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June 2, 2012

Overpaid Public Workers: Actually, We're Moving Toward Consensus

By and

Many public workers are overpaid relative to their private sector counterparts, especially in large, unionized states such as Wisconsin, Ohio and California. This may sound like a controversial claim, but it shouldn't.

The methodology we've used to compare compensation in the public and private sectors has broad support, from academic economists to nonpartisan federal agencies. A consensus is building about the need for reform.

Ironically, Dean Baker provides further confirmation in his recent Huffington Post article, "The War on Public Sector Workers." Baker, a prominent left-of-center economist, barely disputes key aspects of our methodology. Instead, his piece is filled with rhetorical misdirection, accusations of hypocrisy and hidden motives, and other ad hominem attacks.

If this is the best that defenders of the status quo on public pay have to offer, the consensus is even stronger than we thought.

First, the facts about public sector compensation. Although state and local government workers receive salaries slightly below those of similarly educated and experienced private sector workers, their benefits are far more valuable. And pension benefits drive most of that difference.

For example, a typical Illinois school teacher who worked for 30 to 34 years would retire with a guaranteed pension benefit of $60,756 a year, an income higher than 95 percent of Illinois retirees. To achieve the same level of guaranteed retirement benefits, a private sector worker with the same salary would need to save roughly 45 percent of his salary in a 401(k). The difference in pension benefits is more than enough to push public sector compensation above private levels.

Our own work simply points out that a guaranteed benefit is more valuable than a risky one. Public employees with traditional pensions receive guaranteed benefits. Private sector workers with 401(k) plans, if they wish to receive benefits at around the same dollar level as public employees, have to take significant investment risk.

Here's how the math works in more detail:

Public sector pensions generally assume 8 percent returns on investments, and they calculate pension contributions based on that assumption. However, benefits to public employees are guaranteed even if the plan's investments fall short of 8 percent. What this means is that public employees as a group effectively are guaranteed 8 percent annual returns on both their own contributions and those made by their employer -- at a time when the guaranteed return on Treasury securities available to workers with 401(k) plans is only 2 percent to 3 percent. The difference in benefits payable at retirement can be huge.

Dean Baker seems to accept all of this, as any economist should. He notes that the "extra [pension] value comes from the guarantee" and adds: "Doing the math this way goes a long way toward showing that public sector workers are overpaid." What Baker doesn't mention is that proper economic analysis requires that we do the math this way.

Baker instead lapses into confusion and personal attacks. He says that public workers do receive a substantial benefit from guaranteed benefits, but that somehow the government can provide that guarantee at no cost. "If we eliminate a guaranteed benefit," he says, "we have just taken away the workers' retirement security, we have not saved the taxpayers a penny."

Actually, we would save the taxpayers many pennies, since the "guaranteed" part of "guaranteed benefits" is not something the state can give away for free. The guarantee comes at a cost that the taxpayer must cover.

As the Bureau of Economic Analysis (BEA) recently noted: "If the assets of a defined-benefit plan are insufficient to pay promised benefits, the plan sponsor must cover the shortfall." And a 2002 by two Wharton School economists made the point succinctly: "When a pension guarantee has economic value to participants, it will have economic costs."

Baker is denying that contingent liabilities -- payments that taxpayers might have to make under certain circumstances -- have any cost to the government. This is simply wrong, and a slew of experts know it's wrong. Beginning in 2013, for example, the BEA will use an approach similar to ours in accounting for risk when estimating government pension costs. Academic economists, the Congressional Budget Office and the Federal Reserve all have endorsed this principle. It's what sound financial economics calls for.

Baker goes on to imply that we are predicting historically low investment returns for public sector pension funds. This is a familiar straw man. In fact, neither we nor others who have analyzed pension valuation argue that public pensions can't receive 8 percent average returns going forward.

We simply have stated that public pensions can't attempt to achieve such returns without taking significant market risk, and such risk is borne by all taxpayers rather than the public employees. The cost of that risk to taxpayers must be measured and incorporated into comparisions of public and private compensation.

Most Americans agree that public workers should be compensated for their skills at the same market rates as private employees. But right now, many public workers get an unjustified premium. A growing chorus of experts acknowledges this reality -- even to some degree Baker himself. Economic efficiency, good government and basic fairness dictate that we need to reform compensation for public employees.

Jason Richwine, Ph.D., is a senior policy analyst at The Heritage Foundation.

Andrew G. Biggs, Ph.D., is a resident scholar at American Enterprise Institute.

First Appeared in Huffpost Business.

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