent. There were at least 60 million fewer Americans without health insurance in 1960 compared to 1940 despite a population increase of nearly 50 million over that same period. This dramatic decline reflected the enormous expansion of employer-based health coverage fueled by the tax subsidy that began in 1943.

These numbers are approximations for the earliest decades. The nation did not start to seriously measure the extent of lack of coverage until the mid-1970s. Before that time, the only consistent annual data on coverage came from health insurance industry surveys that counted the number of individuals with various types of medical insurance policies (for example, hospital insurance). Thus, one could obtain an approximate count of the uninsured using assumptions about how much duplication there was between policies of various types and then subtracting this insured number from the total population. Today, the most widely quoted current numbers about the uninsured (such as this week’s report) come from the Current Population Survey (CPS), which did not start collecting a consistent measure of coverage until 1988. There are multiple surveys, each with various shortcomings, but the CPS has gradually improved over time so that it is less likely to over-count the number of uninsured than it was in the past. The point is that the numbers for 1990 forward are a more precise approximation of the truth than the numbers that precede it, although every effort has been made to convert these earlier figures into estimates of how many uninsured would have been counted had a CPS-like survey been conducted in those earlier years.

By 1970, the uninsured rate had fallen to less than 15 percent, reflecting continued expansion of employer-provided coverage and the introduction of Medicare and Medicaid. There is substantial evidence of “crowd-out” of private health coverage by both programs: that is, the programs cover individuals who otherwise would have had private insurance. For example, one-quarter of seniors had comprehensive health insurance even before Medicare was introduced. When Medicaid expanded coverage to children and pregnant women between 1987 and 1992, crowd-out accounted for nearly half of those who were newly enrolled through these eligibility expansions. Consequently, there is much less than a one-for-one reduction in the number of uninsured for each new beneficiary who is enrolled. Conversely, the entire decline in the uninsured rate through 1970 cannot be attributed to public coverage since private coverage also was expanding during this same period.

After 1970, the uninsured rate remained quite stable for decades. Thus, the slight increase between 1990 and 2010 is barely a blip from this much longer-term view. Official government projections of what is supposed to happen to the uninsured rate if health reform is fully implemented are included in the figure shown. There still is substantial uncertainty about how much of the Affordable Care Act (ACA) will ultimately be implemented. But the 2020 number is a useful reminder that the ACA did not intend, nor will it possibly achieve, universal coverage. Some 23 million uninsured Americans would still be uninsured that year, according to the latest projections by the Congressional Budget Office. By 2021, assuming ACA is fully in place, half of the decline in the number of uninsured would be attributable to expansions of Medicaid and the Children’s Health Insurance Program (CHIP). This is a marked contrast to prevailing patterns of coverage: that is, in 2010, there were four people covered by private insurance for every person covered through Medicaid/CHIP. In short, notwithstanding the many severe limitations of Medicaid, the ACA would move the system in the direction of much heavier reliance on that program to cover those who cannot afford their own health insurance coverage. Moreover, the decline in the rate of being uninsured will be much more modest over the next decade than during the remarkable expansion of private coverage in the 1940s and 1950s. We can only imagine what might have happened had the designers of ACA been more willing to contemplate greater reliance on the expansion of private, rather than public health insurance.

Christopher J. Conover is a research scholar at Duke University’s Center for Health Policy and Inequalities Research and an adjunct scholar at AEI. The charts shown are from his new book American Health Economy Illustrated, to be released in January 2012 by AEI Press. See PowerPoint version of Figure 6.6 and Excel spreadsheet on health insurance coverage from 1940-2020 for data, sources, and methods.

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Categories: Health Policy, Retirement and Social Security | Tags:

Social Security as a ‘Monstrous Lie,’ Obama’s Jobs Plan, and More: What You May Have Missed in the Polls

By Karlyn Bowman and Andrew Rugg

September 16, 2011, 10:20 am

Social Security: A Monstrous Lie?: CNN and the Opinion Research Corporation did not mention Rick Perry in their question about whether the Social Security system was a “monstrous lie and a failure.” Twenty-seven percent said this was an accurate description, but 72 percent disagreed. Forty-two percent of young people thought the description was accurate; 58 percent disagreed.

In another question in the poll, only 4 percent said the system “has no serious problems, certainly none that require changing the current system.” Twenty-eight percent said it has minor problems that can be fixed with minor changes, 55 percent said it has serious problems that can be fixed with major changes, and 12 percent said the problems are so bad that the system should be scrapped. More 18-24 years olds (21 percent) than people in any other age group thought it was irredeemable.

Obama’s Plan: Early Reviews: When asked about approaches that would be more likely to be successful in growing the economy, 57 percent in the new Selzer/Bloomberg poll said spending cuts and tax cuts will give business more confidence to hire, while 23 percent said the government needs to spend more to stimulate the economy. Thirteen percent wanted government spending kept at the same level. When the Bloomberg pollsters described the Obama plan as “a package of tax cuts, spending on public works, and aid to local governments that will cost an estimated $447 billion,” 40 percent said it would help lower the unemployment rate, while 51 percent said it would not.

In a new Gallup poll, 45 percent wanted their member of Congress to vote for a jobs plan like the one Obama proposed, while 32 percent were opposed.

In the Bloomberg poll, 43 percent said President Obama had laid out the better vision for a successful economic future, and 41 percent said the Republicans had.

Handling the Country’s Top Problem: For decades, Gallup has asked Americans to tell them in their own words what the most important problem facing the country is. Sometimes Gallup follows up by asking people which party would do a better job handling the problem they have just mentioned. In their latest poll, 44 percent said the Republican Party and 37 percent the Democratic Party. The GOP had an edge in September 2010, the last time the question was asked, but not in 2009 or 2008.

Constitution Day: On September 20, in celebration of Constitution Day, AEI will honor its great constitutional scholar Walter Berns. Supreme Court Justice Antonin Scalia and a distinguished panel will discuss Berns’s contributions. In a 2002 essay, Berns discussed the Constitution’s enduring popularity, noting that Americans esteem it and the men who framed it.

To the extent that Americans know much about the document, it is because of the work of people such as Walter Berns. In a poll conducted this summer for Time, 85 percent said they knew a “great deal” or “some” about the document. In a new poll conducted by the National Constitution Center, 74 percent said the document is an enduring one that remains relevant today. Twenty-four percent said it was outdated and needs to be modernized.

