policy review - december 2011 & january 2012, no. 170

8/3/2019 Policy Review - December 2011 & January 2012, No. 170

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ELECTION 2012 : AN UNUSUALLY CLEARPOLICY CHOICE

JAY COST

THE PRIVATE-SECTOR PENSION PREDICAMENT

CHARLES BLAHOUS

CHINA: BIG CHANGES COMING SOON

HENRY S. ROWEN

THE SORDID ORIGIN OF HATE-SPEECH LAWS

JACOB MCHANGAMA

ALSO: ESSAYS AND REVIEWS BY

JAMES W. CEASER, PETER BERKOWITZ,MARY EBERSTADT, DAVID R. HENDERSON,

HENRIK BERING

December 2011 & January 2012, No. 170, $6.00

POLICYReview

A Publ icat ion of the Hoover Inst itut ionstanford un ivers ity


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POLICYReviewDECEMBER 2011 & JANUARY 2012, No. 170

Features

3 ELECTION 2012: AN UNUSUALLY CLEAR POLICY CHOICE

Nationalism through commerce versus egalitarianism through

redistribution

Jay Cost

15 THE PRIVATE-SECTOR PENSION PREDICAMENT

A systemic underfunding that could leave taxpayers on the hook

Charles Blahous

35 CHINA: BIG CHANGES COMING SOON

Economic growth and political upheaval

Henry S. Rowen

45 THE SORDID ORIGIN OF HATE-SPEECH LAWS

A tenacious Soviet legacy

Jacob Mchangama

59 NO THANKS TO GRATITUDE

Struggling to keep national memory and appreciation alive

James W. Ceaser

Books

75 GORDON WOODS AMERICAPeter Berkowitz on The Idea of America: Reflections on the Birth of the

United States by Gordon Wood

79 WITNESS TO LIFE

Mary Eberstadt on A Point in Time: The Search for Redemption in this

Life and the Next by David Horowitz

83 WHEN ECONOMICS WAS YOUNG

David R. Henderson on Keynes Hayek: The Clash that Defined ModernEconomics by Nicholas Wapshott

88 FIGHT BY FLIGHT

Henrik Bering on The Age of Airpower by Martin van Creveld

A Publ i cat i o n o f th e Ho o ver I nst i tut i o nstanfo rd uni vers i ty


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PO

LICYReview

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December 2011 & January 20 12, No. 170

Editor

Tod Lindberg

Research Fellow, Hoover Institution

Consulting EditorMary Eberstadt


Managing Editor

Liam Julian


Office Manager

Sharon Ragland


4/93

T

he presidential election of2012 is shaping up to

be an epic contest. It is uncommon for an incumbent presi-

dent to be considered an underdog, yet as of this writingPresident Barack Obamas odds of winning reelection,

according to the Intrade prediction market, stand at less

than 50 percent. An endangered incumbent always makes for a fascinating

political dynamic, one that will be compounded by the enormously high

stakes of the upcoming battle. With the unemployment rate stuck at near

nine percent and the Democrats new health entitlement set to go into effect

relatively soon, the winner of2012 will have unusual power to set

American domestic policy for the rest of the decade.

But 2012 is shaping up to represent much more than even all this. It is a

very rare event in American electoral politics that the country is faced with

such a stark choice between two competing visions for the governments role

in the society. Using a strict standard, there have really been only two such

Election 2012:

An Unusually ClearPolicy Choice

ByJay Cost

Jay Cost is a staff writer for the Weekly Standard and the author of SpoiledRotten (HarperCollins), a revisionist history of the Democratic Party, due out in

May2012

. A graduate of the University of Virginia and University of Chicago,he currently resides in Pennsylvania.

December 2011 & January 2012 3 Policy Review


5/93

4 Policy Review

elections, those in 1832 and 1896. In other cycles, nonideological issues or

national concerns ultimately kept the country from focusing on the ideologi-

cal contrasts between the two parties. For instance, the election of1800 was

fought in part over large differences in economic policies, but much of it hadto do with foreign affairs and extreme ad hominem attacks. The election of

1936 was certainly consequential for the long-term political economy, but

the substantial rebound from the depths of the Great Depression gave

Franklin Roosevelt an easy valence issue to campaign on. Even the

Election of1860 unquestionably the most important in the nations his-

tory was confused by the presence of four candidates, each offering dif-

ferent approaches to the slavery issue and ensuring that Lincoln could not

claim a popular mandate.So, it is an extremely unusual event in the nations public life that the peo-

ple are posed with such a straightforward question of ideology 1832,

1896, and now perhaps 2012. Interestingly, the broad ideological contours

of the 2012 contest resemble those prior contests. On the one side is a

nationalist coalition dedicated to advancing the public interest by sponsoring

American commerce. On the other side is an egalitarian faction that believes

that those pro-business policies undermined the republican character of the

government, and instead offers proposals to redistribute political power, eco-nomic resources, or both.

The divisions roots

The idea of a strong national government to facilitate American

commerce and industry is as old as the nation itself. Frustrated by

the experiences of the American Revolution, where runaway infla-tion, lack of pay for soldiers, and poor infrastructure to move men and

materiel hampered the war effort, American nationalists were downright

appalled by the crackup in society during the 1780s under the measly

Articles of Confederation. Leading nationalists like Alexander Hamilton,

John Jay, James Madison, and George Washington were prime movers in

organizing the Constitutional Convention, where they pushed for a robust

national government capable of solving big problems.

One of the first articulations of this nationalist philosophy can be found

in Hamiltons contributions to the Federalist Papers. In his famed

Federalist No. 10, Madison focuses on the ability of a large republic to

protect the public interest from the machinations of factions, but Hamilton

offers a different approach in the oft-overlooked Federalist No. 11. In it,

he suggests that a strong central government could engender national great-

ness, in part by encouraging trade between the states:

An unrestrained intercourse between the States themselves will advance

the trade of each by an interchange of their respective productions, not

Jay Cost


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only for the supply of reciprocal wants at home, but for exportation to

foreign markets. The veins of commerce in every part will be replen-

ished, and will acquire additional motion and vigor from a free circula-

tion of the commodities of every part. Commercial enterprise will havemuch greater scope, from the diversity in the productions of different

States.

As secretary of the Treasury during the Washington administration,

Hamilton was central in enacting an economic program that included the

federal assumption of state war debts, the repayment of all debt at face

value, and above all the chartering of the semi-public Bank of the United

States (bus). Hamilton believed that this program would establish the cred-itworthiness of the United States, and thus promote economic growth and

broad prosperity. In his Report on Manufactures in 1792, Hamilton went

beyond this to anticipate much of the 19th-century Republican economic

program by calling for protective tariffs, tax exemptions for certain raw

materials, and facilitation of transportation.

This view forms the foundation of the modern Republican party, especial-

ly its conservative wing, although at first blush this might be difficult to

appreciate. After all, todays conservatives consistently promote limited gov-ernment, whereas Hamilton and the Federalists were in favor of an activist

government. How to bridge this apparent gap? The difference is accounted

for in the rise of progressivism, the political philosophy developed at the end

of the 19th century that promoted an active government to regulate business

and redistribute income among the classes. Todays conservative

Republicans generally favor limited government when compared to mod-

ern progressives, but they are as activist as ever when viewed from the

Hamiltonian perspective in that they prefer a government that encouragesAmerican commerce and industry.

The Hamiltonian view of the federal government has long provoked

intense backlash, with critics usually blasting the philosophy as being inher-

ently unequal and anti-republican. This was the charge leveled by the

Jeffersonians, who took control of the government in 1800 by demagogu-

ing the Hamiltonians as an aristocratic clique plotting to impose monarchy

upon the United States.

