Many thanks to John Arnold for responding to my post about how he (and his foundation) should approach pension reform. We agree on many things, it turns out; but there’s one big area where we disagree, which is encapsulated most cleanly in the question of what exactly is going on in San Jose mayor Chuck Reed’s Pension Reform Act. I characterized Reed’s ballot initiative as “allowing governments to default on their pension obligations”, and “an attempt to renege on governments’ existing pension obligations”. Arnold says I’m entirely wrong about that:

Salmon repeatedly claims that my wife, Laura, and I and our foundation, LJAF, “support plans making it easier for governments to default on existing promises.” Nothing could be further from the truth. We strongly believe that pension reform should not aim to cut or eliminate benefits… The initiative explicitly honors and guarantees the benefits earned for work done to date. The only question here is whether the employer and employees should be able to negotiate retirement compensation for work that is not yet performed. In other words, does an employee who was hired yesterday have the guaranteed right to earn pension benefits under the same formula for all future years of service? Under Reed’s proposal, cities in California could negotiate with employees, through the collective bargaining process, to change retirement compensation for future service just as they would do for salaries or health benefits. That change would have no effect whatsoever on benefits that have already been earned.

So, who’s right? In order to answer that question, it’s helpful to follow one of Arnold’s links, to a paper on teacher pensions which was put written by the Arnold Foundation’s Josh McGee. The paper addresses a serious problem: that “teachers accrue relatively meager benefits through much of their careers, and then abruptly become eligible for much more as they near retirement age”. For instance, here’s what happens for a teacher who enters the New York system at age 25, if you value pension wealth as the present value of your pension payments:

For the first decade, the teacher accrues essentially zero pension wealth, while the value of the pension rises in value by $101,667 in the two years between age 61 and age 63.

Other school systems have even more dramatic backloading. Here, for instance, are McGee’s charts for Miami and Las Vegas. Look at the darkest line, the one showing “pension wealth” over time. In Miami, that wealth can jump by some $250,000 in just one year; in Vegas, the jump is more than $300,000.

So here’s the question. Put yourself in the position of someone who’s been teaching in Las Vegas for 29 years. The way that John Arnold sees things, over that time, you’ve managed to earn pension benefits worth roughly $200,000. If you teach for one more year, then the value of your pension benefits soars to more than $500,000: effectively, between salary and increased pension benefits, you’re being pad about $400,000 for that one year of teaching. Arnold wants school systems to “be able to negotiate retirement compensation for work that is not yet performed” — which is to say, to be able to pay you much less than $400,000 for that 30th year of teaching.

But that’s a very self-serving view of what’s going on in this pension scheme. Las Vegas teachers get their $500,000 package in return for 30 years of teaching, not in return for the 30th year of teaching. There’s a big difference. And it’s a difference that Arnold, for one, understands.

When a 25-year-old teacher joins the Las Vegas system, Arnold believes (and I agree with him) that the government should pay real money into its pension plan, in order to cover the actuarial costs that she’s going to qualify for in retirement. He doesn’t think that the government should drag its feet and wait until she’s 54 before it suddenly pays in an extra $350,000 or so: that’s not how pension plans work. Instead, they work by putting aside a certain amount of money every year, so that everybody in the system can receive, when they retire, the benefits guaranteed by the system. Indeed, when Arnold complains about pension plans being underfunded, what he means is that local governments aren’t putting enough money away to cover the sums which will be owed, in the future, to teachers who today are in their 20s or 30s. Those sums — and those funding shortfalls — are real, and substantial.

Arnold and I agree on what has been going on here: governments have promised juicy pension benefits in the future, in lieu of paying higher salaries in the present. Sometimes, they’ve failed to fully fund those benefits. But the promises are real.

Let’s make up some numbers for the sake of argument, and let’s ignore things like healthcare for the sake of simplification. Take a 25-year-old teacher on a salary of $50,000, where the government needs to make annual payments of another $9,000 per year in order to fully fund her pension. Effectively, what’s happened here is that the government and the unions have agreed on a total package worth $59,000 per year, of which $50,000 is salary and $9,000 is made up of pension promises. How much are those pension promises worth after ten years of service, in today’s dollars? The answer is about $125,000, if you assume the government’s investments grow at a real rate of 4% per year. The government has a liability to the teacher, which might be funded or might be unfunded, of roughly that amount. (In fact, the promise is worth more than $125,000, because of the effect of other teachers dropping out of the workforce before they reach ten years of service.)

If you ask Arnold, on the other hand, he’ll tell you that the teacher’s “benefits earned for work done to date” are basically zero — since if the teacher retired today, she would not be eligible for pretty much anything.

I disagree. I think that if the government has a liability — and Arnold is busy telling anybody who will listen that the government has a substantial liability, in this case — then the teacher has an equal and opposite asset. And it seems to me that the point of the Reed plan is to give the government the ability to take that liability, and — at least in the case of the teacher with ten years’ tenure — write it down to zero. Which would also have the effect of taking the teacher’s asset and writing it down to zero.

When you write down a future liability, you’re defaulting on your future obligations: that’s why I consider the Reed plan to be a means of reneging on existing promises.

Here’s another way of thinking about our hypothetical teacher: when she joins the school system, she’s granted a set of Restricted Pension Units, which vest over the course of 30 years. If she stays in the system until she’s 55, then those RPUs will be worth more than $500,000, in today’s money. But because of the way that money compounds, and because of the likelihood that she won’t stay in the system until she’s 55, the cost to the government of granting those RPUs, in year one, and also in any subsequent year, is only $9,000.

Nevertheless, those RPUs have been granted, and once granted, they belong to the teacher, not to the government. She can leave any time she likes, and leave most of her RPUs unvested. But that’s her choice, not the government’s. Unless the Reed initiative passes, in which case the government can essentially confiscate all of her unvested RPUs, and replace them with something else.

Now I agree with Arnold and McGee that there are better ways of designing pension plans, in a world where it’s not reasonable to expect teachers to stay in the same district for 30 years, and where it is reasonable to expect teachers with ten years’ service to have built up a meaningful retirement benefit, over the course of that decade, if they decide to move. I agree that if we were starting from scratch, we would design a plan which would look more like the grey upwardly-curving line in McGee’s charts, rather than the black back-loaded line.

But I disagree that if you’ve been teaching for ten years, then the pension promises that the government has made to you are, at this point, essentially worthless.

So here’s what I think should happen. First — and I agree with Arnold on this point — the government should make every effort to fully fund its existing and future obligations. Then, once those obligations are being fully funded, the government can start negotiating with the unions about ways in which to start offering choices to new teachers, and possibly even existing ones. If the government’s going to be spending $9,000 per year on your retirement benefits, where would you like that money to go? Would you like to join the existing defined-benefit plan? Or would you like to opt for something more like McGee’s smooth-accrual system?

The point is to ensure that everybody who has been promised something by the government has the right to demand that the government keep those promises. Not all governments keep all of their promises, but breaking promises is a serious thing: it’s called bankruptcy. We shouldn’t let cities and states get away with it by dint of a simple ballot initiative.

Update: John Arnold responds.