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Categories: Economic Policy, Law and the Constitution, Politics and Public Opinion, Retirement and Social Security | Tags:

CalPERS Admits that Market Valuation Makes Sense

By Andrew Biggs

August 29, 2011, 3:06 pm

The California Public Employees Retirement System (CalPERS), and public pensions across the country, have been pushing back on the idea that they should value their liabilities more conservatively, using methods that economists, financial markets and, more recently, the Congressional Budget Office, have deemed more accurate. Currently, public pensions “discount” their future benefit liabilities using the high 8 percent return they project they’ll receive on their plans’ investments. Financial economists counter that this is wrong, because this 8 percent return is based on a risky investment portfolio while public pension benefits are effectively guaranteed. Financial markets value a liability based on the risk of the liability itself, not of any assets used to fund the liability. Most studies have argued for discount pension liabilities using the risk-free Treasury security rate (currently around 3.1 percent over 20 years, although the studies tend to use older values of around 4 percent). Using the Treasury rate, economists such as Josh Rauh and Robert Novy-Marx have estimated that public pensions face unfunded liabilities not of the $600 billion or so that the pensions acknowledge, but more like $3 trillion. Ouch.

I took a somewhat similar tack in an AEI working paper (forthcoming in Public Budgeting and Finance). Public pensions argue that using the Treasury rate ignores the actual investments they make and the returns they can expect to receive. (It doesn’t, but I’m indulging them.) So I took a different approach, which was based on actual pension investment portfolios but also included the price of the taxpayer guarantee to back up the pension if the investments fell short. The cost of this implicit “put option” is ignored in pension accounting, but when you do calculate it, total unfunded liabilities sum to—lo and behold—around $3 trillion. Maybe Rauh and Novy-Marx were right after all. Pensions continue to squabble over these points, but substantively the argument has pretty much been won (with the important exception of the Government Accounting Standards Board, which can’t seem to make heads or tails of the whole thing).

Recently, though, CalPERS essentially acknowledged my main point: that the ability to turn to taxpayers for additional funds when needed is actually worth something. And that something turns out to be a lot. Steven Greenhut of the Orange County Register reports that some local governments are looking to terminate their pension plans to reduce costs, and CalPERS recently issued new rules on how to handle the liabilities of such plans.

Under those rules, liabilities would no longer be discounted at the 7.75 percent interest rate that CalPERS currently uses. Instead, CalPERS would value them using a lower 3.8 percent discount rate. Why? Because when a plan is terminated, CalPERS would no longer have recourse to the sponsoring government—that is, the taxpayers—to bail out the plan should it need additional funds. This is exactly the argument I made—that the difference between the expected return on risky assets and the riskless return is captured by the taxpayer guarantee in case the investments go south.

CalPERS, of course, claims that this is a special case—but it’s not. CalPERS says that in the case of terminated plans, they must invest more conservatively to be sure that assets and liabilities are more closely matched. This is the investment approach you would take if you wished to “immunize” taxpayers from future benefit liabilities—that is, to ensure that you won’t need to go back to them for more cash. CalPERS follows this approach simply because, in the specific case of terminating plans, they have to. But in terms of the value of public pension liabilities, this approach follows across the board. Guaranteed public pension benefits include the implicit right to go back to the taxpayer for more money when needed. This guarantee is valuable to the pension and expensive to the taxpayer since, as recent history shows, it’s most likely to be accessed in an economic downturn, when the taxpayer is least able to come up with additional funds.

So thank you, CalPERS—you’ve gotten it right at last.

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Categories: Economic Policy, Retirement and Social Security | Tags:

Are Military Pensions too Generous?

By Andrew Biggs

August 23, 2011, 1:25 pm

The Associated Press asks “Are military pensions too generous,” which in terms of precision is a little like asking “How’s your wife?” (In both cases, “compared to what” comes into play.) The AP reports that the Obama administration is thinking of shifting both the form and the generosity of military pensions. A report from the Defense Business Board points out that military pensions are generous relative to the private sector, but that benefits are concentrated in the small percentage of servicemen who stay for 20 years. The Board recommended a shift to the defined contribution Thrift Savings Plan, which the military participates in but does not match employee contributions.

Military pensions require that an individual have 20 years of service before becoming eligible. And, unlike other areas of public service, in the military you need to be promoted to retain your job, meaning that a lot of folks who would be willing to stay 20 years don’t get to do so. This makes military pensions a winners vs. losers game: the 83 percent who leave before 20 years get little or nothing, while those who make it to 20 years receive half pay for life. (Full disclosure: my brother is a career Navy officer with more than 20 years of service, who presumably is looking forward to a life of half-pay leisure…)

The generosity is more difficult to measure due to the differing accounting conventions of defined benefit pensions. What we want to know is the value of what’s called the “normal cost” of the pension, which represents the value of benefits accruing in a given year. If the normal cost is 10 percent of pay, then you would be roughly indifferent between receiving your pension and getting a 10 percent salary increase each year.

The Department of Defense reports a “normal cost” of pensions for full-time workers of 32.7 percent of pay. That’s pretty generous; for ordinary federal employees, the normal cost, including both defined benefit pensions and employer matches to the Thrift Savings Plan, is around 17 percent of pay. So military pensions are more generous than federal civilian pensions, which are themselves far more generous than pensions in the private sector, where the typical employer contribution toward pensions is around 6 percent of salaries.

Moreover, to make defined benefit pensions comparable to defined contribution plans you need to adjust for different accounting conventions. Federal DB pensions assume an interest rate of 5.75 percent, versus the current Treasury yield of around 4 percent. Put another way, federal employees receive a guaranteed return of 5.75 percent on their and their employers’ contributions while a worker with a 401(k) plan could receive a guaranteed return of only around 4 percent. Adjusting for those differences, military pensions are worth around 1.6 times more, or about 52 percent of salaries. Pretty sweet, so long as you make it to 20 years to receive the pension.

How do military pensions compare to those of other high-risk government jobs, such as police and firefighters? For instance, the Florida Retirement System’s Special Risk plan reports a normal cost of 22 percent of pay, but this is based on an assumed 7.75 percent discount rate. Again adjusting to a 4 percent Treasury rate for consistency, that would rise to close to 58 percent of pay. So Florida police and firefighters receive more generous pensions than do members of the military. My guess is that being in the military is a bit tougher — more time away from your family, plus a fair amount of getting shot at — but that demands more analysis.

My gut is that both military pensions and public safety pensions are too generous; that is, the military allocates a greater share of total compensation to retirement benefits than a rational individual would if you simply gave him a single pot of money and let him split it between wages and benefits. My gut also tells me that part of the reason public sector pensions are so generous is that — because no one can figure out exactly what they cost (see my calculations above) — generous pensions and other fringe benefits allow total compensation to rise higher than would be politically sustainable if pay increases came through salaries, the generosity of which are easy for the public to gauge.

