Friday, August 13, 2010

Pensions are complicated

The Economist has a nice blogpost about Jobs, pensions and markets: Required reading | The Economist. Here is one important quotation:
Public sector pension funds have just followed the pattern of private sector schemes. Step one, promise employees better pension benefits in lieu of higher pay. Step two, allow older employees to retire early as a "cost-saving" measure. Both employ the economics of the never-never.
And this,
Pension funds are classic Ponzi schemes in which the benefits of retirees depend on the income generated by new employees. (This is true even of funded schemes, since they invest either in equities, a claim on the profits generated by future workers, or government bonds, a claim on their taxes.) They were thus bound to be in trouble once the demographic pattern shifted, and the next generation was no bigger than the last.
This is already a hot political issue as my US colleague notes in this post; as in Britain, attacks on public sector pensions are generally launched by the taxpayers' party (Republicans. Conservatives) and resisted by the public sector workers' party (Democrats, Labour). It will also be a legal issue. In Colorado, retirees are suing over plans to reduce the scope of their inflation protection.

The pension problem is not that straight forward. Paul Krugman posted an interesting study about public-sector and private sector wages. He points to a study by John Schmitt which concludes that after adjusting for education and age, public sector workers are not overpaid as compared to private sector employees. Wages ultimately impact pensions, so ideally pension liabilities should not be unjustly high. 

However, as the article points out, the pension scheme by design is flawed. We need other means to protect the lifestyle of the retired worker. By protect we do not absolve the worker of economic prudence, but ensure that some fixed income can be earned without having to continue rigorous work. So in the post-retirement phase the work is different. Such work opportunities must be available in the first place. Singapore uses such a concept creatively.

While, pensions scheme design may be flawed, it does not allow government to renege on its promises to older workers. I discussed earlier that changing terms of pension being equivalent to breaking contract or promises to the employees. I believe the modification of terms by government for common people is not a prudent move, particularly considering the enthusiasm with which AIG was paid.

In Sum
We do need pension reforms, but it has to be humane. Governments cannot simply cut pensions just because they cannot pay. After all didn't monarchy do it in similar way - spend and if you cannot pay kill your creditor.