Mitchell’s Musings 4-18-16: Insidious Incentive? Not So Much

16 Apr 2016 2:16 PM | Daniel Mitchell (Administrator)

Below in italics is a quote from a recent Urban Institute policy brief:


“Though the Supreme Court’s four-to-four deadlock in Friedrichs v. California Teachers Association on Tuesday upheld the requirement that nonunion members pay union fees, it raised new doubts about the fairness of a practice conservative activists have fought for decades. But a more insidious—and lesser known—injustice faces teachers in California and around the nation: they must contribute a substantial share of their salaries to pension plans that deny them a fair return…  A 25-year-old teacher hired today would receive a future annual pension of only $12,000 if she teaches for 20 years or $3,500 if she teaches for 10 years. That teacher would have to remain employed for at least 28 years to collect benefits worth more than the required plan contributions. Teachers who stop teaching earlier lose money in the mandatory plan. They would receive more retirement income if they could opt out of the plan and invest their contributions elsewhere. Teachers with shorter tenures end up subsidizing the large pensions received by the longest-tenured teachers. Only 35 percent of new hires and 47 percent of teachers who work at least five years will receive pensions more valuable than their required plan contributions…”[1]


What is odd about the quote above is that the author’s seemingly-astounding discovery of an “insidious” element in teacher compensation is simply a description of any run-of-the-mill defined-benefit pension plan. All such traditional plans favor long-service employees and can be viewed as “subsidizing” the pensions that are received by those long-career workers by those with short careers. The more generous the plans are to long-service career workers, the greater is the cross-subsidy they provide from short-timers.


But is such a compensation structure “insidious”? Let’s note that a retirement plan that is offered as one part of an employment package differs importantly from, say, a stand-alone investment opportunity offered by a financial institution. Whether you should invest in a stand-alone opportunity is your own decision and is independent of your occupational choice. Absent false promises by the offering financial institution, you should not - and presumably won’t - invest in something that offers you an expected below-market, substandard return.


Employment packages are different from stand-alone investments in that they contain elements that may be more or less advantageous depending on your job-related behavior. Thus, a sales commission could be said to be a bad deal for sales personnel who turn out not to sell much. A piece rate would be a bad deal for a factory worker who turns out to be not especially productive. Contingent and competitive promotion arrangements (tenure for professors; making partner for lawyers) – sometimes referred to as “tournaments” by economists - can be bad deals for those who don’t “win“ the tournament prize. (That is, those faculty who don’t make tenure and those lawyers who don’t make partner are losers in such arrangements.) Etc. Etc.


A defined-benefit pension is meant as a reward for those employees who don’t leave the job early (voluntarily or not) and who stay for a long time. They also provide a significant incentive toward the end of a career to retire (and thus for labor force renewal). If you don’t stay for a long career – or if you persist beyond some “normal” retirement - such pensions are not going to reward you and you will in effect subsidize those who do follow the incentives. So, yes, it’s true that a 401k plan or cash balance plan would be better deal for short-career teachers.[2] But if that’s not the kind of employee school districts want, is it insidious for those districts to offer a particular compensation arrangement that isn’t a good deal for them?


If we drop the inflammatory language of the policy brief (which I have to say is a bit surprising for the Urban Institute) and if we look at the critique apart from that language, is there something more useful to be said? Note that Congress, in its wisdom, has chosen the employment relationship as a locus for a kind of privatized social insurance. Through tax incentives, it has incentivized employers to offer health insurance (an offering now reinforced by “Obamacare” rules) and retirement plans.


Congress does directly provide health care for older individuals (Medicare) and a defined-benefit pension (via Social Security). However, to the extent social insurance is promoted through the employment relationship, the social welfare motivation doesn’t necessarily mesh with a general policy preference to let employers design workplace compensation and incentive packages as they think best. In effect, there are two objectives of public policy at issue here – adequate retirement income and letting employers design their own personnel motivational systems. Tinbergen’s rule in economics – usually stated as a general need to have the number of policy instruments match the number of policy goals – points to the tension created when social welfare/social insurance objectives are imposed on workplace arrangements. One instrument – a tax incentives for retirement plans – may not accomplish both goals.


If the concern is for adequate retirement incomes for oldsters, perhaps beefing up Social Security – a program which Congress directly controls – would be a better approach than discouraging defined-benefit pensions.[3] Social Security could be a Tinbergen-style second instrument. It’s too bad the Urban Institute’s policy brief didn’t consider that approach, although I wouldn’t characterize that omission as insidious.

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[1]http://www.urban.org/urban-wire/teachers-required-pension-contributions-are-less-fair-union-fees

[2]We are ignoring substantial behavioral research that suggests that employees are not great at either setting appropriate saving levels for themselves or at selecting investments for their retirement funds. So 401k plans in practice may turn out to be inferior to defined-benefit pensions. Surely, the security value of defined-benefit pensions has to be considered in comparing them to other tax-favored saving plans; 401k-type plans create risks assumed by employers under defined-benefit pensions. The cash-balance approach deals partly with such risks, but typically offers a low rate of return. None of these complications are addressed in the Urban Institute brief.

[3]Note that public school teachers under defined-benefit pension are often excluded from Social Security. 

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