Unfortunately, the Jeffersonians would have to learn the hard way that

Hamiltons nationalistic policy was sound. Having all but vanquished their

Federalist opponents, the Jeffersonian Republicans cut government spending

to the bone and allowed the charter of the Bank of the United States to

expire in 1811. The next year, amid a wave of nationalistic sentiment, they

entered the country into another war with England with calamitous

results. A lack of internal infrastructure again prohibited the efficient move-

ment of men and supplies, a lack of a standing army left ill-prepared state

militias to handle most of the fighting, and a lack of strong financial institu-

tions made it extremely difficult for the government to fund the war opera-

December 2011 & January 2012 5

Election 2012: An Unusually Clear Policy Choice


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6 Policy Review

tion. The country had to suffer the ignominy of seeing the capital city

burned to the ground, and it was only Andrew Jacksons victory at the Battle

of New Orleans that salvaged the national pride. The Treaty of Ghent

accomplished none of the goals America had set when it initiated the con-flict, and the War of 1812 has been all but forgotten by 21st-century

America.

Yet it had a profound effect on the Jeffersonians. Almost immediately

after the war, the party split apart based on the old Jefferson-Hamilton

divide of twenty years prior. Moderate Jeffersonians like John Quincy

Adams, Henry Clay, and Madison rediscovered the virtue of a strong central

authority to promote internal development, and chartered a second bus.

Indeed, Clay, who would dominate American poli-tics for the next 30 years, elaborated a neo-

Hamiltonian political program that he dubbed the

American System: a national bank to stabilize cur-

rency and credit, protective tariffs to grow nascent

American industries, and infrastructure improve-

ments to promote internal development.

Mismanagement of this second bus abetted the

Panic of1819, but under the stewardship of presi-dent Nicholas Biddle, it contributed to the robust

economic growth of the 1820s, when real gdp

increased by an estimated four percent per year. Yet

the bus had its detractors: Debtors in the South and

West often viewed it as an institution that transferred wealth from their

regions into the more prosperous Northeast; radical Jeffersonians consid-

ered it an unconstitutional expansion of government and a threat to simple

republican virtue; and a growing number of observers would articulate a cri-tique that has since become common in American political discourse the

idea that the bus executives played political favorites and created a climate

of cronyism and corruption.

Andrew Jackson would come to expound all of these criticisms. His

rough-hewn exterior belied a cunning political mind and firm belief that

hard specie was superior to bank notes as the national currency, and

Jackson set about to cut the power of the bank down to size, virtually from

day one of his administration. Though Jackson would himself expand and

enhance the powers of the presidency by vetoing bills for political purpos-

es and by standing up to the South Carolina Nullifiers he was certainly

no advocate of Hamiltonian, big government nationalism, believing that

such intervention in private affairs inevitably favored the prosperous classes

and therefore threatened the republican character of the government.

When Biddle requested that Congress renew the bus charter just as the1832 election season began, Jacksons worst fears seemed confirmed. Biddle

was clearly in cahoots with Jacksons opponents, above all Clay, the nomi-

nee of the National Republicans who was casting about for an issue to

Jay Cost

The Jeffersonians

would have to

learn the hard

way that

Hamiltons

nationalisticpolicy was

sound.


8/93

campaign on. Hence the petition for an early re-charter, and to Jackson a

clear signal that an unelected financial elite were trying to influence the

democratic process. Despite the fact that Jacksons allies in Congress gener-

ally supported Biddles petition, the president vetoed the new charter andissued a stern rebuke in his veto message:

It is to be regretted that the rich and powerful too often bend the acts of

government to their selfish purposes. Distinctions in society will always

exist under every just government. Equality of talents, of education, or

of wealth can not be produced by human institutions. In the full enjoy-

ment of the gifts of Heaven and the fruits of superior industry, economy,

and virtue, every man is equally entitled to protection by law; but when

the laws undertake to add to these natural and just advantages artificialdistinctions, to grant titles, gratuities, and exclusive privileges, to make

the rich richer and the potent more powerful, the humble members of

society the farmers, mechanics, and laborers who have neither the

time nor the means of securing like favors to themselves, have a right to

complain of the injustice of their Government.

To this day, Jacksons veto message remains the most cogent and effective

critique of the Hamilton/Clay approach to policy. A government that ispowerful enough to facilitate economic growth is also powerful enough to

play favorites, and will inevitably favor the elite over the humble members

of society. Though modern-day Democrats have since embraced big gov-

ernment progressivism, they nevertheless still regularly invoke this

Jacksonian critique against todays Republican Party and its pro-business

policies, instead calling for reforms that address the injustices the hum-

ble suffer.

Unsurprisingly, the 1832 election became a referendum on these compet-ing ideologies. The result was a decisive win for Jackson, who carried nearly55 percent of the vote, the most for any Democrat until fdrs victory a cen-

tury later.

The Jacksonians dominated politics for the next quarter-century, but their

inability to deal with the slavery issue meant that the new Republican Party

would rise to power starting in 1860. Dominated by former Whigs, the

Republicans would not only put an end to slavery, they would also push

through a version of Clays American System over the next 30 years: protec-

tive tariffs to grow American industry, a stable currency pegged to gold, and

federal land grants to nurture education and transportation. It seemed as

though Prince Hal, as Clay was known during his lifetime, had finally

been crowned king; though he would lose three presidential elections, his

economic platform was largely implemented after he died, with the result

being fantastic economic growth for the next 30 years.

The problem with a dynamic, industrialized economy is the persistent

cycle of boom and bust, and the economic collapse of the 1890s was the

worst depression the country had suffered to that point. The fallout from the




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8 Policy Review

Panic of1893 exacerbated an already bad situation in the South and

Great Plains, where indebted farmers labored to make ends meet despite a

tight money supply, falling crop prices, and railroad monopolies that soaked

them for every last penny. The frustration of the hardscrabble farmers gaverise to the Populist Party, whose spirit in turn overtook the Democrats in

1896. At its convention in Chicago, the party all but disowned Democratic

President Grover Cleveland an eastern conservative who favored the gold

standard and nominated the young, brash William Jennings Bryan after

he gave a stunning speech.

The issue that year was not the bus, which had never been revived since

Jackson killed it some 60 years prior, but rather the de facto gold standard

the country had adopted to stabilize the currency in lieu of a central finan-cial institution. Bryan and his populist Democrats favored the unlimited

coinage of silver, which would bring about inflation (or so they hoped) and

thus transfer a portion of the national wealth from the creditors in the

Northeast to the debtors in the South and West. Bryans convention address

in praise of free silver hit on many of the same themes from Jacksons veto

message, and has since become the template for modern Democratic poli-

ticking:

There are two ideas of government. There are those who believe that ifyou just legislate to make the well-to-do prosperous, that their prosperi-

ty will leak through on those below. The Democratic idea has been that

if you legislate to make the masses prosperous their prosperity will find

its way up and through every class that rests upon it.

This argument is like nails on a chalkboard for the political descendants

of Hamilton and Clay, then and now. Their belief is that a government that

actively encourages commerce and industry may disproportionately help afew individuals at the top, but it is of lasting benefit to all classes of people.

The Democratic view, then and now, was that this trickle down approach

only made the rich richer and the poor poorer.

In 1896 the nationalists found a champion who was more than a match

for Bryan Ohio Governor William McKinley. A bona fide expert on the

tariff who won the gop nomination over the objection of the party bosses,

McKinley was more than happy to fight Bryan on the issue of the currency.

He framed his support for the gold standard in the context of the tariff and

the entire national program for economic growth, arguing that it was all

part of a package that had brought about vast improvements in the national

standard of living since the Civil War, and that it would continue to do so if

the country just retained the present course. Republican campaign literature

hailed McKinley as the advance agent of prosperity, and the country

agreed, electing him over Bryan by a 5146 margin, the largest presidential

victory in 28 years.

While the concept of an electoral realignment remains a problematic

and controversial idea in academic circles, it is a pretty fair assertion that

Jay Cost


10/93

something substantial and enduring happened to both parties during 1890s.

