Against state pension funds

For all the talk, these days, of the problems that state pension funds are getting into, I haven’t seen anyone argue against their existence. But the case against them is simple and strong.

To define what is being argued against: state pension funds pay the pensions of retired employees of the state government. Without pension funds, states would be paying these pensions directly out of tax revenues. With pension funds, the government plays the markets, investing tax revenues in stocks, bonds, and such, and then later selling them and using the proceeds to pay pensions to retirees.

If you were to ask anyone of pretty much any ideological stripe whether it’d be a good idea for the government to play the market in the service of any other obligation, he’d likely ask whether you were crazy. The idea that, for instance, maintaining roads should be done by investing money in the stock market, then using the dividends to do the actual road maintenance, would be laughed at — and not just by small-government advocates who doubted the government’s ability to choose winners in the stock market; socialists, from their point of view, might question why you were giving money to the capitalists on Wall Street in the first place, and whether you really could have any hope of getting it back from those lying pigs. But somehow for pensions the political situation in the US is the opposite: at the state and local level (but at least mostly, not at the federal level), pension funds are taken for granted; there is much controversy about some of their details, but generally all parties accept that they should exist. Yet the situation that everyone would laugh at and the situation that is generally accepted are really one and the same: when state money is sent to Wall Street, the official reasons why it is sent make little difference; all that really matters is the amount and the timing. Whether the name on the account be “pensions” or “roads”, the funds used for investing come out of the same pot of money and the proceeds go into the same pot.

Plenty of private companies have pension funds; so it’s easy to think states should, too, especially in this era of much talk about how government should try to imitate the private sector. But for private companies, there is a potent rationale for pension funds: companies often fail; a pension fund is a way to promise that pensions will be safe even if the company ceases to exist. States don’t cease to exist, except via war or troubles that verge on war; and when a state disappears via such events, its pension funds are extremely unlikely to survive the tumult.

The biggest attraction of state pension funds has no doubt been the extravagant promises they make, as to returns. I’ve seen in several sources (Michael Lewis’s recent article on California’s financial troubles being one) that state pension funds generally expect returns of about 8% per year. To illustrate the impact of this, suppose that any given piece of money spends about twenty years in the pension fund. That is the length of a short government career, and also a common length of time spent in retirement, and thus is a reasonable figure for the average interval of time between when a pension obligation is incurred by employing someone, and when that obligation finally comes due and the money is withdrawn from the fund to cover it. Twenty years’ compound interest, at 8%, multiplies the initial amount of money by a factor of 4.6; or if we figure that the 8% is just in nominal dollars, and subtract 2% to adjust for inflation, the multiplying factor is 3.2. So by assuming that 8% yield, they can justify much larger pensions than could be justified if pensions were to be paid directly out of tax revenues: in particular, the pensions can be around three times larger. A modest pension of $20,000 a year can turn into $60,000.

When the market fails to deliver that 8% increase, the result is what many states have now: an “underfunded” pension plan, where even when an 8% return is assumed for the future, the fund won’t be able to meet its obligations. The conventional way of regarding this is to be horrified at it, as a harbinger of state bankruptcy. But if one regards state pensions as things that should just be paid out of tax revenues, without any resorting to Wall Street to amplify money, then the pension fund is a nice big fat asset, and the only thing its “underfunding” is a harbinger of, is a switch to a system of accounting where future pension obligations are not counted as present-day liabilities. There would be nothing dishonest about such a switch; other future obligations, such as schools and roads that will predictably need repair, are not counted as present-day liabilities. As for the promises made, both as regards returns the pension fund would make, and as regards the size of the eventual pensions that would be paid to retired state employees, those were always just fantasies that could never be delivered for long. (For how fantastic some of those pensions have gotten, see this article, as well as Michael Lewis’s above-linked article.)

If an attempt were made to reduce pensions, lawsuits would no doubt be filed; promised pensions have a certain legal standing, as contractual obligations. But it’s not enough of a standing to give them absolute priority over the basic rule of elected government that no legislature can bind its successors. To force a state government to pay pensions that bankrupted the state would be an especially bad violation of that rule. Of course there is never any guarantee that judges will see it that way, especially if the bankruptcy is several years in the future. Still, any judge who tried to enforce payment of every dollar promised would, sooner or later, run into all the usual difficulties of getting blood from a stone. Would he force taxes to be raised? Which taxes? Force cuts in other spending? Which spending? Legislatures don’t have an easy time deciding such things; and judges would find it even harder, especially with the public screaming at them for usurping the legislature’s proper role.

