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Public Pension ‘Air Time’ Is an Absurdly Generous Perk

Friday, January 13, 2012

Why do public employees get a generous deal that is available pretty much nowhere else and to no one else?

USA Today reports that “government workers in 21 states are using an obscure perk to retire early or to boost their annual pensions by thousands of dollars, which can cost taxpayers millions more in payments to retirement funds.” This perk, known as “air time,” allows public employees to purchase extra years of service that are credited toward their pension benefits, which are a function of the employee’s final salary and his number of years of employment. For instance, USA Today points to a $56,000-a-year analyst for the Michigan State Police who paid $30,265 to buy five years of work credit, which means that when he retires after 27 years of service his pension will be calculated as if he had worked for 32 years. This will add around $6,825 to the worker’s annual pension, boosting lifetime benefits by around $170,000.

USA Today examines a number of reasons air time can be more expensive than anticipated. But the reality is that air time purchases are simply an absurdly generous deal for public employees, one that is available pretty much nowhere else and to no one else. To understand, you need to know how public pensions calculate how much to charge for air time purchases.

A pension’s actuaries first calculate the extra benefit payments a purchaser could expect to receive over the course of his retirement. This is fairly straightforward, based on assumptions about purchasers’ final salaries and how long they will live. Next, the plan’s actuaries “discount” these future benefits at the rate of return the plan expects to receive on its investments, usually around 8 percent. The cost to the purchaser will be the discounted present value of the future benefits. Thus, the plans can say, as the Oregon Public Employees Retirement System does, that “The amount to be paid to the PERS Board is the full cost to the system of providing the retirement credit to the member.”

Public pension plans are simply giving away a rate-of-return guarantee that private financial markets would charge a bundle for.

Except it isn’t, which becomes clear if you look at air time purchases from a different perspective. If the future benefits generated by the air time purchase are discounted at an 8 percent interest rate, that also means purchasers are guaranteed an 8 percent return on the money they pay for their air time.  This is an insanely generous deal for employees, since there is no place in private financial markets where they could receive a guaranteed 8 percent return on investment. Guaranteed U.S. Treasury securities currently pay less than 3 percent, while annuities issued to federal government employees by the Thrift Savings Plan have an underlying interest rate of around 2.25 percent. Public pension plans are simply giving away a rate-of-return guarantee that private financial markets would charge a bundle for.

In the private sector, guaranteeing an 8 percent return on a mixed stock/bond portfolio over one year would cost around 8 percent of the portfolio value; over 25 years, it would cost around 133 percent of the portfolio’s value. (You can approximate this value by calculating the price of a “put option” that would guarantee the right to sell an investment for no less than 8 percent per year over the investment’s initial price.) Any financial economist would tell you that the appropriate interest rate to use in calculating air time purchases is one that reflects the fact that these future benefits are guaranteed. In other words, a very low interest rate, certainly lower than 8 percent.

Acting as if they can earn high investment returns without risk encourages public pensions to promise excessive benefits, put away too little to fund those benefits, and take too much risk with the investments they do make.

And it’s actually worse than that, because it’s not simply purchases of additional years of service that are distorted due to the incorrect discount rates used by public pensions. The same point applies to all benefits paid out to public employees. Here’s why: public pensions calculate the contributions needed to fund future benefits based on the assumption that those contributions will earn 8 percent per year. But, since practically all of those funds will be paid out as future benefits, this also means that public employees are paid an 8 percent guaranteed return on both their contributions and the contributions made by their employer. Think about it this way: if your employer told you he would guarantee you an 8 percent return on your 401(k) account, wouldn’t that be better than merely having the chance of earning 8 percent? That’s a huge subsidy that goes unrecorded in the pensions’ financial reports and ignored in most comparisons of public and private sector pay.

The solution to this is for public pensions to get their numbers right. Acting as if they can earn high investment returns without risk encourages them to promise excessive benefits, put away too little to fund those benefits, and take too much risk with the investments they do make. Using realistic discount rates that account for the fact that public pension benefits are guaranteed is not just an academic accounting issue, it’s essential for getting public pensions policy right.

Andrew G. Biggs is a resident scholar at the American Enterprise Institute.

FURTHER READING: Biggs also writes “How Many Hours do Public School Teachers Really Work?” “Cadillac Pay in the Land of Lincoln,” “How Much Does the Federal Government Really Spend?” and “From Ponzi to Perry: The Truth about Social Security.” With Jason Richwine, Biggs coauthors “Are Teachers Overpaid? A Response to Critics” and “Why Public Pensions Are so Rich.”

Image by Rob Green / Bergman Group

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