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Home Publications Blogs Beat the Press Steven Pearlstein Needs an Economics Lesson

Steven Pearlstein Needs an Economics Lesson

Wednesday, 12 January 2011 06:48

Individuals are generally risk-averse. This is why they buy items like life insurance and health insurance. On average, people pay more for these protections than they get in benefits. This means that they fear bad outcomes (e.g. early death or severe illness) and that they are willing to forgo income to protect against this situation.

The fact that individuals are risk averse explains why state and local governments can benefit by offering workers defined benefit pensions. Since governments generally do not go out of business, they can provide pensions that smooth out fluctuations in the market. This is of great value to individual workers, who do not want to take the risk that the stock market will be down at the point when they retire.

Therefore, state and local governments can offer workers defined benefit pensions that impose little risk, if properly managed. Since the guarantee is of considerable value to workers, it means that these governments will have to pay workers somewhat less than would otherwise be the case. Therefore a defined benefit pension should save state and local governments money. 

Washington Post columnist Steven Pearlstein has apparently never learned this basic economics lesson, hence his diatribe in the paper today.

Comments (12)Add Comment
written by John Wright, January 12, 2011 8:11
I agree that public employees should be willing to discount their wage rate to allow for the defined benefit pension they will receive, but perhaps the public workers or their negotiators place too low a value on the pension benefit and are able to negotiate relatively high wages in addition to the defined benefit pension.

If this is the case, the taxpayer is not getting good value for the defined benefit pension they are providing.

Perhaps an indirect measure of the total compensation package should be used such as the employee turnover rate. If public entities have no difficulty finding many qualified applicants and relatively few current employees leave for better opportunities, then one might suggest the total compensation package is too high.

There still could be a problem with a persistent undervaluation of the pension benefit by both applicants and current workers.

John Wright
Risk Aversion and Defined Benefits: More Nanny State Socialism
written by izzatzo, January 12, 2011 8:27
From the WaPo article, these quotes:
Going forward, unions might propose tying overall compensation to the rhythms of the business cycle, making up in good times what is lost in bad. ... Such an arrangement would give governments the budget certainty they need to meet pension obligations without the financial risk of market fluctuations.

In contrast to the stupid liberal rant of Whose Your Nanny Baker, Pearlstein understands the real nanny statist state as it is composed of risk averse individuals who bleed dry the private sector in bad times as well as good.

Any economist knows that contracts in free markets always define benefits to mean that current income is less, traded for future income that is more, so Mr Nanny says nothing new here.

For example, typical contracts for CEOs include stock options and golden parachutes designed to shift all risk to others as CEOs set about destroying a private company from quarter to quarter, so there is absolutely no reason that unions and public workers should be immune from the same contractual standards in free markets to which everyone else is subjected.

Public workers should continue to be hired on the same pay-as-you-go contractual standard as Plunder-and-Pillage Specialists in the private sector, where the true jobs are created.
Doesn't look familiar to me....
written by diesel, January 12, 2011 8:35
You know, it's funny. I was a public employee for nine years, in Engineering, one of those guys building the "infrastructure" everyone keeps talking about as job creating stimulus. And I don't recognize anyone I worked with in the descriptions I read that are critical of supposedly lavish benefits bestowed on retired (or currently employed) public employees. We contributed half to our pension fund, or more if we wanted to, and our county was self insured as far as health care went and took a proactive approach to cost containment by encouraging prevention. Also, employees took a severe hit if they retired before the age of 65. Now there may be cases of abuse and fraud, but my guess is that the cases cited as typical by journalists like Pearlstein are not the norm. Just saying.

By the way, besides "roads and bridges", infrastructure includes managing storm water runoff or drainage, utilities location and right of way (almost all cable and water run on public land), providing clean drinking water, sewage treatment, waste disposal, parks, lighting, ports, construction surveying and maintaining the system of public survey monuments etc. etc. The point being that there is a lot of work that could be done to improve that part of our public lives that make living together possible and plenty of room for employing our underutilized workforce. That we fail to do so and instead squander money on foreign military escapades is a choice we make as a society, and reflects our nation's priorities.
written by Bloix, January 12, 2011 9:03
There's another risk that is smoothed out by defined benefit pensions: the risk that you'll live a long time.

An average 65 year old American can expect to live for another 18.6 years - to age 83 or 84. This data includes people who are sick or disabled at age 65, so a person retiring at 65 can expect to live longer.

So if a person puts aside enough money at retirement to live for, say, 20 years - to age 85 or so - he or she is likely to have enough.

But what if you don't die? What if you live to be 88, or even 92? A 65-year old has over a 30% chance of living to be 90. The risk of running out of money at 85 is far to great for an ordinary person to shoulder.