That election reaffirmed the Republican Partys commitment to the pro-

growth, pro-development policies of Hamilton and Clay, while the conserva-

tive Bourbons such as Cleveland in the Democratic Party lost out to thepopulists and later the progressives, both of whom advocated the use of the

federal government to legislate to make the masses prosperous, as Bryan

put it.

The divisions return

It is curious, then, that the country has not had another clear ref-erendum on the McKinley/Bryan divide since 1896. Why is it that,

despite the fact that there are great differences between the two sides

in terms of their core economic philosophies, Americans have not been

forced to choose one path or the other since 1896?

One reason is the spectacular economic growth over the last 100 years.

Despite the persistence of the business cycle, including a nasty downturn

after World War I, the real size of the American economy nearly quadru-

pled between the Panic of1893 and the Great Depression. And while thelatter shaved off nearly 25 percent of the national income, the country

began climbing out of the hole by 1934 and over the next 70 years real

gross domestic product grew fifteen-fold. This miraculous growth seemed

to be independent of the party in office or the ill-conceived proposals one

side or the other cooked up; Democrats or Republicans, liberals or conserv-

atives, the economy seemed to grow like gangbusters year in and year out.

To put this growth in perspective, the 1970s which people today gener-

ally remember as a period of weak growth saw real gross domesticproduct increase by some 38 percent, the private sector create some seven-

teen million new jobs, and real disposable income per capita increase by 27

percent.

In light of this, both sides could have their cake and eat it, too. The

Democrats could emphasize greater social welfare benefits without techni-

cally redistributing wealth, as Bryan had proposed. Instead, they would

take a relatively small slice of the annual national surplus and distribute it to

the less fortunate. Republicans, meanwhile, were generally able to keep

taxes low and business regulations from becoming too onerous without

challenging the social welfare programs Americans had come to support.

Whats more, both sides were able to dabble in policy realms usually domi-

nated by the opposition Democrats could cut taxes and Republicans

could enact social programs. Indeed, the domestic policies of the second

Clinton term and the first George W. Bush term seem interchangeable; either

man could have embraced welfare reform, No Child Left Behind, the

Medicare prescription drug benefit, financial deregulation, school uniforms,

the v-chip, or faith-based initiatives, and both cut taxes multiple times.




11/93

But the old McKinley/Bryan cleavage is beginning to come back to the

forefront because the American political economy has shifted decisively in

the last few years. Two substantial problems have emerged. First, the great

American prosperity machine has slowed noticeably. Economic growth inthe last decade has averaged less than 1.6 percent per year, compared to 3.3

percent over the prior twenty years. Along with this slowdown in growth

has come a decade-long jobs recession: The employment-to-population ratio

peaked in April 2000 at nearly 65 percent and has never recovered; today it

stands at an anemic 58 percent. More people out of work naturally means

those still employed are less able to bargain for higher incomes, and so

unsurprisingly the average inflation-adjusted salary per private sector work-

er has declined over the last decade.The second problem is the inability of the federal

government to pay its bills. This deficit problem is

both short- and long-term in scope. Over the past

few years, tax revenues have fallen off while gov-

ernment efforts to stimulate the economy have

expanded dramatically thus yielding the $1 tril-

lion and larger annual deficits of the last few years.

As daunting as these numbers are, they pale in com-parison to the long-term deficit problem, which is

above all a consequence of the social welfare oblig-

ations that politicians made generations ago, when

gdp growth averaged nearly four percent per year

and the retirement of the Baby Boomers was too far

in the future for the actuaries to consider. But the day of reckoning is quick-

ly approaching: According to the Congressional Budget Office, if all current

policies are kept in place for the next 70 years, total federal spending willequal more than 34 percent ofgdp , nearly double what we have seen over

the last 40 years.

Combined, these two points offer a grim vision of the future. Economic

growth is already slowing markedly, and to fund federal entitlement obliga-

tions already on the books, the government will have to nearly double in

size, further impeding the ability of the private sector to create wealth for

subsequent generations. A continued weak economy, in turn, will put pres-

sure on government to grow the safety net even more, which would mean

more spending, taxes, and thus a vicious cycle.

This means, in turn, that the ideological contrasts between the Democrats

and Republicans will only grow sharper as the two parties articulate

more clearly their side of the McKinley/Bryan cleavage.

Democrats have made the first move, although one would not recognize

that by listening to their rhetoric alone. President Barack Obama and former

House Speaker Nancy Pelosi talk a good game about reigniting the

American economy, but their rhetoric does not match the reality. Time and

again, the president and his liberal allies in Congress have chosen to expand

Jay Cost

The American

prosperity

machine has

slowed, and

the federal

government isunable to pay

its bills.

10 Policy Review


12/93

the size and scope of the federal government, further hampering the private

sector and stalling the economic recovery.

The stimulus bill passed in 2009, for instance, promised to pump $800

billion of borrowed money into the economy, but the point of entry waslargely through core Democratic clients: tax credits for the poor, public

works projects that employed the trade unions, and bailouts for state gov-

ernments full of public workers made up most of the package. Businesses

saw very little in terms of tax incentives to spur a private sector rebound.

With the economy supposedly fixed, Democrats turned their attention to

redistribution of the national wealth. The cap-and-trade bill passed by the

House in 2009 would have cut gross domestic product by nearly 0.5 per-

cent by 2020, and cost the median household more than $200 per year.The winners in the scheme would be the environmentalist groups that are

now essential to the Democratic coalition, the big banks and industries with

insider connections that yielded special payoffs hidden in the legislation, and

the poorest of Americans, who would actually receive a modest increase in

annual income due to the redistribution programs in the bill.

With health care, the president pitched his reforms as a way to solve some

of the enduring structural problems with the economy. In a February 2009

address to a joint session of Congress, he called attention to the crushingcost of health care:

This is a cost that now causes a bankruptcy in America every 30 seconds.

By the end of the year, it could cause 1.5 million Americans to lose their

homes. In the last eight years, premiums have grown four times faster

than wages. And in each of these years, one million more Americans have

lost their health insurance. It is one of the major reasons why small busi-

nesses close their doors and corporations ship jobs overseas. And its one

of the largest and fastest growing parts of our budget. Given these facts,we can no longer afford to put health care reform on hold.

Yet cost control was simply a smokescreen to win broad public support.

An overwhelming majority of Americans have health insurance, so a reform

plan designed mainly to expand coverage at the expense of those who

already have it was bound to go nowhere fast. So Obama and congres-

sional Democrats disguised what was at its core a coverage expansion bill in

the rhetoric of cost containment. By the time the number crunchers at the

Center for Medicare and Medicaid Services reported that the bill would

actually increase the total cost of health care in this country and only exacer-

bate the runaway costs of federal health subsidies, the bill had already been

made the law of the land. The price that the public will pay for this new

entitlement will be broad-based. Independent estimates suggest millions will

lose their current health care coverage as businesses drop insurance plans to

save money, and in the meantime the bill has only added to uncertainty in

the businesses community, which has not fully figured out what the reforms

will mean for the bottom line.




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12 Policy Review

From a certain perspective, all of this seems like par for the course for the

Democratic Party. Indeed, payouts to unions, tax credits for the poor, reams

of new environmental regulations, and health entitlements have more or less

been the partys bread and butter for generations. But what makes this soextraordinary is the shift in the political economy. It is one thing to pass a

cap and trade bill when economic growth averages more than three percent

per year; quite another when it struggles to rise above two percent. It is one

thing to burden businesses with a health insurance mandate when hiring is

at an all-time high, quite another when it has hit a 30-year low. It is one

thing to promote deficit-financed public works programs when the deficit

amounts to less than one percent ofgdp, quite another when it is nearly ten

percent. This is not about dedicating a portion of the nations annual surplusto achieve goals of social welfare; this is about simple redistribution, about

taking from Peter to pay Paul to equalize the slice of the national pie both

enjoy. No doubt Bryan would heartily endorse all of these programs if he

were alive today.

