Stromata Blog

The Future of the ESG Bubble

The Wall Street Journal has published a symposium of ten brief essays addressing the question, “Where Will ESG Investing Be in Five Years?” The authors are split between academics specializing in finance and various sorts of investment professionals. They express, as the symposium’s subtitle notes, “some very different views”.

Two of the contributors caught my eye, because they are well known figures in the pension commentariat: Olivia S. Mitchell, a Wharton School professor and director of the Pension Research Council, and Alicia H. Munnell, Peter F. Drucker professor of management sciences at the Carroll School of Management (Boston College) and director of the Center for Retirement Research. Both, I’ll note at the outset, are political liberals, but “everyone is conservative about what he [she in this instance] knows best”.

Professor Munnell is the more emphatic:

Where will ESG investing be in five years? Dead, I hope.

In my view, ESG funds are a marketing ploy by financial-services firms to repackage actively managed investments – which were becoming increasingly less appealing – in a trendy wrapper. They are expensive and accomplish nothing. And they divert people’s attention from the hard work that needs to be done.

Proponents argue that integrating ESG factors into existing methods of financial analysis allows investors to reduce risk and earn higher returns, while supporting socially beneficial practices and outcomes. But it isn’t clear that ESG money is even reaching the right targets. The Securities and Exchange Commission has started to crack down on greenwashing – the claim that investments will save the world with little evidence to support it.

An even more pernicious aspect of social investing through ESG funds is that it allows people to think that they’re really solving an important world problem when, in fact, they are doing nothing. It’s delusional to think that business can lead the way on fighting climate change or racism. The only people gaining from ESG investments are financial-services firms that monitor corporate promises in exchange for higher fees.

Professor Mitchell, without calling for ESG’s demise, says that the growth of ESG investment faces “several big obstacles” and is “skeptical” that they can be overcome. The obstacles include:

• the lack of any “coherent and unique definition of what ESG involves, making it impossible for investment professionals as well as everyday investors to identify whether these approaches are actually being carried out”;
• the consequent inability “to show that ESG helps (or hurts) invest performance”;
• the general absence of any correlation of “ESG ratings developed by corporate ratings firms . . . with each other or with firm performance”; and
• the very high expense ratios of ESG funds.

I have provided links to supporting studies cited by Professor Mitchell under “Further Reading”. She concludes by drawing attention to what seems to me to be one of the glaring weaknesses of ESG: that it puts three very different eggs into a single basket.

A better system would delink the environmental, the sustainable and the governance criteria, require disclosure of firms’ policies along each dimension, and require them to lay out their efforts to change.

The ESG-positive contributors don’t all ignore the murkiness of the concept. Some of them want more clarity, but for a reason that suggests a fundamental misunderstanding of the difference between investments and political contributions. Derek Tharp, a professor of finance and, perhaps more pertinently, founder of a wealth management firm, writes:

A major limitation of ESG funds is that it is hard to find a fund that perfectly aligns with one’s own values. Even two individuals who agree on the broader focus of a fund – say, protecting the environment – may still disagree on the best way to implement that. Nuclear energy is a popular example that splits environmental advocates. There is no neutral resolution to this divide, so a fund will inevitably need to take a stance on how to handle nuclear energy within the portfolio – and that will inevitably leave some potential investors in disagreement with the fund’s stance.

We may wish that companies of whose goods and services we approve will prosper, but that doesn’t mean that they will. If all users of word processing software or Internet browsers shared my own preferences, WordPerfect and Opera would dominate their markets, and Mr. Gates’s toy products would occupy minor niches, but my velleities would be a poor guide to increasing the value of my portfolio.

A final note: It’s striking that in these essays, the academics for the most part write clearly, while the investment professionals churn out jargon-heavy word salads, such as this from “Manisha Thakor, founder of financial well-being consultancy MoneyZen”:

I see ESG investing growing in effectiveness as it becomes knitted into the fabric of the global business ecosystem. At the board-of-directors level, ESG will become a clearly delineated component of existing subcommittees or a distinct subcommittee on its own. Institutional analysts and portfolio managers, irrespective of investment strategy and asset class, will discuss why they do, or don’t, incorporate ESG factors into their portfolio-construction process in the same manner as discussing whether they focus on P/E ratios and debt ratings. Institutional clients such as pensions, endowments, foundations and their consultants will consider their stance on ESG to be as vital a component of their investment-policy statements as asset allocation.

