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February 8, 2006

Thinking about pensions—Where to start

Rick Mattoon, Senior Economist and Economic Advisor
Federal Reserve Bank of Chicago

Trying to address pension issues can seem quite daunting by their sheer complexity. Funding pensions is far more than just a public finance problem. Here, I would like to review a selected set of issues on funding pensions raised in the academic literature.

A good starting place for addressing pension issues is by assessing what the optimal level of funding should be for any particular pension fund. Depending on local factors, it may be prudent for some pension funds to carry balances in excess of 100% of liabilities. In other cases, lower balances are perfectly fine if the local tax base is growing aggressively and outstripping growth in pension liabilities. Stephen D’Arcy, James Dulebohn, and Pyungsuk Oh have an interesting paper on this topic in which they model optimal funding levels for all 50 states.1 Their study finds that the optimal funding level is highly related to the relationship between the rate of growth of pension costs and the tax base within each state. The study also finds that interest rates and intergenerational equity play a role in pension funding. Interest rates can affect the return on pension assets, while issues of intergenerational equity involve whether pension costs are borne by current workers or shifted to future workers. The authors’ concern is that pension funding decisions are too often driven by the condition of the current state budget and do not pay enough attention to fundamental economic and demographic variables that should dictate an appropriate funding strategy.

Another key determinant of pension fund solvency concerns the investment performance of fund managers. In their paper, Tongxuan Yang and Olivia Mitchell2 examine how investment performance is related to several structural and governance features. One key finding from their study is that the move by government pension funds to hold greater stock positions has been a double-edged sword. While public funds benefited from the run up in stocks in the 1990s, the authors estimate that the 30% drop in the S&P 500 from 2000 to 2002 cut public pension investment returns by 12 percentage points. Given that the real annual rate of return over the 1990s averaged 8%, this loss had a substantial impact. The authors also find a relationship between investment performance and stock funding ratios. Better investment performance leads to higher stock funding ratios that in turn positively affect flow funding ratios. Governance factors that seem to support this positive relationship include more independent and professional fund managers and the issuance of reports on financial, actuarial, statistical, and investment information. Factors depressing fund performance include having active or retired employees on the pension investment board. In addition, having a dedicated revenue source such as a particular tax source, does not appear to enhance funding.

Coronado, Engen, and Knight3 examine the investment performance of pension funds operated by state and local governments on behalf of their employees. Their study compares these plans run by state and local governments to private plans and finds that after controlling for differences in asset allocation, certain kinds of political interference in the former may reduce returns on their assets. Some of the political restrictions they examine in their paper include requirements to invest in-state to spur local economic development and limitations on investments in certain countries or industries. The authors also examine governance issues, including the percentage of the pension board that is elected.

The final issue I review here is the relationship of pension benefits to total employee compensation in both the public and private sectors. Much has been made about the withdrawal from defined benefit pension programs by private sector employers. In defense of the termination of these programs, many employers note that a pension model based on an employee working a lifetime for a single company is no longer suitable. Benefits that are portable, such as defined contribution programs, better serve the needs of today’s work force. However, this logic has been questioned when applied to public sector employees whose longer job tenure is still more common. Furthermore, defined benefit programs for public employees have long been seen as an important tool for recruiting and retaining workers in the public sector. A related question is what is the total compensation structure for public employees versus private employees and how do pension benefits relate to their total compensation. A report by the Employee Benefit Research Institute4 found that overall compensation costs were 46% higher for state and local employees ($34.72 per hour) versus private sector employees ($23.76). Driving this disparity were differences in work force composition and occupations. A large percentage of state and local workers are in occupations such as teachers, university professors, police officers, and fire fighters. These professions either require greater levels of education or entail physical risk, and therefore, they are more highly compensated than private sector positions that tend to be dominated by retail sales and office occupations. Public sector workers are also more likely to be enrolled in benefit plans than private sector workers. Public sector employee benefits as a percentage of total compensation run 60% higher than private sector employee benefits. This has led some analysts to suggest that more accurate assessments of compensation differentials can be found when comparing public and private workers in the same industry, such as health care. With regard to public and private pay in areas such as construction, transportation and utilities, and health services, the wage differential is much smaller and even favors the private sector employee in some cases.

In future blog entries, I will discuss other issues that are affecting public pensions. I encourage you to share your thoughts on public pensions as well. What pension issues concern you the most?


1Stephen D’Arcy, James Dulebohn and Pyungsuk Oh, 1999, “Optimal funding of state employee pension systems,” Journal of Risk and Insurance, Vol. 66, No. 3 pp. 345–380.
2Tongxuan Yang and Olivia Mitchell, 2005, “Public pension governance, funding, and performance: A longitudinal appraisal,” Pension Research Council, working paper, WP 2005-2.
3Julia Coronado, Eric Egen, and Brian Knight, 2003, “Public funds and private capital markets: The investment practices and performance of state and local pension funds,” National Tax Journal, Vol. 56, No. 3, September, pp. 579–594.
4Employee Benefit Research Institute, 2005, EBRI Employee Benefit Research Institute Notes, Vol. 26, No. 4, April, available at www.ebri.org/pdf/notespdf/0405notes.pdf

Posted by at February 8, 2006 3:04 PM

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