For their part, Republicans are returning to the principles laid out by

Hamilton, Clay, and McKinley. No longer are they promoting Democratic

lite social welfare programs like Bushs Medicare prescription drug bene-

fit. Instead, the bulk of the gops intellectual efforts has lately been indevising entitlement reforms, such as those proposed by House Budget

Committee Chairman Paul Ryan, designed to keep the basic social welfare

commitments in place without doubling the size of the government.

Additionally, Republicans are increasingly pushing fundamental tax reform,

something that has not been done in 25 years. Whats more, in an unprece-

dented shift, Republicans are now talking seriously about comprehensive

health care reform not just wiping Obamacare from the books, but

making a serious, sustained bid to lower the costs of care. All of these ideaswould, if realized, reduce the size and scope of the federal government, alle-

viate the burdens that are currently carried by businesses, and hopefully

rehabilitate private sector growth. In other words, the economic crisis has

refocused the Republican Partys attention on the ways that the federal gov-

ernment can support American private enterprise. McKinley would surely

be pleased.

The 2012 decision

One way in which 2012 will likely differ from 1832 and 1896 is

that in those prior two contests the combatants were eager advo-

cates of their own side, whereas Barack Obama probably will not

be. The man who, as a candidate, declared that it was time for the country

to make the hard choices prefers, as president, to recast the hard choices as

false choices; he probably does not want to get pinned down in the same

way that Jackson, Clay, Bryan, and McKinley did. Instead, if recent history

Jay Cost


14/93

is any guide, he will rather prefer to cast himself as the defender ofboth tra-

ditions, and cast his opposition as the representatives of a radical fringe.

Still, this might not matter. A challenger with a slender record in govern-

ment can define himself whatever way he chooses, but a president is boundby his record; thus, President Obama faces more limitations in 2012 than

candidate Obama did in 2008. With persistent weakness in the economy, a

massive new health care entitlement set to go in effect, and a looming deficit

crisis that will require either massive new taxes or major entitlement reforms

President Obama may have no choice but to defend the political tradition

of the liberal Democrats.

If so, 2012 might turn out to be one of those elections that our grandchil-

dren, and their children, talk about. It could be one of those decisive contestswhere the choice of the electorate sets the course of public policy for genera-

tions to come. And once again, it looks to be another battle between the

political heirs of Hamilton, Clay, and McKinley against the heirs of

Jefferson, Jackson, and Bryan. Will the government continue to facilitate the

expansion of the private sector, or will it further burden it with new layers of

regulation and taxation? A year from now, we might very well know the

answer to that question.




15/93

R

ecently there has been substantial press attention

paid to underfunding in state and local government pen-

sion plans, a longstanding problem made more urgentby recent troubles in the larger economy. There has of

yet been comparatively less attention given to a similar

(though smaller) set of mounting financial risks associated with private-sec-

tor worker pensions covered by the Pension Benefit Guaranty Corporation

(pbgc). Yet here, too, public policy corrections are required to address

underfunding and avoid another taxpayer-financed bailout we can ill afford.

pbgcs latest annual report shows a net deficit of over $23 billion, of

which roughly $21.6 billion is attributable to its single-employer insurance

program. Whats worse, pbgc estimates its exposure to reasonably possible

The Private-Sector

Pension PredicamentBy Charles Blahous

Charles Blahous serves as one of two public trustees for the Social Security andMedicare programs and is also a research fellow at the Hoover Institution. He

previously served as deputy director of the National Economic Council, andexecutive director of the Presidents Commission to Strengthen Social Security.This material is condensed from his paper, The Other Pension Crisis: Options

for Avoiding a Taxpayer Bailout of the PBGC, published by the MercatusCenter in March 2011.

December 2011 & January 2012 15 Policy Review


16/93

16 Policy Review

plan terminations at approximately $170 billion. While these figures may

appear small relative to the potential losses in state and local government

plans, they reflect underfunding in employer-provided plans that is propor-

tionally comparable.Elected officials face a fundamental value choice about whether employer-

provided pensions should be funded and insured only by plan sponsors, or

whether the dollars of others (i.e., taxpayers) should be tapped to fill the

gap. Either policy requires substantial changes to existing law. If the former

policy is not enforced so that pbgc is kept solvent, the approaching cost of

the latter course should be disclosed. Each scenario requires unattractive

actions but is nevertheless preferable to the current situation, in which tax-

payers face a growing financial risk that is disguised rather than forestalledby the existence of the pbgc.

The financing shortfall

Employer-provided, defined-benefit pensions (both single-

employer and multiemployer) are insured by the pbgc, a federally

chartered corporation. When an insured pension plan terminates,the pbgc assumes the plans assets as well as the responsibility for paying

promised benefits up to a cap set in law.

To simplify the pertinent issues, I will focus primarily on the single-

employer pension insurance system, where the vast majority of the pbgc

financing shortfall is concentrated. Its current $21.6 billion deficit is nearly

the largest on record, falling just behind those posted in 2004 and 2005.

While the size of the deficit fluctuates from year to year, it has remained per-

sistently significant over most of the last decade (that is, more than $10 bil-lion in each year since 2003, inclusive). Indeed, in each of the last eight

years pbgcs liabilities have been measured as being at least 15 percent larg-

er than its assets, and usually much more.

These figures dont capture the full extent ofpbgcs potential difficulties,

as evidenced by its estimate of reasonably possible termination exposure

i.e., underfunding in plans with below-investment grade credit ratings

at roughly $170 billion. pbgc s multiemployer program is also presenting

increased risks; in 2010, reasonably possible exposure in multiemployer

plans suddenly rose from roughly $300 million to approximately $20 bil-

lion.

The financing hole in Americas pensions is now of such a size that we

cannot expect it to close unless someone pays substantially greater costs out

of pocket than is currently the case. In October 2009, pbgc provided con-

gressional staff with estimates indicating that to comply with existing law,

pension contributions by plan sponsors would need to rise from roughly

$50 billion in 2008 to more than $250 billion annually by the mid-2010s.

Others projections show considerably smaller figures but nevertheless agree

Charles Blahous


17/93

that substantial future contribution increases will be required. Recently

enacted funding relief could delay the full effects of these requirements, but

that does not change the reality that markedly increased contributions will

ultimately be necessary.A critical public policy question, therefore, is to what extent the cost of

filling the shortfall is to be met within the current pension insurance system,

and to what extent risks and costs will be shifted to those now perceived to

be outside of it.

Why the inadequate finance?

T

he pension insurance system was weakened when recent

financial market declines both depressed pension-plan asset values

and undermined the financial health of plan sponsors. From 2008

to 2009 the size ofpbgcs net deficit roughly doubled, in part due to a

decline in interest rates (which increased the present value of plan liabilities),

and also due to an increase in plan terminations. In 2009, pbgc reported

that it had become responsible for paying benefits to more than 200,000

additional workers, the third-highest increase in its history and roughly nine

times the number of new participants for which it had assumed responsibili-

ty in 2008. Over the same year, pbgcs exposure to reasonably possible

terminations drastically increased, from $47 billion to $168 billion.


The Private-Sector Pension Predicament

figure 1

Net financial position, PBGC single-employer insurance program

Source: 2010 pbgc Annual Report.

10

5

-

-5

-10

-15

-20

-25

$b

illionso

fpresentvalue

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010


18/93

18 Policy Review

Though this represented a sharp downturn in pbgcs outlook, its finances

were on an unsustainable course even when financial markets were at their

peak. The reasons were rooted in longstanding flaws in federal pension law.

Although the 2006 Pension Protection Act (ppa) addressed many of theseproblems, their effects continue to permeate the pension system. The ppa

provided up-front pension funding relief to most plan sponsors while estab-

lishing tighter funding targets for the long term. But many of the ppas criti-

cal reforms are being phased in only gradually, and its near-term funding

requirements were further relaxed in subsequent legislation. Regardless, any

positive impact of the ppa is being swamped by the financing deterioration

resulting from worsened market conditions.