If your financial advisor starts talking to you like that, you’re probably better off with meme stocks and RobinHood.

Further Reading: David F. Larcker, Brian Tayan and Edward M. Watts, “Seven Myths of ESG”
Florian Berg, Julian F Kölbel, Anna Pavlova and Roberto Rigobon, “ESG Confusion and Stock Returns: Tackling the Problem of Noise”
Rebecca Moore, “Morningstar Finds ESG Funds Are More Expensive Than Conventional Funds”
Matt Wirz, “Green Junk Bonds May Not Deliver Green Results”

BBB: Collateral Damage to Pensions

Among its many other dubious features, the Biden Administration’s “BBB” (“Build Back Bankrupt”) bill (a/k/a “budget reconciliation”) would add to U.S. tax law a new corporate minimum tax based on book income rather than taxable income. While the new tax would affect only companies with profits over a billion dollars a year, that is a significant segment of the American economy. The Tax Foundation calls it “the most economically damaging provision in the bill”. According to the Foundation’s modeling (to be taken with the same quantity of salt as all other economic modeling), it will reduce GDP by 0.1 percent and employment by 25,000 jobs. The Brandonites probably aren’t bothered by that “minor” impact on the proles. The detriment is not, however, spread evenly, and one big loser will be pension plans.

The American Benefits Council has released a paper describing how a tax on book income will affect pension funding. I’ll try to provide a non-technical explanation. (My entire professional career has been spent in the field of pension law, but yours probably hasn’t.)

At present, tax law and generally accepted accounting principles treat defined benefit pension plans very differently. The Internal Revenue Code allows employers to deduct their contributions (subject to liberal deduction limits and stringent minimum contribution requirements), and income earned by the plans is exempt from tax (with nugatory exceptions). Once made, contributions effectively leave the employer’s control. If a plan accumulates more money than is needed to provide accrued benefits, the employer can recover the surplus only by paying an excise tax that can be as high as 50 percent of the amount recovered.

GAAP takes a different approach. The plan’s finances are combined with the employer’s. Plan assets, liabilities and income appear on the company’s balance sheet and earnings statement. Income that the plan earns thereby is aggregated with corporate income and will be subject to the minimum tax. Contributions have no effect on GAAP incoem at all. They are viewed as money taken from one employer pocket and put into another.

The net effect of a tax on book income would be to turn pension plans into taxpayers. In the remote past, when pensions were in their infancy, that was how they were treated for tax purposes. As a consequence, employers didn’t fund their pension promises. The current system was set up to neutralize the tax effects of funded plans. Minimum required contributions weren’t added until the Employee Retirement Income Security Act of 1974, by which time funding pensions was a familiar and accepted concept.

The new minimum tax can’t help but discourage companies from contributing to their plans. They must, of course, comply with the minimum funding requirements. The Pension Protection Act of 2006 stiffened those requirements markedly, but Congress has since then backed away, most recently in the just-passed infrastructure bill. A return to the era when pension funding was a tax detriment won’t arrest that trend.

One likely effect will be accelerated migration of retirement plans from defined benefit to individual account format. Individual account plans, such as 401(k) plans, won’t be affected by the change in their sponsors’ tax treatment. Ironically, the conventional wisdom among the left-of-center pension community is that defined benefit plans are preferable to individual account plans, because the latter shift investment risk from employers to employees and don’t ensure that retirees won’t outlive their income. That position isn’t unreasonable, even if it can be carried to the point of unreasonable hostility toward individual accounts. There’s a broad consensus that defined benefit pension plans play a valuable role and ought not to be legislated into oblivion.

Doubtless, BBB will wreak much other collateral damage in areas that I know little about. Rarely has so little serious thought gone into so monumental a statute.

Way to Go, Brandon!

The Democratic Party grifters who send me half a dozen or so e-mails a day declaring that if I will just send them money, Donald Trump will go to prison and Anthony Fauci will be canonized yesterday sent one with the subject header, “Biggest Social Security increase in DECADES!”

