Almost every week brings new word of the crisis in public pensions. Yesterday the news was that New York City pensions are underfunded, make unrealistic assumptions about future investment returns, and are subject to political interference in their management. Consequently, public spending for necessary projects like infrastructure is crowded out and future generations will likely be stuck with a big bill.
Public pensions may provide the best illustration of the truth of a branch of economics known as public choice. Public choice understands that politicians are no more public-spirited than other individuals, but are simply maximizers subject to different constraints. As a result, they tend to provide benefits to concentrated groups, like public sector unions, that can deliver blocs of votes and campaign contributions at the expense of diffuse groups, like taxpayers. And as politicians themselves recognize, diffuse groups also tend to be rationally ignorant of public policy. Because any individual’s chance of actually changing the results of an election is less than being hit by lightening on the way to the polls it is simply not rational to invest much in learning about politics. It is far better to use one’s time to learn about opportunities for profit or for fun.
Given the realities of public choice, it is hardly surprising that public employees tend to receive better compensation than private employees when the compensation is corrected for skills and intelligence. But public choice also predicts that the nature of that compensation will be skewed toward benefits, particularly pensions, rather than salary. First, benefits are less transparent and easy to understand than salaries, thus confusing even the more attentive citizens. Second, most pensions will be paid out when the politicians responsible for granting them are themselves retired and beyond the reach of voters who are left holding the bag. This is one reason that public pension schemes are important part of big government’s war on the young. Not only are young the bag holders, but they are even less likely than the old to protect their interests through politics because they are distracted by more opportunities for fun.
It is also not surprising that the leaders of the public employees unions want to use political criteria for choosing managers. For instance, in New York City the teachers’ union does want any investment managers who have been favorable to charter schools. Leaders care as much about politics as about investment results. The taxpayers, not the unions, are on the hook for shortfalls in defined benefit plans. Moreover, union members have an agency problem with their leaders. The leaders enjoy the political payoff today from picking compliant mangers, but the union members are the ones who must deal with the increased risk of bankruptcy down the road.
One partial solution to the public choice problem is clear: eliminate defined benefit pensions for public employees and offer them defined contribution plans instead. Under these plans, the equivalent of 401(K) plans in the private sector, employees will be accountable for their own retirement savings, and their unions, in league with politicians, cannot play games at the expense of taxpayers and future generations.But the bankruptcies of Detroit and a few California cities are starting to make some citizens take notice of the danger ahead. Political entrepreneurs on the right should not let this crisis go to waste.