The following is a capsule list of factors that have contributed over timeto pension underfunding. More details about all of these factors can be

found in Pension Wise (Hoover Institution Press, 2010).

1. Inaccurate measurements of plan assets. Plan underfunding can only be

successfully addressed to the extent that contributions are based upon

accurate, up-to-date measurements of plan assets, liabilities, and any

gap between them. Prior to the ppa, sponsors could smooth asset

valuations by blending more recent values with older valuations from

the previous four years. Even under the ppa, the plan sponsor still hastwo years to fully recognize any discrepancy between a plans actual

and its previously projected plan assets, though assets cannot be valued

more than 10 percent differently than current market value. Such

smoothing has often delayed recognition of underfunding, causing

delays in contributions that would otherwise be required. Smoothing

was often rationalized as being necessary to limit the volatility of and

to prevent pro-cyclicality in contribution requirements. This rationale,

however, conflated two separable concepts the accuracy of pensionfunding measurements on the one hand, and the policy for determining

contributions on the other.

2. Inaccurate measurements of plan liabilities. An accurate projection of

plan liabilities requires both that future benefit payments be accurately

estimated and that they are appropriately discounted into their present

value. Accurate benefit payment projections in turn require accurate

estimates of the number of individuals who will be receiving benefits,

the amount and form of those benefits, and the time over which they

will be paid. The ppa required plan sponsors to use updated mortality

tables, addressing a problem that had long persisted before the legisla-

tion. The ppa also now accounts for the empirical phenomenon of the

rush to the exits i.e., the likelihood that individuals in a troubled

plan will claim benefits at the earliest possible age and in a lump sum

when available (both choices drain a plan of assets in the near term).

The ppa s transition period, however, has the effect of postponing

recognition of most of these at-risk plans. As for liability discount-

Charles Blahous


19/93

ing, what must be assessed is the degree of risk in pension benefits as

well as the time period over which they will be paid. Current law dis-

counts these liabilities according to a yield curve of corporate bond

rates, which the sponsor has the option of smoothing over two years. Acorporate-bond yield curve is potentially an appropriate means of dis-

counting. It is, however, appropriate only to the extent that worker

benefits are at risk whenever corporate financial health is also at risk;

that is, when benefits are not backstopped by the taxpayer.

Furthermore, it is accurate only to the extent that smoothing and other

interest rate specifications do not introduce a distortion of up-to-date

market conditions. Additionally, the ppa also allowed certain political-

ly favored industries (e.g., airlines) to employ arbitrarily higher dis-count rates in their pension funding calculations.

3. Inadequate funding targets. A core principle of the ppa is that a pen-

sion plans appropriate funding target is 100 percent, with plan spon-

sors being given seven years to amortize contributions to address any

shortfall. The ppa did not establish the 100 percent funding target

immediately, however; even the firstsponsor payments pursuant to full

funding were not to be required until at least five years after the ppas

enactment. Moreover, additional funding relief was enacted in 2010that, while it did not waive the 100 percent funding target, reduced

contribution requirements in relation to it. While it is understandable

that Congress would choose to provide additional funding relief at a

time when plan sponsors face unusual economic difficulties, the relief

took immediate effect in a funding environment that was already quite

weak.

4. Unfunded benefit increases. Prior to the ppa, employers had the lati-tude to increase benefit promises without fully funding these increases

before a plan was assumed by the pbgc. This had the effect of worsen-

ing underfunding in some terminating plans. The ppa clamped down

on such practices, imposing various limitations respectively upon lump

sum payments, unfunded benefit increases, and in some cases even ben-

efit accruals, though these safeguards have yet to fully take effect.

5. Loopholes and special preferences. Pre-ppa law contained enormous

loopholes, many of which made significant contributions to pension

underfunding. Among these was the credit balance rule. Specifically,

any contribution made in excess of minimum statutory requirements

was not only counted once in adding to a plans funding percentage but

a second time in reducing the amount of future contributions otherwise

required. Moreover, plan sponsors were permitted to assume that the

credit balance had appreciated in value even if the actual investment

had not. The ppa corrected the worst abuses of credit balances but per-

mitted the basic concept to persist. It did not, however, reform various




20/93

20 Policy Review

special statutory preferences for politically favored industries. It explic-

itly permitted airline plan sponsors to use longer amortization periods

and to employ a higher discount rate to artificially shrink the size of

plan liabilities. More recently, one domestic automaker was also per-mitted, while receiving government assistance, to top up affiliated

union workers pension benefits, to circumvent the spirit of pbgcs

statutory benefit caps.

6. Inadequate premiums. Unlike other federal insurers (such as the fdic),

the pbgc does not have the power to levy premium assessments suffi-

cient to pay for the cost of the insurance that it provides. In 2005, the

Congressional Budget Office calculated that pbgc premiums would

need to be roughly 6.5 times higher to fund the size of anticipatedclaims. Equally important, not only is the levelof premium income

inadequate but premium assessments do not reflect the level ofrisk in a

pension plan, arising from such factors as its investment portfolio, its

funding percentage, and the health of its sponsor. Earlier this year, the

Obama administration proposed that the pbgc be given increased

authority to modify both the level and structure of premiums that

sponsors are charged for pension insurance.

7. Limitations upon the national pension insurer (PBGC). The pbgc has

only limited power to enforce contribution requirements. In one exam-

ple from recent years, one airline sponsor simply stopped making statu-

torily-required contributions to its plan once the sponsor entered bank-

ruptcy. As an unsecured creditor, pbgc was unable during bankruptcy

proceedings to perfect a lien placed against the skipped contributions.

pbgc also generally lacks the authority to regulate the investment poli-

cies of plan sponsors, or otherwise prevent them from taking actionsthat degrade its financial position. Moreover, pbgc has an ambiguous

position in relation to the Department of Labor, in some respects

appearing to sit within it, in others appearing to be independent. This

occasionally calls into question pbgcs latitude to take fully indepen-

dent actions to defend pension plan funding. This is particularly prob-

lematic in circumstances where a presidential administration chooses to

advance a conflicting policy priority, whether that competing priority

involves providing direct taxpayer-backed assistance to the automotive

industry or attempting to stimulate near-term job creation at the

expense of pension funding.

8. Inadequate disclosure. Transparency and disclosure are effective spurs

to stronger pension funding. Present funding disclosure requirements

can only be described as inadequate. The 4010 form (pbgcs primary

source of detailed plan funding information) is only required of plans

deemed less than 80 percent funded. This has the dual adverse impacts

of both limiting information about some large plans that may pose a

Charles Blahous


21/93

large aggregate risk to the pbgc and of stigmatizing the comparatively

few plan sponsors who must file the information.

9. Barriers to funding up during good times. During the late 1990s,

annual contributions to pension plans shrank (and in some cases wereeliminated altogether) as plan assets rose during the stock markets dot-

com bubble. After the bubble burst, plan funding percentages declined

to lower levels than they would have if sponsors had overfunded

during good times. Pre-ppa law constrained the extent to which plan

sponsors could do so, limiting the tax-deductibility of excess pension

contributions to 100 percent of the plans current liability. The ppa

increased employer flexibility to fund up during good times, allowing

sponsors to fund to 150 percent of their target liability plus expensesbased on future salary increases (a long-term reform of limited applica-

bility in a recession environment). Current federal budget rules also

remain a problem. Because employer pension contributions are tax

deductible, the federal government can still raise revenue by reducing

employer pension contributions, a tactic used as a budgetary offset for

added federal spending in 2010. A better budget framework would

recognize worsening pension underfunding as an increase in potential

taxpayer exposure, rather than treat it as a cost-free source of financingfor added federal spending.