Would it make sense for the military (and, for that matter, police and fire) to shift to a DC pension structure? Probably so. It’s fairer to different employees, doesn’t penalize people who want to leave for a different career, and has far more transparent accounting so the risk to government finances and the taxpayer is lower.

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Categories: General, Retirement and Social Security | Tags:

Entitlement Spending Can be Constrained

By Alan Viard

August 16, 2011, 11:13 am

Charles and Nick, I can’t subscribe to your view of the Republican candidates’ uncompromising stand against tax increases at last week’s Iowa debate. Like Peter Wehner and Norm, I am deeply disturbed that all of the candidates said they would reject a hypothetical deficit reduction agreement featuring $10 of spending cuts for each dollar of tax increases. I stand by my position (see here and here) that Republicans should be willing to compromise on tax increases in order to reduce entitlement spending.

As I pointed out, the additional government debt that will be issued if we fail to reach a deficit reduction agreement today must be serviced with tax increases or spending cuts in the future. Is there any real doubt that future presidents and Congresses will turn to tax increases for more than 10 percent of the financing? If so, then rejecting a 90-percent-spending-cut deal today actually increases the long-run tax burden.

Despite Charles’s claim to the contrary, there is such a thing as a real spending cut deal. To be sure, agreements to cut discretionary spending are hard to sustain over extended periods, because discretionary spending levels must be voted on each year and frequently change in response to unexpected developments. Even in this area, though, it’s possible to achieve some savings. The two Gramm-Rudman-Hollings laws and the Budget Enforcement Act restrained discretionary spending growth in the late 1980s and early 1990s.

In any case, it’s entitlement spending that really need to be restrained. Fortunately, agreements to cut entitlement benefits are more durable than agreements to cut discretionary spending. Because entitlement spending is not voted on each year, spending reductions remain in effect unless and until the president and Congress affirmatively pass legislation to overturn them. The historical record shows that real benefit cuts adopted in a bipartisan agreement can remain in place.

In 1983, Ronald Reagan signed a Social Security compromise that included both payroll tax increases and benefit cuts. One of the benefit cuts, a six-month delay in the cost-of-living adjustment, took effect as scheduled in the year of enactment. The largest benefit cut, an increase in the normal retirement age, may have initially seemed more vulnerable to backsliding because it wasn’t slated to take effect until decades down the road. Yet, the first stage of that increase, with the age rising from 65 to 66, has now taken effect. The second stage, with the age rising from 66 to 67, is still on track to take effect in upcoming years, with nary a proposal from either party to block it.

Besides, if there were no real spending cut deals, what would be the policy implication? That entitlements will be unilaterally cut by Republicans when they control all branches of government? Republicans’ track record offers no support for such a prediction. Or, that entitlements will never be cut? In that case, tax increases are unavoidable; blocking tax hikes today merely puts them off to the future and needlessly allows deficits to crowd out investment in the meantime.

In reality, entitlement spending can be restrained. But doing so almost always requires bipartisan agreement and therefore compromise. Of course, Republicans should insist on a good deal. But a 10-1 ratio is likely to meet that standard, at least if a significant portion of the spending cuts are to entitlement benefits.

A hard-line stance may offer some short-run political benefits, as evidenced by the resounding applause that the candidates received from the Republican audience last week. Unfortunately, an absolute refusal to accept tax increases today is likely to doom efforts to cut entitlement spending, guaranteeing onerous tax increases tomorrow.

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How Much Risk Do Public Sector Pensions Need to Take?

By Andrew Biggs

August 11, 2011, 12:37 pm

Public pensions report that over the 25-year period from 1985 through 2011 they have achieved a median investment return of 8.8 percent, exceeding the 8 percent returns they project for the future, and have earned these returns without taking undue risks. Given this, they say, why shouldn’t we assume they can keep on doing so into the future?

One reason is that over the last 25 years you didn’t need to take that much risk in order to generate a high return, simply because the riskless interest rate—that is, the rate of return generated by low-risk investments like U.S. Treasury securities—was a lot higher than it is today. Standing on this foundation, a plan could achieve decent returns without overloading on risk. When the riskless return falls, though, a plan needs to take more risk in order to achieve the same returns.

In 1985, the yield on 30-year U.S. Treasury securities was 10.8 percent. Even from 1986 through 1990, after interest rates had fallen, the average 30-year yield was 8.5 percent. So during that period you could get 8.5 percent with pretty much no risk other than inflation; getting it up to 8.8 percent didn’t demand a huge shift into risky assets. And in fact, as of 1986 public sector pensions held less than a third of their assets in stocks, according to the Fed’s Flow of Funds data. They didn’t really need to go beyond that.

Over time, though, interest rates have fallen—today, the yield on 30-year Treasury securities is about 3.5 percent. So if you want to keep on earning 8 percent—which is the most common assumption made by public pension plans today—you’ve got to jack up the risk to get there. Public pensions have doubled the share of their portfolios invested in equities, and increasingly are shifting to “alternative investments” such as hedge funds and private equity, which now make up almost a tenth of pensions target portfolios.

If you don’t care about market risk and the costs it imposes on the public—and public pension accounting, to be clear, does not care about those things—then all that matters is a plan’s expected return, not how much risk it has to take to get there. In the real world, though, a market downturn imposes costs on a whole range of government stakeholders, from taxpayers, to beneficiaries of government programs that might be cut to make room for rising pension costs, to bondholders, to public employees themselves, who today are paying higher pension contributions as a direct result of poor investment returns. Those costs somehow need to be tallied, yet both the pensions and their nominal regulator, the Governmental Accounting Standards Board, show no intention of doing so.

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Why Do U.S. Pensions Invest More in Stocks?

By Andrew Biggs

July 27, 2011, 11:27 am

Paul Kedrosky at Infectious Greed looks at how much pension plans in different countries invest in stocks, finding that the U.S. and Australia are the leaders, with around half their asset allocations in equities. Korea, Luxembourg, and both the Czech and Slovak Republics put next to nothing into stocks. Why?

One reason may be that public pension accounting in the U.S. rewards plan sponsors who invest in equities and other risky assets. Plans are allowed to discount their liabilities using the interest rate they expect to receive on their investments. Meaning, higher risk = higher expected return = higher discount rate = lower liabilities. As I’ve written before, substantively it makes no sense—taking more risk in funding a liability doesn’t make that liability any smaller—but to politicians who are looking to promise benefits today without paying for them, the discount rate is like magic.

