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BOHANON & STYRING: Government pension plans don't always pay up

October 1, 2016

Economic AnalysisGovernment workers accept a risk-averse employment bargain. The employee gets a modest current salary in exchange for job security and a comfortable retirement income. Mary, an Indiana government employee, works for 30 years. Upon retirement, she receives a government pension that is about a third of her salary, plus Social Security, plus an annuity from a forced set-aside of 3 percent of her earnings. Added together, Mary retires on something like 70 percent to 80 percent of her final salary—provided, of course that Mary’s employer makes good on the pension promise: And there lies the rub.

Public pension schemes remain primarily defined-benefit plans. Such plans are argued to be “safer” for the employee.

Under defined-contribution plans, the employer periodically contributes a fixed sum to the employee’s own retirement account. The employee invests it and retires on whatever income that nest egg can generate. The employee, not the employer, assumes the investment risk.

For Indiana state and local employees, the case is closed in favor of the defined-benefit plans, right? Not quite. There is the real political risk that the governmental unit might not make the necessary pension fund contributions. Mary retires and there is nothing in the kitty except the promise to tax current taxpayers to pay Mary’s pension.

This is a real risk. Suppose you are a politician. At budget crunch time, you are faced with a choice: Appropriate money to give current public employees a raise or earmark the same money to their retirement fund with no raise. The re-election incentives all favor stiffing the retirement fund. Employees see the raise. They’re happy (and vote). They don’t see that their years-down-the-road pension has been impaired. Besides, when the pension promise eventually proves hollow, you’ll be long gone.

This unstatesman-like choice is made all too frequently. Detroit retirees took a major hit. Future retirees in states like Illinois and New Jersey haven’t the slightest chance of ever seeing their promised pensions.

Indiana has done better. Our retirement funds aren’t fully funded, but not impossibly so. But we’re not immune to the Shortchange Pension Disease. Indiana spent the 1950s through the 1980s paying nothing but retired teacher pensions, setting aside nothing for active teacher future pensions.

So, defined-contribution plans expose the employee to investment risk. Defined-benefit plans are subject to political risk. Which do you trust more—securities markets or the promises of politicians? For our part, we’d opt for markets.•

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Bohanon is a professor of economics at Ball State University. Styring is an economist and independent researcher. Both also blog at INforefront.com. Send comments to ibjedit@ibj.com.

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