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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