10. Moral hazard and political economy factors. Current funding require-

ments and premium assessments are determined not by economic reali-

ties but rather by a political process. Elected officials remain under con-

stant pressure to relax contribution requirements so that employer

funds can be made available for new hiring or for more immediate

forms of compensation (e.g., wages). Similar pressures are commonthroughout existing defined-benefit systems and have caused significant

underfunding to arise in each of employer-provided pensions, state and

local pensions, and in Social Security.

11. Periodic contribution relief. One specific manifestation of the moral

hazard inherent in the current pension system is the recurrent congres-

sional behavior whenever previously enacted funding requirements

begin to bind too tightly. In the early 2000s, funding relief was first

provided by allowing sponsors to discount using a widened corridor

around Treasury bond rates, and then later by shifting to higher corpo-

rate bond rates. In 2006, the ppa provided additional near-term fund-

ing relief in exchange for a tightening of long-term funding standards.

More recent funding relief has repeatedly been justified by difficult eco-

nomic conditions. While the funding relief may have been defensible in

each of these individual circumstances, the overall pattern has been

unchanging; Congress has repeatedly shifted the risks of pension under-

funding from plan sponsors to the pension insurance system as a whole.




22/93

Common moral hazards

There is periodic but largely separate public attention to the

funding issues facing Social Security, state and local pension plans,

and employer-provided defined-benefit pensions. All of these sys-

tems are underfunded; all suffer from inadequate accounting; and all face

analogous moral hazards. Yet there has been comparatively little attention

to the common factors driving underfunding in all three.

While defined-contribution systems also face their challenges, a funda-

mental misalignment of interests is not one of them. A workers ultimatedefined-contribution benefit is a direct function both of the adequacy of plan

contributions and of the rate of appreciation on investments. It is clearly in

the workers interest to see that contributions are sufficient, that they are

profitably invested, and that administrative expenses are minimized. If any

of these elements is poorly handled, the workers ultimate retirement income

will diminish. While the worker may lack sufficient information or educa-

tion to assess these factors, the workers interestis at least straightforwardly

aligned.In a defined-benefit system, however, the interests of different actors

diverge. Because the sponsor, rather than the worker, accepts the funding

risk, it is in the sponsors interest to minimize his costs in providing a given

benefit, while it is only in the workers interest to maximize his chance of

receiving the full benefit, irrespective of who pays for it. The presence of

pension insurance injects substantial moral hazard into this dynamic. When

pension insurance is present, a plan sponsor can potentially reduce funding

costs by investing in higher-risk securities (unless specifically prevented byregulation from doing so). If the upside returns are received, the sponsors

pension liabilities are reduced; if the downside risk is realized, the pension

insurance system is there to potentially absorb the loss. Pension insurance at

the same time reduces the workers incentive to verify that pension contribu-

tions are both adequate and prudently invested.

The same problematic incentives exist in public-sector plans, including

both state and local pension plans and the federal Social Security program.

Elected officials responsible for controlling the finances of these plans have

powerful incentives both to minimize costs faced by taxpayers while maxi-

mizing benefits paid to program participants. This leads naturally to two

predictable results; first, to aggregate underfunding (an excess of promised

benefits over contributed revenues); second, to rising pay-as-you-go obliga-

tions (that is, an escalation of obligations that must be financed by future

contributors at the moment of benefit payment, as opposed to having been

prefunded).

The adverse funding consequences of these hazards have resulted in

roughly one-fifth to one-quarter of future benefits being unfunded in each

Charles Blahous

22 Policy Review


23/93

defined-benefit sector, depending on the particular estimate. State and local

plans have frequently employed aggressive liability discount rate assump-

tions that reduce near-term funding and increase the share of benefit pay-

ments that must be funded by future taxpayers. Similarly, the federal SocialSecurity program continues to be operated essentially on a pay-as-you-go

basis despite widely recognized population aging, a long-predicted decline in

the ratio of workers to beneficiaries, and the recommendations of multiple

bipartisan technical panels and advisory boards to shift toward partial pre-

funding.

Although the pbgc insures private-sector pensions, its operations are also

greatly affected by political economy factors. Both premium assessments and

funding requirements are established via a politicalprocess. The pbgc is not permitted to perform the

equivalent of a private-sector insurers pricing of

insurance coverage, nor does it have the legal

authority to change premium assessments as finan-

cially necessary. And each time that legislators must

vote on a bill to determine premium levels or fund-

ing requirements, they are subject to enormous polit-

ical pressure to relax each of these relative to what isrequired to achieve a fully funded pension system.

Unless the process itself is changed, this phenome-

non should be expected to continue.

A striking parallel between the three major forms

of defined-benefit pensions is the extent to which near-term funding relief

has often been provided through the manipulation of asset and liability mea-

surements in all three sectors. Asset and liability smoothing, artificially high

discount rates, credit balances, and other techniques have delayed recogni-tion of underfunding in employer-provided pensions. In state and local

plans, the chief accounting tool by which liabilities have been understated

has been the use of aggressive liability discount rate assumptions. In Social

Security, Trust Fund accounting is the primary culprit, where Trust Fund

assets are deemed to reduce future funding shortfalls even though these

assets are simply a further debt obligation facing federal taxpayers. A classic

example of the manipulation of this accounting occurred last December,

when Congress cut payroll taxes by over $100 billion for 2011 but stipu-

lated that additional debt would be issued to the Social Security Trust Funds

just as though the additional taxes were being collected.

In each of these defined-benefit systems, the ongoing battle over transpar-

ent accounting is fought along predictable interest group lines. In the

employer-provided pension world, plan sponsors often argue for asset/liabili-

ty smoothing and higher discount rates, while the opposing case is made by

those responsible for the health of the pension insurance system. With state

and local plans, state officials and public employee unions both advocate

high discount rates, while pushback comes from academics, taxpayer-watch-



While defined-

contribution

systems also face

their challenges, a

fundamental

misalignment ofinterests is not

one of them.


24/93

24 Policy Review

dog groups, and federal officials concerned about pressure for a federal

bailout. In Social Security, the beneficiary-advocacy group aarp has defend-

ed current Trust Fund accounting methods, while counter pressure has come

from bipartisan technical expert panels and fiscal watchdog groups.Unfortunately, in each of these cases, those who have argued to disguise

funding inadequacy have generally carried the day, contributing to the signif-

icant funding shortfalls in all three systems.

Avoiding a taxpayer bailout ofpbgc

Regardless of the future structure ofpbgc, certain reformprinciples should be observed. Specifically:1. Limit asset smoothing to the extent practicable. Pension funding policy

cannot be sensibly constructed if it is not built on a foundation of mea-

surement accuracy. The only properly imposed limitation on the accu-

racy of asset measurements should reflect limits on practicability for

plan sponsors. If requiring an asset measurement on a specified date

proves to be particularly disadvantageous for a plan sponsor, this out-

come is best avoided by allowing the sponsor to select from valuation

dates within a narrow time window. To the extent that minimizing

smoothing causes real asset volatility to be formally recognized, fund-

Charles Blahous

table 1

Moral hazards operating in defined-benefit systems

system risks shifted to method(s) result

Employer-provid-

ed pensions

pbgc pension

insurance system

Asset/liability

smoothing, dis-

count rates, loop-

holes, inadequate

funding rules

Underfunded

State and local

pensionsFuture taxpayers

Aggressive dis-counting assump-

tions

Underfunded

Social Security Future taxpayers

Trust Fund

accounting; pay-

go financing

Underfunded


25/93

ing rules should be designed to limit volatility in annual required con-

tributions rather than relying on smoothed asset valuations. Asset

and liability valuations should be conducted to produce the most accu-

rate information about plan finances, not to steer toward a particularfunding policy result.