But can these accounting rules explain differences in pension allocations across countries? To really do it right I’d need to dig up a lot more data, however I did manage to find discount rate data on a limited number of countries from this paper published by the OECD. Based on an (admittedly small) sample of seven countries, the logic outlined above seems to hold: when pensions can discount their liabilities at a higher discount rate, they tend to invest more in assets that would justify those high discount rates.

The regression line shows that, for each percentage point increase in the discount rate, pensions tend to increase the equity share of their portfolio by around 3.5 percentage points. In total, differences in pension discount rates account for around 59 percent of differences in the equity allocations of pension plans in different countries.

In short, if you tell pensions they can make themselves better funded by taking more risk, they’re going to do that. The Governmental Accounting Standards Board, even in its revised accounting rules released this month, continues to encourage excessive risk-taking by ignoring the laws of economics and common sense.

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The Disabled Deserve the Right to Work

By Richard Burkhauser

July 26, 2011, 3:29 pm

Today, President Obama issued a statement commemorating the 21st anniversary of the Americans with Disabilities Act of 1990 (ADA). While the Act itself should be celebrated, Americans should be concerned that government programs are failing individuals with disabilities: a lower percentage of Americans with disabilities are working today than in 1990 despite the ADA’s efforts to remove barriers to work.

The cause, in large part, is that policy changes in the federal disability transfer programs, including Social Security Disability Insurance (SSDI), Supplemental Security Income (SSI)-disabled adults, and SSI-disabled children, are undermining a core goal of the ADA—the full integration of people with disabilities into the workforce. These programs have made work less attractive and less profitable and as a result the share of adults with disabilities on either SSDI or SSI continued to grow, as does the share of poor children with disabilities on SSI-disabled children benefits. In part because of this, the 2011 Social Security Trustees Report on the Status of the Social Security and Medicare Programs notes that the SSDI Trust Fund is projected to be exhausted in 2018, threatening the future welfare of those with disabilities.

Any reform to our disability programs must start with work-first strategies. Encouraging work rather than benefit receipt following the onset of a disability will slow the process that eventually leads to an inability to work and can solve a range of problems currently burdening the disability system. This strategy is consistent with the goals of the ADA, which calls for the integration of people with disabilities into the labor market. A work-oriented approach provides a long-term opportunity for people with disabilities to reap some of the rewards of a growing economy, an opportunity not granted by the current cash benefit system.

Richard Burkhauser and Mary Daly’s book, ‘The Declining Work and Welfare of People with Disabilites,’ will be released by AEI Press in September 2011. You can read an excerpt here.

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Means Tests as Marginal Tax Increases

By Andrew Biggs

July 25, 2011, 2:04 pm

Tyler Cowen, citing Modeled Behavior and Paul Krugman, hits on a point I’ve been thinking about lately: means tests as marginal tax increases. The question they have been wrestling with is how large the effects of these de facto taxes would be.

My gut is that an explicit means test, like that proposed by the Heritage Foundation, which would reduce Social Security and Medicare benefits by around 45 cents for each dollar of a retiree’s income above $55,000, would have its largest effect on earnings of retired individuals. That’s the variable they can most easily control, and it’s also a variable that will push many retirees in or out of the test’s income range. Social Security’s Retirement Earnings Test, which reduces benefits by 50 cents for each dollar of earnings above a threshold, is generally taken to have negative impact on work and earnings. (See here for a discussion of the RET.)

It’s likely that a lesser effect would be felt on saving; high saving rates during working years can trigger the means test in retirement but, as Tyler points out, this demands some foresight. Moreover, given the variability of asset returns, the effects would be difficult, though not impossible, to predict. A more plausible effect might be for people with high savings to dissave in the years immediately preceding retirement, or to use their savings to generate consumption that wouldn’t be subject to the means test (say, by paying off a mortgage). That’s what financial planners are for.

The effect on labor force participation during working years is likely to be the smallest, because these individuals are less sensitive to marginal tax rates than older people who have the option to retire. For instance, Lucie Schmidt of Williams College and Purvi Sevak of Hunter College found, for individuals over age 65, that “a reduction in the marginal tax rate that would increase the payoff to working by 10% would increase labor force participation by 7.5% among men and 11.4% among women.” This is around three times the effect that the CBO assumes for the population as a whole. Optimal tax theory generally says to levy higher taxes where the sensitivity to taxes is lowest; a means test applied to retirees flips this idea on its head.

My proposal to reduce retirement benefits based on lifetime earnings rather than current income has been confused as means testing, but I believe the effects would be very different. Yes, lowering Social Security or Medicare benefits for high earners does reduce the payoff for the payroll taxes these individuals contribute—in effect, it increases the “net tax rate” they pay, meaning taxes net of benefits earned. However, imposing a small marginal tax increase on individuals with lower sensitivity to marginal taxes produces different results than imposing large marginal tax increases when individuals were highly sensitive to tax rates.

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Categories: Fiscal Policy and Taxes, Retirement and Social Security | Tags: Social Security, taxes

Are States’ Budget Surpluses Sustainable?

By Rohan Poojara and Lindsay Eisenhut

July 22, 2011, 12:10 pm

While the federal government struggles to rein in the deficit and come to an agreement on the nation’s debt ceiling, Virginia announced a revenue surplus of $311 million in its General Fund, which covers most of the traditional state services. Virginia is not alone, as more than two dozen states have reported revenue surpluses for the fiscal year that ended on June 30.

Every state except Vermont has a statutory or constitutional requirement to balance its budget. However, through a combination of spending cuts and revenue increases, many states have gone a step further and actually have some funds left over. The key question is whether or not these surpluses are sustainable.

To answer this question, we first need to examine how so many states were able to build up surpluses during such difficult economic conditions in the first place. The primary method has been spending cuts in all major areas of services, including healthcare (31 states), services to the elderly and disabled (29 states and the District of Columbia), K-12 education (34 states and the District of Columbia), and higher education (43 states), to name a few. As seen in Figure 1 below, there was a 10 percent reduction in General Fund spending between fiscal years 2008 and 2010. While spending increased in fiscal 2011, it was still significantly below pre-crisis levels.

Another factor that has helped states build up surpluses is the increase in tax revenues, as shown in Figure 2 below. While spending cuts in 2009 and 2010 were insufficient, by themselves, for most states to run a surplus, a combination of lower spending and higher tax revenues (a 6 percent increase) in fiscal 2011 enabled many state governments to keep their books in the black. It is important to note that this growth in revenues was largely driven by a jump in sales taxes receipts and personal income rather than higher tax rates.

