Pension Reform?

Professor Edward Glaeser, who writes on a regular basis for the Boston Globe, penned an article on public pensions a couple of months back. It raised some very interesting concepts, which included a call for additional centralization (getting rid of the local control over investment decisions) but calling for additional local flexibility in the types of pensions that could be offered to public employees.

On local control over investments Professor Glaeser decries the balkanized nature of the way we invest our pension money.

The same tension exists in public-sector pensions, which present a particularly precarious balance of state and local control. Since 1945, the terms of public-sector pensions — for instance, how large a pension a teacher can expect after a certain number of years of service — are determined by state law, and a state commission determines how much communities must set aside for pensions. But localities can run their own investment funds, as long as their returns aren’t too low. This is a bizarre set-up, since local investment boards are unlikely to out-invest the state system.

Good investments require expertise, and there is no advantage from having little laboratories of financial engineering. Using data provided by the state pension authority, Harvard graduate student James Mahon has found that since 1986, the systems outside of the main state fund have, on average, earned lower returns during every five-year period. This doesn’t mean that the local systems are boobs — some earn lower returns because they take on less risk — but the sheer number of funds is illogical.

The State legislature has recently changed the law, which now forces local systems to meet minimum return thresholds in order to remain “independent”. This change forced the Methuen Retirement System into the State system, where local money is now invested by the Commonwealth. That law, and the trigger that forced Methuen in, was deeply unpopular with both the Retirement Board members and the staff. I can only imagine the type of political firestorm that the Glaeser suggestion would have if all local boards were forced to turn over their investment portfolios to the State. But political unpopularity due to turf issues is not a good reason to dismiss the suggestion out of hand. Beyond the point that Professor Glaeser makes on better investment returns from the State other factors, such as duplication of costs, would tend to support consolidation. (Do we need to pay for separate staff for all these distinct localities?) Glaeser does not comment on how his suggestion might deal with local systems that have outperformed the state, but you can rest assured that question would be asked by those in opposition.

The second part of the Glaeser column dealt with the ability of the locals to modify the type of pension offered.

The core dollar amount that localities now contribute to worker’s pensions should be preserved, and there should also be a strict lower bound on the generosity of the traditional defined-benefit plan. Our public workers need that cushion, because they are not in Social Security. Above that base, though, local communities should be free to offer different deals, such as allowing workers to take 401(k)-style defined-contribution plans, instead of defined-benefit plans. This experimentation may help us explore lower-cost options that deliver more of what workers actually want: to be paid now, not in the distant future.

Another proposal that would likely cause a pretty big firestorm of opposition from public employees. Glaeser recognizes the inherent financial problems with our current pension obligations, and how we have funded them. From a financial perspective there is no question that his suggestion makes fiscal sense for localities. From a political perspective this is another slog, with deep opposition from public sector unions very likely. Glaeser does not go into deep detail on the pension problems we face, but he does not have to. They are steep, and will require additional painful reform at some point. For now it is possible to defer those decisions, but the day of reckoning is coming. Not a bad question for some of the upcoming debates! Candidates beware.

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