2. In liability measurements, limit smoothing, use up-to-date mortality

tables, and account accurately for worker behavior. Like asset measure-

ments, liability measurements should be as accurate and up-to-date as

is practicable. Specifically, liability measurements should reflect the

most up-to-date mortality tables as well as the best available informa-

tion about how and when workers are likely to claim benefits. This in

turn requires that the pension insurer is able to ascertain the risk of arush to the exits due to the sponsor itself becoming a credit risk. As

with asset valuation, periodic fluctuations in liability discount rates are

better handled by allowing a narrow time window during which a

sponsor can choose a discount rate, rather than by smoothing with

long outdated discount rates.

3. Eliminate special deals for politically-favored industries. Rules of play

should be applied fairly across the board. There should be no specialexemptions for politically favored industries as exist under current law.

A private insurer would not be allowed to discriminate between cov-

ered entities based on political preference; the public pension insurance

system should be bound by a similar ethic.

4. Enforce prohibitions on unfunded benefit increases by underfunded

plans. Even where plan sponsors are suffering from economic forces

beyond their control, little good can arise from permitting plan spon-

sors to promise benefits that they cannot pay. Recent funding relief leg-islation has permitted plan sponsors to escape restrictions on unfunded

benefit increases by allowing funding valuations to be made based on

pre-recession conditions. However faultless a sponsor with respect to

the broader financial market decline, it should not then take the further

irresponsible step of making further benefit promises that it cannot

fund.

5. Increase disclosure of funding information. Sunshine and transparency

are useful spurs to stronger pension funding. The 4010 submission

requirements should be expanded to provide pbgc with the informa-

tion necessary to gauge the likelihood of further financial hits on the

pension insurance system. This would also help to destigmatize those

plan sponsors who provide it. To prevent small employers from undue

burdens and to focus information on the largest potential threats facing

the pbgc, 4010 filing requirements should be based on aggregate plan

underfunding rather than on a funding percentage. This filing threshold

should be reestablished at a level low enough to enable pbgc to see at




26/93

26 Policy Review

least the majority of the underfunding in plans for which it is reason-

ably likely to become responsible.

Three frameworks for reform

Elected officials should choose between three basic options

for comprehensive reform of the employer-provided pension insur-

ance system.Option #1: Empower PBGC with the tools necessary to fill the shortfall

in the national pension insurance system. Ifpbgc is to remain financially

viable without taxpayer funds, it must be provided with the resources

required to close its funding shortfall. These must include enhancements of

its financial, legal, and organizational tools. Among them:

1. Premium income. An insurance system cannot survive if it cannot ade-

quately charge for the cost of insurance provided. The pbgc currently

lacks the authority to charge premiums that are sufficient to fund

anticipated claims. President Obama has recently proposed that pbgc

be given the authority to raise premiums as necessary to prevent a gov-

ernment-financed rescue. Different methods of doing so are available

that reflect different potential value choices. A higher flat-rate premi-

um for all participants would reflect a judgment that the cost of filling

the shortfall should be spread among the greatest number of plan

sponsors (including those with well-funded plans). Alternatively,

greater reliance on risk-based premiums would reflect a judgment that

Charles Blahous

table 2Three options for pension insurance reform

option #1Empower pbgc with the tools necessary to fill the shortfall in

the national pension insurance system.

option #2Eliminate pbgc and replace it with compulsory private

insurance that would charge market rates to participants.

option #3

Unless and until the federal government requires that pbgcs

financing risks be resolved via Options #1 or #2, treat the

shortfall for federal budgetary purposes as an obligation

facing U.S. taxpayers.


27/93

higher costs should be imposed on those sponsors who pose the great-

est risk to the insurance system. A truly risk-based premium would

provide greater incentives for full funding and should thus be a part of

any solution. At the same time, it is unlikely that weak sponsors ofunderfunded plans will themselves be able to provide sufficient addi-

tional revenue to fill pbgcs financing hole, necessitating an increase

as well in the flat premium paid by all plan sponsors.

2. Adequate funding rules. The law should be revised to undo recent

complexity creep and to once again provide all plan sponsors with

a single amortization schedule (with 100 percent funding as the ulti-

mate funding target). Under almost any scenario, future contributions

by plan sponsors will ultimately need to be much larger than theyhave been in the recent past. Interim funding relief should therefore

be limited only to that required to offset recent economic events, and

notaim to avoid the funding increases eventually required even under

more typical economic conditions. One way of implementing this

would be to adopt a single 2 + 7 policy for everyone (two years of

interest-only payments, followed by seven-year amortization). Under

this framework, Congress would also repeal the special discount rates

and amortization schedules for the airline industry, as well as othertargeted exceptions to the funding rules.

3. Strengthened legal tools for PBGC. pbgc cannot adequately protect

the pension insurance system with its current set of crude legal tools.

Bankruptcy code changes could be enacted to give pension plan con-

tributions the same status as wage payments, to move pbgc ahead in

line over other unsecured creditors. pbgc could also be given an

authority comparable to that of the fdic, to implement cease and

desist orders to prevent plan sponsors from taking actions injurious

to the health of the pension insurance system.

4. PBGC Independence. To fully empower pbgc to close its own fund-

ing shortfall Congress would clarify in law that pbgc is an indepen-

dent regulatory agency and no longer a part of the Department of

Labor. The current pbgc can never be wholly independent of White

House direction because of the constitutional unitary nature of the

federal executive branch. It could, nevertheless, wield a degree ofdefacto independence roughly comparable to that of the fic or

Securities Exchange Commission. The goal would be to free pbgc to

make determinations predicated exclusively on the health of the pen-

sion insurance system, without conscious subordination to the broad-

er economic policy objectives of the presidential administration.

In sum, the basics of the approach in Option #1 are to provide pbgc

with the necessary funding rules, premium income, legal tools, and organiza-




28/93

28 Policy Review

tional standing to address its own financing shortfall. If Congress is unwill-

ing to permit this within the present pbgc system, it will need to choose

between other alternatives.

Option #2: Eliminate PBGC and replace it with compulsory privateinsurance that would charge market rates to participants. Option #2 differs

from Option #1 primarily in the structure of the pension insurance system;

specifically, whether it is a compulsory system of private insurance or contin-

ues to be a government-chartered system. Certain core elements of reform

would be implemented in Option #2 as they would be in Option #1:

1. Premium reforms. Just as with a strengthened pbgc, a private insurer

would need to charge higher premiums than have been imposed to

date and would likely increase its reliance on risk-based premiums.

2. Adequate funding. In a private insurance system, adequate funding

would be facilitated not via government prescription but through the

general requirement that the new system be self-financing.

3. Strengthened legal tools. Whether public or private, a pension insurer

could be provided with stronger legal tools in bankruptcy proceedings,

such as a higher claim priority given to pension plan contributions.

4. Independence from other government departments. This would be

implicit in any private insurance model.

Choosing between Options #1 and #2 is therefore primarily a value judg-

ment as to whether the above reforms are more likely to occur within a gov-

ernment-chartered or a privately administered system. If the conclusion is

reached that persistent legislative tinkering will always prevent reforms

under the current pbgc structure, then the private insurance model must beconsidered as an alternative.

The premium structure for pension insurance is of particular relevance

when weighing whether to continue the pbgc or to transition to a private-

sector model. A private insurer would be expected to assess premiums based

in large part on its evaluation of risk, including sponsor default risk, under-

funding risk, and asset-liability mismatch risk, among other factors. The

public sector has generally shown an unwillingness to implement true risk-

based pricing.

An important policy specification for any private-sector successor to

pbgc involves whether it must not only sustain its future operations, but

also carry the burden of an inherited pbgc deficit of roughly $23 billion.

To require pension plan sponsors to make up this deficit is in effect to

require that their future pension insurance costs are $23 billion higher than

the value of the insurance itself. Some advocates of private pension insur-

ance have therefore proposed that taxpayers shoulder the cost of financing

the current pbgc deficit so that subsequent compulsory pension insurance

can be given a clean slate free of legacy debt.