So, are these surpluses sustainable? State government spending is projected to increase in fiscal 2012, but so are revenues, which might suggest an equal effect on both sides of the state government’s ledger and continuation of surpluses. Unfortunately, the picture isn’t so rosy when you dig into the details.

First, research from the Federal Reserve Bank of Cleveland suggests that the increase in tax revenues may be transitory because it was not driven just by an increase in wages but also by the capital gains taxes. Heightened uncertainty about increasing capital gains taxes, combined with the removal of income restrictions in 2010 on the conversion of traditional IRAs to Roth IRAs (where the amount converted is taxable) may have played a role in boosting states’ revenue. There is no way to know for sure because states don’t report capital gains revenue consistently or in real time, but if the source of the revenue growth was capital gains taxes, revenues might fall back down to 2009-2010 levels.

Second, states face the wind down of significant funding that was provided through the American Recovery and Reinvestment Act of 2009. As Figure 3 below shows, that temporary federal aid to states will fall from $89 billion to $23 billion in the coming year.

Third, and most importantly, are the unfunded liabilities of state pension and retiree health plans. For example, while Virginia claimed a budget surplus of $311 million this year, it also withheld $620 million in contributions to the state employees’ pension fund. This effectively means that Virginia is borrowing from its pension fund to avoid balancing its budget. In fact, while defenders of public employees argue that public pensions only cost state and local governments less than 4 percent of their budgets, this proportion is artificially low because of improperly valued pension liabilities. In total, states report underfunding in their pension plans of $438 billion. However, as Andrew Biggs highlights in his Retirement Policy Outlook, the market value of these public-sector pension deficits is in excess of $3 trillion. Therefore, correctly valued, state and local governments should dedicate almost one-quarter of their budgets to public employee pension funding and an additional 7 percent for the costs of health benefits for retired public employees.

Clearly, there is a long way to go before states can claim to have their fiscal house in order.

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A Koch-and-Bull Story on Social Security

By Andrew Biggs

June 24, 2011, 5:35 pm

A group called the Brave New Foundation has a video circulating the Internet touting a conspiracy by the Koch brothers (or Koch Brothers, I guess) to create an “echo chamber” calling for the destruction of Social Security. The video itself is almost comical, with narration by slightly disheveled Senator Bernie Sanders (Socialist-Vermont) and newsreel footage of a variety of analysts, including yours truly, nefariously intoning on the need to increase the retirement age. It’s really worth a watch, if you’re into this kind of stuff.

But since it’s so widely circulating on the Lefty blogs, I figured a few comments from one of the villains were in order.

First, the video gets a number of the speakers’ affiliations wrong, including my own. To the best of my knowledge AEI isn’t funded by the Kochs, so the video labels me as from the Cato Institute, a place I worked, oh, eight years ago. But anyway, this is fine by me: at least the hate mail will go to the wrong address.

Second, there’s a basic logical error here. You have a lot of people, presumably funded by the Kochs, who favor raising the retirement age. But guess what? There are a lot of other people who also favor raising the retirement age who are not funded by the Kochs.

Or are they? Let’s look at some of the suspects…

—Henry Aaron: Brookings Institution economist, solidly liberal on Social Security and health policy. Except on the retirement age, which he favored increasing in his book Countdown to Reform. He must have needed some extra money and given the Koch Brothers a call.

—Robert Reischauer: President of the left-leaning Urban Institute and Democratic appointee as public trustee of the Social Security and Medicare programs. But the Kochs got to him, too, apparently. Co-author with Aaron on Countdown to Reform, Reischauer also favored increasing the retirement age.

—The Academy of Actuaries: No one knows the value of a payoff more than the green eyeshade guys. But I bet they got rolls of KB cash in exchange for supporting a retirement age increase.

—Richard Durbin: As second-ranking Democrat in the Senate, you’d think he’d be loyal to the cause. But as a member of president Obama’s fiscal commission, he supported increasing the retirement age. ‘Nuff said.

And the list goes on. The video portrays the Koch Brothers as octopuses with tentacles spreading in all directions. Little did the video producers know how right they were.

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Florida Teachers Get Nine Times Typical Pension Contribution from Employer, Are Suing

By Andrew Biggs

June 21, 2011, 3:16 pm

CNN reports that Florida teachers are protesting—and more important, suing—against a requirement that they contribute 3 percent of their pay toward funding their pension benefits.

The lawsuit, filed Monday by the Florida Education Association in Circuit Court in Tallahassee, argues that the new mandate is unconstitutional because Florida law says employees do not have to contribute toward the state retirement system.

I’m no lawyer, but I’d guess that a new law can supersede an older law, though you never know how it will play out in the courts.

More importantly, the Florida Retirement System (FRS) recently published an actuarial memo showing the true value of benefits paid to public employees. After reading it, it’s very hard to feel sorry for Florida state workers.

In the private sector, a typical worker has a 401(k) plan with an employer match. If the employee wants a guaranteed benefit, like those paid to public-sector workers in defined-benefit plans, he needs to invest his contributions in U.S. Treasury securities, currently yielding around 4 percent. Usually, if the worker contributes 6 percent of pay his employer will match half, so the employer contribution is worth around 3 percent of pay.

The FRS memo, responding to critics of public pension accounting who argue that governments understate costs by assuming excessive rates of return on investment, calculates the value of FRS benefits using a 4 percent interest rate. This approach, the Congressional Budget Office recently declared, “provides a more complete and transparent measure of the costs of pension obligations.”

It also provides a better measure of the generosity of benefits paid by public pensions, since it effectively shows how much a private-sector worker would have to invest in a 401(k) to match the guaranteed retirement benefits paid to public employees.

How much are FRS benefits worth? Slightly more than 27 percent of wages, meaning that a typical Florida government worker would be more or less indifferent between receiving his pension benefits or getting a 27 percent raise that he could then invest himself.

So, we’ve got a teacher or other state worker getting a pension contribution from his employer that’s, oh, nine times larger than a typical worker with a 401(k) gets. Maybe someone should be suing, but it’s sure not the public employee.

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Fact-Checker’s Day Off at the New York Times

By Andrew Biggs

June 20, 2011, 11:53 am

I’ve written only one piece for the New York Times editorial page, along with several others for their website. They fact-checked the articles, as they should have, and I responded with revisions where needed. All in all, a very normal experience. It’s strange, then, that today’s op-ed “Get Radical: Raise Social Security” by labor lawyer Thomas Geoghegan contains a dubious assertion in almost every paragraph. Was anybody checking this stuff?