Indeed, to some extent, my whole argument here is merely a justification for what inevitably will be done anyway, barring economic miracles. There is little political will for levying the huge tax increases that would be necessary to restore pension funds to being fully funded, and no short-term downside to leaving them underfunded; simple neglect and inertia would leave them underfunded until they ran out completely, at which point the only things to be done would be to fire the staff administering their investments, and adjust the size of pensions to whatever could be borne out of tax revenue. But to accept that this was actually the goal, rather than just drifting along in that direction, would open up other possibilities. For one thing, the assets in the pension fund could be sold to wipe out other debts of state government, so that the government was no longer, in effect, borrowing money and using it to play the market with. For another, the pension fund administrators could stop trying for unrealistically high returns (something which David Goldman has blamed for their recent losses in mortgage-based investments). Also, the sizes of pensions paid out could be adjusted before the final crunch actually hit; the transition could be a smooth one, rather than an abrupt emergency measure.

Thus far, I’ve focused on the effects of pension funds on government finances; but that’s not all, and likely not even the most important part. When pension funds buy corporate stocks, they get an ownership interest in those companies. They can vote in corporate elections; and they control such large blocks of stock that their votes carry serious weight. Even if they were to abstain from voting, their large purchases have big effects on companies’ stock prices, and thus on how easily those companies can raise more capital. Bond purchases, too, affect what companies do: in many cases, if bonds can’t be floated for a proposed venture, it won’t be done. So for the government to own large quantities of stocks and bonds is a big step towards Marx’s dream of the “workers” (via the government) owning “the means of production”. Not that a Marxist conspiracy to take over the economy is even vaguely possible: today’s Marxists are not intelligent enough to put together a decent conspiracy. Petty corruption is more of a danger, as are politicized investments. But although pension fund scandals and politicization of investments have often made the news, in the grand scheme of things they are minor and occasional problems; the big problem is the everyday mediocrity of the oversight that government pension funds apply to their investments. I have made no particular study of the quality of that oversight; but unless state governments miraculously do it much better than they do everything else, state pension funds must be a large contributor to what might be called the Dilbert-ification of corporate America, in which companies are taken over by people who chase after management fads, while the people who can actually do useful work struggle with silly orders from above, trying to construe them into something sensible. The cartoon of course exaggerates; but the phenomena it mocks are quite common, and a tremendous problem.

Most of what has been said above applies not only to state pension funds but also to those of local governments. The exception is that local governments sometimes do cease to exist: there are plenty of ghost mining towns out West, whose population evaporated when the mine closed. In such a case, just as the mining company may want to promise pensions which will survive the closure of the mine, so may the town government want to promise pensions which will survive the abandoment of the town. But for that, explicit measures would be needed to put the pension fund in some hands that would administer it honestly after the town was defunct as a political entity — a difficult enough proposition that giving control to the payees themselves, via 401(k) plans or the like, is likely better than establishing any sort of collective pension fund. (Not that corporate pension funds are immune from getting hijacked as the company fails; far from it. But politics has a nastiness all of its own.)

There may even be a few cases like this at the state level, where it might be forseen that, due to some economic factor, the population and tax base will diminish drastically. The oil boom in North Dakota might be one such factor: at some point that oil will be exhausted, and people will leave. In such rare exceptions, state pension funds might be justified. Such a justification would, of course, involve a very different attitude from the sort of giddy optimism that assumes that an 8% return will always be available. Also, for the justification to work, the decline would have to be local rather than general; in a general decline, good investments are no more common elsewhere than they are locally — so instead of trying to pick global winners in the market (and distorting it in the process), the government can take the easier and more certain approach of just letting the local winners emerge, and taxing them. In a decline that was national but not worldwide, investments in a foreign country which still had a growing economy might seem attractive — but the catch is that that country might decide, with the newfound power that economic growth brings, that it didn’t care to pay back the money.

In any case, even considering pension funds as an evil, they’re one we’re stuck with for a while, since arguments like this never prevail quickly. Even when everyone with good sense agrees immediately, that still leaves the majority unconvinced. Even if by some miracle this argument did prevail quickly, selling off pension funds’ investments would best be done slowly, so as not to unduly depress the markets and make the sale yield less than it should. And that scenario isn’t so different from what is happening today, since when a pension fund is “underfunded”, it uses up its capital at an increasing rate. Even as regards the effects of pension funds’ oversight of corporate America, that has been a slow process, and can’t be reversed quickly. Good oversight doesn’t magically appear when lousy oversight is destroyed, but rather takes time to build. For the moment, the hope and the threat of it will have to do.

Update: Alexander Volokh, a law professor, has written a nice overview of the legal rules surrounding pension funds. It falls short of considering what might happen when things really get bad, but that’s sort of inherent in legal analyses: they cover precedents (court rulings), not situations that are unprecedented.