And therefore, retirees who don't have defined benefit pensions either have to put aside enough money to take them to age 95 - and most people can't possibly save this much - or, they have to scrimp and save and live at a standard of living lower than they otherwise could live, or they have to fear poverty in extreme old age.

There's no reason for individuals to have to assume the risk that they won't die, because defined benefit plans be based on the average life span of all members of the plan.
Valuing Defined Benefit Pensions for Public and Private Employees
written by Ron Alley, January 12, 2011 11:26
Although employees of both public entities and private firms are willing to forego immediate benefits in return for pension benefits, the underlying issue is funding the promised pensions. The employer is in effect a guarantor of the promised benefit. If the employer establishes an investment fund and makes contributions that prove to be sufficient to cover the actual cost of the defined benefits at the time those benefits are paid, then everyone is happy.

The issue is whether the contributions made by the employer are invested honestly and whether the assumptions made by the employer about the amount earned by the pension fund prove to be accurate. If the fund is embezzled, defrauded or merely invested in assets that fail to provide the hoped for return, then the employer must make up the shortfall. The question is how frequently the employer is required to value the fund and the freedom the employer has in making both investment and actuarial assumptions and actually depositing additional funds to cover unfunded liabilities.

Private employers are subject to well defined (but inadequate?) funding standards. Public employers have considerably more latitude to delay valuations and defer contributions. It is possible for a public employer to create substantial unfunded and undisclosed liabilities. The public does not understand the amount of unfunded pension liabilities created by state and local government entities. And public concern is justified. The Directors of corporations can be held liable for their some of their actions and omissions, so they carry errors and omissions insurance. Legislators, governors, city council members, mayors, school board member and school superintendents are virtually immune from liability for their errors and omissions.

However the unfunded liability issue has been exaggerated and spun to foment public resentment of benefits earned by and promised to public employees rather than pillorying public official for their failure to disclose and fund pensions properly.

The best course of action is to enact legislation holding elected officials accountable for failing to disclose unfunded pension obligations promptly and permitting public employees to sue to force prompt funding of pension benefits.
The can has come to a stop
written by Jim, January 12, 2011 2:32
Kicking the can down the road has been a favorite practice for decades of politicians and government employees (not unlike Corporate America), and the can has come to a stop at the feet of politicians who have been elected by the anti-everything crowd. Union leaders have been complicit with governors and mayors who agreed to wage, benefits and pension settlements that they knew or should have known could not or would not be funded. BTW, I didn't think Pearlstein's essay was a diatribe.
written by PeonInChief, January 12, 2011 2:36
Tying overall compensation to fluctuations in the business cycle is what makes 401ks a disaster as a retirement vehicle. For small investors the lows go very much lower than the highs go high.
You lost me with this onw?
written by bailey, January 12, 2011 3:40
"On average, people pay more for these protections than they get in benefits."
Isn't this a neccessity for Businesses to survive?
True but...
written by Floccina, January 12, 2011 4:01
True but public employees are also voters and politicians are very willing to promise to give money in the distant future (after they are long gone) to public employees to get them to vote and work in campaigns now. That creates problems.
This is why they buy items like life insurance and health insurance
written by Floccina, January 12, 2011 4:22
Individuals are generally risk-averse. This is why they buy items like life insurance and health insurance.

But oddly enough, considering what you wrote, they buy low deductible health insurance which is more prepaid health-care than health insurance. Now if one prepays for something you would think that he would get a discount rather than higher overhead costs but not in this case. Prepaid might make sense if you paid the health-care provider but with the current system were most people have prepaid health-care through 3rd parties it creates a bureaucratic burdened.

Here is my attempt to fix this situation:


Governments going out of business
written by djt, January 12, 2011 4:35
I don't think this comment is true. So the benefits public employees negotiate for are much less sure then they think.

The modes of failure are many: big plant leaves town, town shrinks, can't afford huge pool of retirees anymore.

Towns in the rust belt should be declaring bankruptcy right and left.

Another failure mode: benefits are so large that people start businesses in other states, causing the decline of an area.

We all know the dangers of defined benefit plans by looking at companies that fail; states and cities can fail too. Less likely, yes, but I would rather have the money up front then have it be subjected to the will of the voters.
written by diesel, January 12, 2011 5:00
Once again. Retirement funds were flush during the boom years of the stock market. Planners responsible for the fund's investments decided to scale back employee contributions. At the same time, governments chip in less since they match contributions. Taxpayers loved this since with less revenue needing to be raised, taxes were lowered. So they too benefitted.

Alas, the projections turned out to be overly optimistic due to a plague of shortsightedness common to the era, epitomized by those economists swooning in rapture about Dow 29,000. So, public employees were happy, gov't was happy, taxpayers were happy.......

Now the bill has come due during a severe contraction that could be ameliorated with Federal spending. But influential people insist on a balanced budget while slashing taxes and escalating war. Some of us would rather murder other human beings than build a better society.

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Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.