Geoghegan writes that “right now Social Security pays out 39 percent of the average worker’s preretirement earnings.” Financial advisors recommend a total retirement income “replacement rate” of 70 percent to 80 percent of pre-retirement earnings. Geoghegan wants to raise benefits to hit a 50 percent average replacement rate.

But as I showed in this paper with Glenn Springstead of the Social Security Administration, SSA measures replacement rates differently than financial advisors, comparing benefits to “wage-indexed” average lifetime earnings rather than earnings immediately preceding retirement. Compared to final earnings, the median beneficiary has a Social Security replacement rate of 69 percent and a total income replacement rate of 185 percent. Do some people need help? Sure, but this isn’t exactly a situation crying out for a broad-based benefit increase.

Geoghegan mocks those who say we can’t afford higher benefits. “Oh, come on: We have a federal tax rate equal to nearly 15 percent of our G.D.P. — far below the take in most wealthy countries.” But tax revenues aren’t low because we cut taxes. They’re low because we’ve run the economy into the ground. When people’s incomes drop or they lose their jobs, tax revenues fall too. Once the economy recovers, tax revenues are slated to rise—to around 20 percent of GDP under President Obama’s budget, a level that is above the historical average and which does nothing to fully fund the Social Security program Geoghegan wants to expand by over 25 percent.

Geoghegan then states, “the labor economist Richard B. Freeman points out that the hourly earnings of workers dropped by 8 percent from 1973 to 2005 while productivity shot up 55 percent or more. The United States is one of the few developed countries where workers are routinely cheated of a share in higher productivity.” Actually, as Harvard’s Martin Feldstein has pointed out, this is an almost entirely bogus statistic. Productivity growth over time is calculated using a different measure of inflation (the GDP deflator) than income growth (the Consumer Price Index). Moreover, wage growth is less important than compensation growth, which accounts for the increasing role of benefits. Feldstein shows that “total employee compensation as a share of national income was 66 percent of national income in 1970 and 64 percent in 2006. This measure of the labor compensation share has been remarkably stable since the 1970s.”

Geoghegan’s statement that employers “have had a windfall on pensions” is also dodgy. Department of Labor data indicates that total employer pension contributions in 1975 equaled around 2.3 percent of GDP; in 2008, pension contributions totaled 2.9 percent of GDP. Did pensions shift from a defined benefit to a defined contribution structure? Sure, but a windfall comes when you contribute less, not when you contribute more.

So what we end up with is a plea to increase by 25 percent the largest domestic government program, which happens to be already underfunded by around 21 percent, supported by an array of facts nearly all of which are either irrelevant or false. I’m less puzzled about how this piece got written—after all, there’s a ton of bad stuff written every day—than how it came to occupy what is still one of the most coveted pieces of newspaper real estate.

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AARP’s Shift on Social Security Benefit Cuts: What It Means

By Andrew Biggs

June 17, 2011, 10:48 am

The Wall Street Journal reports this morning that the AARP—formerly known as the American Association of Retired Persons, informally known as the union for old folks—has shifted its position on Social Security reform, now saying that it is open to some reductions in future benefits. This comes about as a consortium of liberal groups argues that no Social Security benefits should ever be cut, now or in the future, for rich or for poor. Notably, AARP declined to join this group.

How big a change is this for AARP? Not so large as you might think. To be sure, I’m confident the internal preference at AARP has been and will continue to be to fix Social Security almost entirely by raising taxes. That’s just where they are on this. However, if you talked to AARP staffers offline it was clear they realized that any deal would likely cut benefits and they would even tell you which benefit cuts they would be most open to.

However, it’s one thing to be open to benefit cuts behind closed doors, but it’s another to speak openly about them, and to hold town hall meetings across the country, as AARP is reportedly planning to do.

Partly this is just AARP coming back to reality. The budget deficit and the long-term entitlement gap is so large that mathematically there’s no way to fix it all by raising taxes. And Medicare is far more likely to need tax increases than Social Security, where, if you reduce benefits—particularly for middle and high earners—they can easily make up the difference by saving more in their 401(k) plans. Cuts to Medicare benefits, as we will soon see through Obamacare, are far harder for affected seniors to make up.

So how far would AARP be willing to go? Here’s where things will likely break down again. Ideally, Social Security would be solved almost entirely on the benefit end in order to leave room in the budget for rising healthcare spending. That’s the approach I took in designing a reform plan as part of a recent Peterson Foundation initiative. Social Security reform looks very different in the context of the rest of the budget than it would if Social Security were the only long-term challenge we faced.

However, while AARP is showing more flexibility, I don’t think it will end up being nearly enough. Based purely on my gut, I would guess that AARP would be willing to go for a plan consisting of around one-third benefit cuts, two-thirds tax increases. Maybe they’d go further, and 50-50 would be nice, but I kind of doubt it.

Is that good enough for people concerned about the rising budgetary pressures of aging and healthcare costs to accept? I don’t think so, particularly since any Medicare deal may prove to be even more weighted toward taxes. So while this is very good news, there’s still a long road ahead.

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More Evidence That Federal Employees Are Overpaid

By Andrew Biggs

June 16, 2011, 10:49 am

In my AEI working paper on federal employee compensation with Jason Richwine of the Heritage Foundation, we compare the salaries, benefits, and job security of federal employees to that received by private-sector workers with similar earnings-related attributes—that is, similar education, experience, region, race, gender, and so on. These calculations, which are performed using regression analysis, show that federal workers receive salaries around 14 percent higher than similar private-sector workers. The federal pay premium is largest for employees with less education, and increases as workers gain experience. (So, for instance, a less-educated federal employee with long job tenure would get a larger pay premium than a newly hired PhD).

Almost no economist really disagrees with this approach, so much so that studies on federal salaries—after a spurt during the 1970s and 1980s—are pretty infrequent today. In other words, most labor economists seem to consider the pay premium issue more or less settled.

But some people find this kind of statistical analysis unconvincing, probably because they don’t think it’s really possible to control for all the relevant differences between different kinds of workers. While regression analysis can control for whether a person has, say, a bachelor’s or master’s degree, it doesn’t control for the quality of the school attended or the grades the person received. Likewise, maybe federal employees are unusually hard-working or creative, such that they create more value than private employees who look the same on paper. I doubt it, but you can’t prove that it’s impossible.

What these folks want to know is how much the exact same person would be paid in the federal government versus the private sector. And Jason Richwine’s new paper released by Heritage answers that question. Instead of comparing pay for different people at the same point in time, it follows the same people over time as they shift into and out of different jobs. If a given person earns more in a federal job than a private-sector job then we can be pretty sure it’s the job that’s making the difference, since the person himself barely changes over time. (And Jason controls for the limited instances where the person’s characteristics do change, say by getting an additional educational degree or by gaining an extra year of experience.)

