'Share the Risk and Share the Harvest': Commentary by Robert J. Shiller
"Share the Risk and Share the Harvest"
By Robert J. Shiller
Published March 20, 2011 in the New York Times
Read the article in its original context on the New York Times website.
Not so very long ago, most Americans lived on farms, with three generations under one roof: grandparents, parents, and children.
Farming was — and still is — a risky undertaking. Sometimes, you have good weather and abundant crops, sometimes bad weather and meager crops. How did our forebears manage their risks, which were as significant for them as the booms and busts of our 21st-century economy are to us?
In good times, all three generations consumed a lot. In bad times, all three consumed less. The risks were spread among the extended family. This is risk management at its most basic level. It is called sharing.
The farmers worked hard, and when they grew old, they were supported by the next generations. The elderly weren't treated differently. Everyone shared in the good and the bad, with adjustments for health and special needs.
Let's apply modern financial thinking to the old-time farm. Rather than sharing, families could set up traditional pension plans like the ones now established for state government employees. In this situation, the extended family would guarantee some of their working adults a fixed income when they retired. If farming families followed our thinking, they would pledge some set percentage of what people had consumed during their last three working years — say, 60 percent. These "payments" would be indexed to inflation, assuming that inflation was a concern in those days.
Down on the farm, however, they would probably laugh at this notion. That's because, when hard times come — as they always do — the children and working adults would have to cut back in order to pay the full "pensions" of the old. Younger generations would be hit with a double-whammy, having to make do with less themselves while having to sacrifice more to meet their contractual obligations to their elders.
In a sense, this is what is happening to us now, as the slack economy increases our tax burdens to support state pensioners. Working people in the private sector know this, and it is no surprise that some of them are upset. That is ultimately why they are pushing to drop traditional government pensions.
But wait. To make things even worse, standard modern finance has more to say. The conventional wisdom is that traditional government pension plans must be fully funded. That would be like assigning a part of the farm — a flock of sheep, say — to a pension trust fund that would then foot the bill for some of the farm's future retirees. Every time those sheep were sheared, the profits would accrue to the pension fund.
If the flock did not produce prosperity — if the price of sheep collapsed, for example — we would say that the farm's pension plan was underfunded. We would ask the children and all working adults to sacrifice more and buy more sheep for the fund.
That, too, is essentially what is happening today, as underwhelming investment returns on state pension funds are forcing governments either to raise taxes or to cut spending on things like schools and health services. During the financial crisis, the funds' investments soured along with the economy, so working people are dealing with the effects of tightened state budgets at a particularly difficult time.
Gov. Jerry Brown of California referred to these inequities in his State of the State message in January. "We must also face the long-term challenge," he said, "of ensuring that our public pensions are fair to both taxpayers and workers alike."
Economic theorists disagree about whether public pension funds should be fully funded, or even funded at all. The economic issues turn out to be surprisingly complicated.
Henning Bohn, an economist at the University of California, Santa Barbara, examined this issue in a recent research paper, using a mathematical version of the three generations on the farm. He concluded that we should not fully fund pensions. He pointed out that raising taxes to support pension funds punishes young working people, who are typically in debt with mortgages and credit cards. These workers usually pay higher interest rates on their debts than the return that the state government can earn on pension fund investments.
So what is the alternative?
One idea that has gained momentum is to replace traditional pension funds with plans akin to 401(k)s. In 401(k)-style plans, no one would be guaranteed a particular income upon retirement. The government would merely contribute to retirement accounts, and state workers would choose how that money was invested — and live with the consequences.
On the old-time farm, some people might choose to invest their retirement money in sheep, others in the vegetable garden, and still others in the cornfield. Their future welfare would depend on how those investments panned out.
But traditional farming families would probably laugh at this, too. What if the sheep died? What would happen to elderly family members who had invested so much in them?
The trouble with the debate over what to do about our strained public pension systems is that so much of it is veiled in abstract, financial terms. The best solution might be the old-fashioned one: sharing, with some adjustments in our modern defined-benefits system. Yes, making the transition would not be easy. We would have to respect promises that have been made to today's retirees.
But, basically, we can keep traditional pensions by changing how we compute them. We should use a formula so that guaranteed future income in retirement bears a fixed relationship to a state's future ability to pay — as measured, for example, by that state's economic output.
It is that simple: Just scrap the current indexing of pensions to the Consumer Price Index and replace it with a link to the state's gross domestic product.
We can't accurately fund traditional pension plans until we have G.D.P.-linked bonds, or "trills," which I described in a recent column. But it is time to start the transition, so that pensions share risks across generations.
Robert J. Shiller is professor of economics and finance at Yale and co-founder and chief economist of MacroMarkets LLC.