Charles Blahous


29/93

Though pbgcs legacy debt is a thorny problem for any transition to pri-

vate insurance, it is important to understand that the problem is not unique

to the private insurance model. Whether pension insurance is publicly or pri-

vately offered, the same policy dilemma exists: namely, whether to requirepension plan sponsors alone to make up the pbgc shortfall, or whether to

pass the cost of that shortfall to general taxpayers.

The most practicable path for transition to a private-sector system might

be via a two-stage process: During the first stage, reforms would be imple-

mented to drastically curtail the size of the pbgc deficit. Only in the second

stage would a transition be effected to a private-sector framework.

Both stages of any such two-stage process would likely need to be estab-

lished in law from the outset to permit successfulconversion to a private-sector model. If, alternatively,

reforms succeeded in eliminating the pbgc deficit

withoutbeing an explicit component of a private-

sector transition plan, the fiscal improvement would

itself eliminate much of the political momentum

toward such conversion. Without establishing an

explicit two-stage process, it appears very unlikely

that such a transition would ultimately be facilitated.Option #3: Unless and until the federal govern-

ment requires that PBGCs financing risks be

resolved via Options #1 or #2, treat the shortfall for

federal budgetary purposes as an obligation facing

U.S. taxpayers. The policy objective underlying Options #1 and #2 is to

enable the pension insurance system to meet its obligations without an infu-

sion of taxpayer-provided revenue. If, however, policymakers are unwilling

both to require and to empower the pension insurance system to be self-sus-taining, there exists a substantial risk that taxpayers will ultimately be called

upon to resolve the shortfall.

There are a number of reasons why a taxpayer bailout of employer-pro-

vided pension insurance is an undesirable policy outcome. First and fore-

most, it would be inequitable. Approximately 21 percent of American

workers have been promised defined-benefit retirement income by their

employers meaning that the other 79 percent have not. To require these

taxpayers to bail out pension promises made by others employers is to

require the vast majority of taxpayers to subsidize a benefit that only a

minority is eligible to receive.

Beyond this, the mere potential for a taxpayer-financed bailout injects

additional moral hazard into a retirement income system already fraught

with it. Pension benefits represent a particular form of compensation

promised by an employer to an employee. To the extent that resources other

than employer funds are used to fulfill that promise, not only specific spon-

sors but employers as a class would be compensating their employees with

third-party (taxpayer) money.



There are many

reasons why a

taxpayer bailout

of employer-

provided pension

insurance is

undesirable.


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30 Policy Review

For general taxpayers to bail out private-sector defined-benefit promises

also renders it difficult to draw a clear line limiting potential taxpayer expo-

sure. If defined-benefit promises are to be made good by the federal govern-

ment, why should there not also be relief to workers who have only defined-contribution accounts severely weakened by the recent financial markets

plunge? Once the federal government goes down the road of assuming

responsibility for the retirement income promises made in private employ-

ment, there is no obvious limit at which the potential costs will be con-

tained.

Finally, the federal government is itself already in dire fiscal circum-

stances. Among other obligations, the federal government is responsible for

financing the benefits of its own Social Securityretirement program, currently projected to be insol-

vent over the long term. The deficit of pbgc is

smaller than the deficits in state and local public

plans or Social Security, and could theoretically be

financed more easily; it nevertheless lacks the direct

claim upon taxpayer resources that the Social

Security program has. Unless and until the federal

government has an effective plan for financing theobligations it has already taken on, it is not in a

position to be shouldering the retirement benefit

obligations of the private sector.

For these and other reasons, a taxpayer bailout of

pbgc should be regarded as a doomsday sce-

nario. If, however, policymakers decline to enable the pbgc pension insur-

ance system to be self-financing, they are creating a risk that this doomsday

scenario will come to pass. Policy Option #3 is to disclose the full amount ofthis risk to taxpayers for as long as it persists.

The procedures for bringing the costs of systems like pbgc onto the fed-

eral budget are not free of ambiguity; scorekeeping decisions of the

Congressional Budget Office and the Office of Management and Budget

sometimes diverge. To appropriately show the full extent of taxpayer expo-

sure to the obligations ofpbgc, the mission of budget scorekeepers would

be to assess a policy outcome in which taxpayers bear the risks of financing

benefit payment obligations. Any net negative cash flows projected would be

scored as a general revenue obligation facing U.S. taxpayers.

Merely reporting this information within federal budgetary documents

would likely be an inadequate public warning of the potential cost of a tax-

payer bailout ofpbgc. To secure the public attention required to deflect

momentum from a bailout, periodic separate reporting of the size of the

pbgc obligations facing taxpayers would likely need to be required, in a

manner similar to the annual reports of the Social Security and Medicare

Trustees. This could be required either ofcbo, the Office of Management

and Budget, the General Accounting Office, or ofpbgc itself.

Charles Blahous

No matter

which of the

preceding reform

models is

adopted, a

contributionfunding schedule

will be required.


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Any such reporting requirement should disclose not only the potential

cost to taxpayers but also the potential losses in worker benefits. Unless

pbgc s statutory cap on benefits is waived, even a taxpayer bailout

would not result in taxpayers making up the entirety of the pension fundingshortfall. The remainder of the gap would be resolved by the loss of all

worker benefits exceeding pbgcs statutory limit. Reporting these projected

worker benefit losses could add substantial cogency to these periodic

reports.

Scoring the potential cost of a taxpayer bailout would have the benefit of

deterring the use of pension funding relief as a budgetary offset for new fed-

eral spending. In the past, Congress has raised revenue by reducing

requirements for (tax-deductible) employer pension contributions, and hasused the revenue increases to finance its additional spending desires. This

practice could be deterred if an increase in the projected pbgc deficit was

simultaneously scored as a direct spending obligation facing taxpayers.

Questions that must be answered

The various tools provided to the pension insurer in Options#1 and #2 are designed to be sufficient to close its financing short-

fall. This, however, does not imply that it would be optimal policy

to require that the shortfall be made up immediately and all at once. Indeed,

to require this in the current economic environment could well be self-

defeating. It would require rapid increases in annual contributions to pen-

sion plans, indeed potentially quadrupling annual contribution levels at a

time when many employers are expected to struggle to recover from the

recent economic downturn.Accordingly, no matter which of the preceding reform models is adopted,

a contribution funding schedule will be required, and almost certainly one in

which employers near-term obligations are limited to levels substantially

lower than ultimately necessary. This inevitably means that there will be

some persistent risk of system insolvency, even after reforms are enacted,

before they are fully phased in.

If past history is any guide, however, legislators relative weighting of

near-term and long-term funding considerations will be far from optimal.

Long before the recent financial markets downturn, legislators repeatedly

valued near-term funding relief for employers above the long-term financing

health of the pension insurance system. Evidence of this exists in the repeat-

ed delivery of additional funding relief, including the provision of higher lia-

bility discount rates in 2002 and 2004 as well as the near-term funding

relief provided in the 2006 ppa itself. The further funding relief provided in2010 was simply a continuation of a longstanding trend of relieving previ-

ous law funding requirements whenever they begin to have a significant

effect on employer finances.




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32 Policy Review

There are two important considerations to bear in mind when reforming

pbgc to better make this judgment call: first, the difficult balancing act of

weighing employers near-term viability against the pension systems long-

term funding needs; second, the demonstrated habit of the political systemto subordinate long-term funding considerations to near-term exigencies.

Reforming the structure of the pbgc system would only address the second

of these considerations. It would not by itself provide answers to the first set

of considerations, which must be carefully handled even from the pension

insurers narrow perspective of self-interest.

These two sets of considerations are sometimes conflated in the public

discussion about pension funding requirements. It is often argued, for exam-

ple, that requiring employers to make significantly larger contributions totheir pension plans would be counterproductive, because doing so might

actually harm pbgc by triggering additional near-term plan terminations or,

alternatively, because doing so would interfere with employers abilities to

create jobs.

While these arguments can each sound similarly compelling to policy

maker

policy review - december 2011 & january 2012, no. 170

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