What does this analysis show? As Jason states, “Private-sector workers who switch to federal jobs receive an average real wage increase of 9 percent, while private workers who find another private job earn just an additional 1 percent, implying an 8 percent federal premium.” These are the same workers, with the employer and job being the only difference. Similarly, most people who leave federal employment take a pay cut, undercutting the common claim by federal employees that they could earn much more on the outside.

But does this study, which finds an 8 percent average pay premium for people switching to federal jobs, undercut our previous estimate of a 14 percent pay premium? Not at all. Remember that our analysis found that the federal pay premium is smallest in the initial years after a worker has been hired, and Jason’s new paper calculates the pay premium only in the first year of employment. So it’s actually fully supportive of the cross-sectional results we generated.

If there’s a convincing rebuttal to all this from the Office of Personnel Management and the public employee unions, who in the past have pooh-poohed federal-private pay comparisons, I’d like to hear it.

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How to Make Entitlements Untouchable

By Andrew Biggs

June 13, 2011, 12:12 pm

To my liberal, I mean, “progressive” friends: I know you’re scared. I know you think that Social Security, Medicare, and other government programs are on the chopping blocks and that even your erstwhile Democratic allies are ready to cut a deal that will scale back these important federal initiatives. You’re doing your best—you’ve got the vitriol, you’ve got the press, you’ve got the interest groups. But still it may not be enough. What you need is an important ally. And I’m about to give you one.

You see, most members of the House and Senate have signed a pledge circulated by Americans for Tax Reform affirming that they will not approve tax increases of any kind, including the elimination of so-called “tax expenditures” that many people consider to be “spending through the tax code.” This has been the subject of a long-running fight between ATR and Senator Tom Coburn (R-Oklahoma) over tax subsidies for ethanol, and Politico reports that Coburn may this week force a vote on the subject. ATR’s pledge opposes any reductions in tax expenditures that result in increased tax revenues. In other words, tax expenditures can’t be cut to reduce the budget deficit, only to finance other tax cuts.

So what has this got to do with you? Remember the phrase, “spending through the tax code”? Let’s say we just shift Social Security and Medicare around a bit. Currently, Social Security pays a benefit based on your average lifetime earnings; instead, Social Security could pay a refundable tax credit of the exact same amount. Likewise, Medicare now pays for health costs under a certain set of conditions; instead, seniors could receive a refundable tax credit to cover their health costs, so long as they meet the same criteria. From the point of view of the beneficiary, it’s all the same. But not from the point of view of ATR’s pledge. With some creative thinking—and I know you guys are good at that—you could turn a whole array of federal programs into tax credits and thereby make them untouchable. Getting the picture now?

There’s an added bonus as well: you get the satisfaction of forcing Republicans to raise taxes. How’s that? Well, consider that Social Security and Medicare together have long-term unfunded liabilities somewhere in the $100 trillion range. That means that total benefits promised are around $100 trillion more than total Social Security and Medicare taxes. So even if conservatives said they’d repeal every penny of Social Security and Medicare benefits, which under the ATR pledge would be used for tax cuts, they’d still be on the hook for an extra $100 trillion in taxes just to fill the gap.

I know this makes for about the strangest bedfellows around. And I know a lot of this doesn’t seem to make much sense—it doesn’t really make much sense to me either. But these are important programs to you folks and I know you’ll do the right thing.

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Categories: Fiscal Policy and Taxes, Health Policy, Monetary Policy, Retirement and Social Security | Tags:

Targeting Economic Growth

By Andrew Biggs

June 10, 2011, 12:49 pm

Former Minnesota Governor Tim Pawlenty, in a major economic speech last week, called for targeting a 5 percent economic growth rate, arguing that “such a national economic growth target will set our sights on a positive future. And inspire the actions needed to reach it.”

I disagree with the target, but agree with the aspiration. Five percent growth is possible in any given year, and may even be likely as the economy eventually recovers and America’s idle stocks of labor, capital, and technology are again fully utilized. Over the long term, however, 5 percent growth really isn’t consistent with a labor force that will grow by only around half a percent per year, with productivity growth required to make up the difference. Five percent is just too high a bar to reach. An aging population means slower labor force growth and, all other things equal, slower economic growth.

But it’s that aging population that also makes it so is important to focus on economic growth. When smaller populations of workers have to support larger populations of retirees, you need the workforce to be as productive as possible. It’s only by raising output that population aging doesn’t get to be a tug of war over resources between the old and the young.

My shorthand is that to support an aging population you want policy to encourage individuals to:

—Work more: Meaning more hours of the day and more weeks of the year;

—Save more: Meaning more participation in employer pension plans and higher contributions into them; and

—Retire later: which means not claiming Social Security at 62 like many people do today, but at 65, 66, or beyond.

This context makes clearer why I oppose relying too much on taxes to fix entitlements and the budget. Higher taxes mean that people will:

—Work less: Since they’ll receive less for each hour of work;

—Save less: Since they’ll have less money to save and less reason to save, since those taxes will support more generous entitlement programs; and

—Retire earlier: Since Social Security and Medicare benefits will look more generous relative to their after-tax pay when working.

Obviously the execution is a lot more complicated than this, but the basic logic isn’t. Economic policy shouldn’t be about a number, be it 5 percent or whatever, so much as about a sign: positive or negative. If you need a stronger economy to thrive then you want public policy to encourage the things that lead to a stronger economy, not a weaker one. And it’s there, more so than in the details, where Pawlenty’s on basically the right track.

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Categories: Economic Policy, Fiscal Policy and Taxes, Politics and Public Opinion, Retirement and Social Security | Tags:

Fertility and Social Security Financing

By Andrew Biggs

June 8, 2011, 11:30 am

The Ethics and Public Policy Center’s Jim Capretta—whose work on health reform I’m a huge fan of—weighs in on an aspect of the Social Security problem that’s received insufficient attention: falling fertility. Capretta argues that Social Security has stifled fertility in America, which in turn has stifled our ability to support the Social Security program. Steps to encourage higher fertility would make Social Security’s finances more sustainable over time. I’m not sure I agree with Jim’s argument on causation, but I think his policy prescriptions deserve more attention as we think about Social Security reform.

Capretta argues that “the presence of the state-based pension benefit—particularly if it is large—reduces the incentive of younger workers to have children.” The question is, why? Capretta’s answer is that

a motivation for having children in earlier times was economic security in old age. As parents became frail and less productive, it was expected that one or more of their adult children would take care of them. Married couples thus “invested” in numerous children, in part to ensure the next generation would have the economic capacity to provide for them in their final years.

