What is, or might be, a pension crisis?

A spectre is haunting the United States — the spectre of pension crises. Since "the pension crisis" is on the lips of policy-makers around the country, I think it is well worthwhile taking a moment to discuss what is, what might be, and what is not a pension crisis. For additional details I recommend this recent Haas Institute paper on public pensions.

Pensions are a mechanism to save money

Today, in the throes of this supposed crisis, pensions are treated as an unaffordable luxury extracted by lazy employees from their unwitting employers.This is dangerous nonsense.Consider the following stylized example: the going rate to employ a firefighter is $60,000 per year. You could, of course, pay the firefighter $60,000 per year. Or you could pay the firefighter $30,000 per year and offer $30,000 in pension benefits. The firefighter still receives $60,000 per year, but your out-of-pocket expenses are just $30,000 per year. Pensions are a way to save organizations money by deferring their payroll expenses into the future.Of course, the firefighter would only be willing to make this deal if she were assured that she'd receive the value of that $30,000, with a reasonable rate of return, in future income. An organization guaranteeing a 5% rate of return, but assuming a 7% actual rate of return on its investments, is able to save money on its current payroll expenses by deferring them into the future at a discount. This is the iron logic of pension accounting.

Public pension funds are a convenient but unnecessary expedient

The current conversation around the pension crisis revolves around the ratio by which pension funds are "fully funded," that is to say, able to pay out all the benefits they're obligated to provide.But pension funds themselves have nothing to do with the underlying mechanics of pension obligations. This is illustrated most clearly by the largest US pension fund: the Social Security trust funds.All the money paid in Social Security taxes in excess of the current payouts of the program are used to purchase Treasury bonds, which are assigned to the Social Security trust funds. The demand for those Treasury securities by the Social Security trust funds decreases the market rate of interest the United States is forced to pay on its debt obligations.It is true that excess Social Security funds could be used to purchase other securities, like stocks or commodities. But using the excess funds in that manner would mechanically decrease the demand for US Treasury bonds and increase the interest rate paid on government borrowing. The increased earning on the Social Security trust funds would be offset by increased debt interest that has to be paid off by American taxpayers. Again, this relationship is mechanical, not ideological in any way.

State pension funds are one answer to a particular question

State pension funds differ from the Social Security trust funds in two related ways:

• they have no control over their tax base;
• they have no control over their currency.

Since people can move freely between the states, each individual state has a peculiar problem: you may pay a teacher to educate children in 2016, but if that child moves out of the state by 2046 he won't be available to provide tax revenue to pay his teacher's pension.Similarly, while the United States can print money to pay the obligations of the Social Security Administration, individual states have to find dollar tax revenue from the taxpayers currently living within the state's jurisdiction.State pension funds are one answer to those problems: the money saved on public salaries in the present (see above) are saved in investments outside the state, so that funds will be available to pay future pensions regardless of the economic conditions of the state itself when those obligations come due. Note that in our stylized example above, the money saved at 7% is less than the future value of the pension paid at 5%, creating a concrete, real-time payroll saving for the public entity involved.It is worth stressing at this point that this is not the only answer to this question! States could, like the Social Security trust funds, simply take pension "contributions" (the decreased payroll expenses of their public employees) and invest them in infrastructure, in lower taxes, in education, in health care, or in absolutely anything else they feel like investing in.

Private workers are right to demand pension funds

A different situation exists in the private sector, where even the most well-established firms can collapse in ignominy from something as significant as a major economic transformation or as trivial as a crisis of governance. Relying on the continued existence and profitability of your employer for both your current and retirement income is a dangerous gamble, so it makes perfect sense for private employees to insist that their pension funds be invested and managed independently of their employer.However, this is correctly understood as an insurance policy, not an intrinsic characteristic of pensions. Apple has never declared bankruptcy since its founding in 1976. It could have promised its earliest employees pensions after 25 years of employment (say 2001) and been able to easily pay those pensions out of current cash flows without ever starting or running a pension fund. Meanwhile it could have used the difference between what it paid its employees and what they were worth to finance ongoing investment in the company, just as the Social Security trust funds do for the United States of America.An independently management pension fund is an insurance policy against bankruptcy, nothing more and nothing less. Perpetual entities like the United States and California have no intrinsic need for such an insurance policy.

What is a pension crisis?

Hopefully all the foregoing illustrates what a pension crisis isn't, and cannot be: a pension crisis cannot be that a pension fund isn't "fully funded," and it cannot be that taxpayers are unwilling to pay higher taxes in order to pay their pension obligations. That is a perfectly reasonable preference of taxpayers that should nevertheless be ignored, because they have already received the services which entitle pensioners to their retirement income.A pension crisis is properly understood to be when the resources available to an entity, whether public or private, are not sufficient to pay the pension obligations that entity has incurred. It does not matter whether it is pleasant or unpleasant to find the resources to pay those obligations; it matters whether it is possible. If it is possible, then there is no crisis. If it is not possible, then there is a crisis.The preferences of current taxpayers as to whether their taxes should be raised or lowered are immaterial to this discussion once the original services have been rendered and the obligations have been incurred.