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Blue Model Blues
Public Pensions and Fiscal Incompetence

In previous posts on America’s ongoing—and underreported—public sector pension crisis, we’ve highlighted the role played by institutional greed and fecklessness—greed by public sector unions that have turned so many state and local governments into ATM machines, and fecklessness by politicians who were willing to keep wildly over-promising to keep their campaign contributions flowing. But as the economist Timothy Taylor points out (h/t Tyler Cowen), the crisis has also been caused by something simpler: fiscal incompetence. If the government-sponsored entities that manage pension funds had been wiser and more steady about their investments over the last three decades, the size of the shortfall might be much smaller than it is today:

If one looks back over the last 30 years, stock markets overall show a dramatic rise. The S&P 500 index, for example, rose from about 250 in 1986 to roughly 2,000 over a 30-year period. That’s a nominal rise of about 7% per year, and adding the returns to shareholders from dividends paid out by firms would make the total return over this time a few percentage points higher. There’s certainly no guarantee that stock markets in next 30 years will perform as well as they have over the last 30.

In short, the reason why the unfunded liabilities of state and local pension funds are so much higher in 2016 than 30 years ago isn’t because the overall stock market performed poorly. Instead, it’s a grim story of mistiming the moves in the market (rather than just being steadily invested throughout), trying out alternative investments that didn’t pan out, not putting enough money aside in the first place, and overpromising what benefits could be paid.

As Taylor points out, there may be no way to reverse this failure—even through better fund management—because the stock market may never again see the kind of returns it did in the late 20th century. And betting on a strong long-term performance by investing heavily in equity is a risky strategy at a time when funds are facing a two-trillion dollar shortfall in the midst of global market turmoil.

Taylor’s analysis doesn’t offer a clear way out of the current crisis, but it does highlight the types of reforms that can prevent it from being repeated in the future. First, states should enact reasonable regulations to curb the political influence of public sector unions, thereby reducing the pressure on politicians to make guarantees they can’t deliver. And second, state and local governments should move away from defined-benefit pensions and toward the individual, defined-contribution, 401(k) systems that are now the norm in the private sector. This would take the responsibility for managing workers’ retirement funds out of the hands of the government, whose ability to do so responsibly is seriously in question.

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  • Andrew Allison

    Not mention here is the sheer lunacy of the proposal to give these incompetents control of general public pension funds.

  • Pete

    “First, states should enact reasonable regulations to curb the political influence of public sector unions, thereby reducing the pressure on politicians to make guarantees they can’t deliver. ”

    No, states should outlaw public sector unions.

  • Kevin

    This underestimates the role looting the treasury by insiders and their cronies has played. It’s not just unions. It’s the financial advisers and managers hired at exhorbitant rates who then produced lousy returns. They have invested in every dubious scheme except tulips, raking massive fees off the top – steady fees when the vestments have cratered and huge bonuses when they worked out. These players have been donating heavily to the politicians who hire them – this sort of pay to play corruption is infuriating. The union leadership looks the other way while everyone feathers their nests and hands out IOUs backed by nothing but hopes of speculative rates of returns to their members. The politicians get donations from the money managers and lucrative post-political work as consultants and advisers – effectively just delayed payment of bribes. The money mangers get great fees fir oarking pension funds in their latest casino roulette wheel.

    It’s no wonder the voters are fed up and looking to people like Trump as well as Sanders and Cruz – the insiders and elites have proven themselves thoroughly corrupt and self dealing.

    • Matt_Thullen

      Amen. Kevin nailed the issue–political cronies of politicians and public union allies are often given the lucrative work of “investment adviser”, and these people used this work as a license to steal.

      • JosefK314

        That’s a second derivative.

  • Beauceron

    I think there’s obviously some truth in the whole market timing critique, but I wonder how much of this was due to the unrealistic projections made in the pension funds about returns– politicians fudging the numbers on anticipated investment earnings to get the deals to pass muster. When the pension plan requires a totally unrealistic profit to remain solvent, it puts a lot of pressure on a portfolio manager, who then might make bad decisions in an effort to bring in higher earnings.

    In any case, I don’t think this is “underreported” as you state. I think people are justifiably unconcerned about the issue. They know the federal government will bail them out.

  • Daniel Nylen

    If the retirees could only get funds from the pensions they would police the investing of those funds more closely. while the taxpayer is on the hook for the shortfall it will always be okay to invest in PC causes and back-handed rent-seeking. A system easy to corrupt will be corrupt–period.

  • Andrew Szakmary

    I draw a pension from the Illinois State Universities Retirement System (SURS), and if the investment results of my pension system (9% average annual returns over the past 30 years, net of fees) are at all typical, then your assertion that pensions are in trouble because of poor investment returns is way off base. We can agree to disagree about whether the true cause is primarily overly generous benefits or massive past undertaxation and underfunding by state and local governments, but I strongly doubt that poor investment returns play any meaningful role.

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