Put another way, parents invested in “human capital”—that is, kids—as a way to save for retirement. With retirement income provided by the government, couples naturally would have less need to have children and fertility would decline.

I can buy this, up to a point. The problem is that, in the same period in which Social Security was developed and its benefits grew, a second innovation took place: it became far easier for individuals to save for retirement through financial capital, such as bank accounts, mutual funds, as so forth. In the 19th century many Americans didn’t really have access to modern forms of saving and so investment in human capital was a rational way to prepare for retirement. But as other saving opportunities arose, it’s likely that parents would substitute financial capital for human capital and reduce household sizes to levels desired for reasons other than retirement security.

If pension benefits were a main driver of fertility, you would expect that countries with relatively more generous pension plans would have lower fertility. Capretta cites research showing that countries that spend more on pensions as a share of GDP tend to have lower fertility. But that doesn’t necessarily show causality. Why? Because, in a pay-as-you-go program like Social Security, if fertility falls then the cost of pensions relative to GDP will rise. In other words, it’s not clear which is the chicken and which the egg.

I try to get around that problem by looking at the generosity of pension benefits from an individual perspective, measured by the replacement rate offered to the average retiree—that is, the pension benefit as a percentage of pre-retirement earnings. The higher the replacement rate, the less need to save on your own. As the chart shows, there’s really no relationship in OECD countries between the generosity of public pension benefits and fertility. Countries with very different levels of pension generosity can more or less have the same fertility rates. That’s not to say that a relationship is impossible at the margin, but it doesn’t appear to be a first-order effect.

However, there does seem to be a relationship between the generosity of pension and other government retirement benefits and ordinary saving. This paper by Jagadeesh Gokhale, Larry Kotlikoff, and John Sabelhaus attributes much of the decline in the U.S. saving rate to increases in Social Security and Medicare spending. They state:

Our findings are striking. The decline in U.S. saving can be traced to two factors: The redistribution of resources from young and unborn generations with low or zero propensities to consume toward older generations with high consumption propensities, and a significant increase in the consumption produce of older Americans. Most of the redistribution to the elderly reflects the growth in Social Security, Medicare and Medicaid benefits.

My takeaway from all this is that it’s likely that fertility would have declined regardless of the presence of Social Security simply as households shifted from saving in human capital (kids) to financial capital (stocks, bonds, etc). However, the significant increase in government spending on the elderly likely reduced saving in financial assets as greater retirement resources were generated on a transfer basis.

Yet, while I disagree a bit with Jim’s analysis of causes, I don’t really disagree with his policy prescriptions: even modest increases in the fertility rate would have a large impact on Social Security’s funding shortfall and a modest, but still significant, effect on Medicare and Medicaid funding. Increasing the fertility rate from 2.0 children per woman to 2.3 would cut the long-term Social Security shortfall by around 16 percent.

Capretta is also right that through Social Security, parents with children are effectively transferring resources to parents without children, and there is an argument, from a fairness perspective alone, for some compensation. A couple years back I ran some numbers on the value of an additional child to Social Security and came to a figure of around $22,000 in present value terms, although others convincingly argued it could be higher. Capretta argues for a reduction in the payroll tax rate for workers with children, which would simply pay that lump sum value out over time.

I also agree (as I argued in this 2008 AEI working paper) that automatic adjustments to Social Security benefits, based on changes in the worker/beneficiary ratio, could keep the program on a stable track with less political angst than the current approach.

The real question is how big an effect policy changes could have on fertility rates. A good chunk of payroll tax cuts for parents would flow to individuals who would have had children in any event, so the trick is in influencing behavior at the margin. Perhaps instead of a general payroll tax cut for all parents, maybe a large cut that kicked in at, say, the third child. But this is clearly an area that deserves more attention and it’s great that Jim has brought it more prominence.

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Categories: Retirement and Social Security, Society and Culture | Tags:

Congressional Retirement Benefits Much More Generous Than Private Sector

By Andrew Biggs

May 16, 2011, 6:47 am

In response to some comments on my previous post on the generosity of federal pensions, I thought I would follow up with some information that might provide additional detail. Instead of looking at the final benefits received in retirement, here I’ll look at retirement benefits earned in a particular year, then compare to what private-sector workers at large firms tend to receive.

According to the Office of Personnel Management, the “normal cost” for congressional pensions—that is, the average cost of benefits accruing in a particular year—is equal to 17.9 percent of wages. (The Federal Register lists a normal cost of 19.2 percent, but that doesn’t net out a 1.3 percent contribution from the Member.) However, those costs are calculated using an assumed interest rate of 6.25 percent, higher than 5.5 percent Treasury yield I’m assuming based upon CBO projections. Adjusting for this (see this recent CBO paper to see why these adjustments make sense, although CBO presents it from a macro, budget-side perspective) increases benefit accruals to 22.4 percent of wages.

On top of this, federal employees receive a government match to their defined- contribution Thrift Savings Plan account of up to 5 percent of pay. They are also eligible for retiree health coverage, which is worth around 6 percent of wages, according to a 2002 CBO report. Relatively few private-sector employees today receive retiree health coverage, and for those who do it is less generous than in the public sector. So you add together the total retirement package provided by the federal government to members of Congress and it’s worth somewhere around 33.4 percent of pay. (In other words, the employee would be more or less indifferent between receiving these benefits or receiving a 33 percent salary increase.)

In my work with Jason Richwine on federal pay, we compare federal employees to private sector workers at large firms. The BLS publishes benefits data and we compare to private workers in establishments of 100 employees or greater. (The establishment size is the number of employees at the location where you work; the firm size is the number of total employees. An establishment size of 100+ correlates with firm size of around 1000+, which is the largest available for salary comparisons, which our paper also calculates.) In any case, the average private sector worker in this category receives employer contributions to defined benefit pensions of around 3 percent of pay and contributions to defined contribution pensions of around 3.4 percent of pay. So if we look at larger private firms, which tend to pay better salaries and benefits, we get a larger employer pension contribution.

But still, a member of Congress receives employer retirement contributions of around 33.4 percent of pay each year while a private sector worker in a large firm receives around 6.4 percent. By my math, 33.4/6.4 = 5.2 – that is, annual retirement contributions for a member of Congress exceed those for private sector employees by a factor of five. Again, not to say that these figures confirm the myths that Norm Ornstein debunks—they don’t. But we shouldn’t come away from this with a conclusion other than that congressional retirement benefits—like federal employee benefits in general—are far more generous than those a typical private sector worker receives.

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