President Biden has long called Social Security benefits “the bedrock of American retirement,” and now, recipients are poised to get the biggest cost-of-living increase in DECADES!

True enough, and Joe Biden deserves 100 percent of the “credit”. The 5.9 percent increase for 2022 is the largest since 1982, and the high rate of inflation that generated it is one of the earliest of what will be many economic disasters of the Biden Administration.

Inflation is, of course, a particularly severe detriment to the elderly, a great many of whom derive most of their retirement income from sources that don’t enjoy cost-of-living adjustments. That Democratic propagandists are celebrating inflation’s resurgence gives one an idea of how much they really care about Social Security recipients.

Today’s Acronyms: ESG and ERISA

The statute to which I’ve devoted almost all of my legal career – the Employee Retirement Income Security Act of 1974 (“ERISA”) – gets only intermittent (and usually only modestly accurate) attention from the media. A new burst occurred on October 14th, when the Department of Labor published a proposed regulation designed to prod investment managers of employer-sponsored retirement plans to give greater consideration to “the economic effects of climate change and other environmental, social, or governance factors on the particular investment or investment course of action”.

The proposed regulation is the latest volley in a back-and-forth that began in 1994, when the Clinton Administration published an “interpretive bulletin” (a document included in the Code of Federal Regulations but of considerably lower status than a real regulation) designed to dispel “a perception [that] exists within the investment community that investments in ETIs are incompatible with ERISA’s fiduciary obligations”. “ETI” was the acronym for “economically targeted investment”, which the bulletin described as “an investment that is selected for the economic benefit it creates, in addition to the investment return to the employee benefit plan investor”. This was the predecessor to the wider-ranging acronym that enjoys favor today: “ESG” for “environmental, social and governance” factors.

The (W.) Bush Administration revoked the Clinton interpretive bulletin, replacing it with one declaring that “ERISA’s plain text thus establishes a clear rule that in the course of discharging their duties, fiduciaries may never subordinate the economic interests of the plan to unrelated objectives, and may not select investments on the basis of any factor outside the economic interest of the plan except in very limited circumstances”. The Obama Administration revoked the revocation and reinstated the Clinton bulletin verbatim.

The Trump Administration sought to put its own reversal of its predecessor’s position on firmer ground by promulgating an actual regulation, whose philosophy is summarized by the statement, “A fiduciary may not subordinate the interests of the participants and beneficiaries in their retirement income or financial benefits under the plan to other objectives, and may not sacrifice investment return or take on additional investment risk to promote non-pecuniary benefits or goals.” 29 C.F.R. §2550.404a-1(c)(1).

The Biden Administration’s proposed amendment to the regulation doesn’t overturn that principle. Rather, it amounts to an op-ed in the guise of regulatory text. The current regulation states that investment managers must consider “The projected return of the portfolio relative to the funding objectives of the plan”. The proposed amendment adds, “which may often require an evaluation of the economic effects of climate change and other environmental, social, or governance factors on the particular investment or investment course of action”.

Similar editorializing shows up in a paragraph that begins innocuously: “A prudent fiduciary may consider any factor in the evaluation of an investment or investment course of action that, depending on the facts and circumstances, is material to the risk-return analysis, which might include, for example”, followed by a list heavily weighted toward “woke” favorites like “exposure to the physical and transitional risks of climate change”, “the positive or negative effect of Government regulations and policies to mitigate climate change”, “board composition”, and “progress on workforce diversity, inclusion, and other drivers of employee hiring, promotion, and retention”.

There isn’t a word in the proposed amendment that puts a fiduciary who wants to make climate stasis or racial discrimination (to call things by their correct names) a key investment criterion in any better position than under the current regulation. What’s more, notwithstanding a quarter century of abrupt volte-faces in official guidance, no reported decision in any case involving ERISA fiduciary duties has turned on, or so much as discussed, plan fiduciaries’ attention or inattention to “environmental, social and governance” factors.

Why, then, are the progressives who now control policymaking at the Department of Labor eager to insert ineffectual pro-ESG propaganda into the regulations? To grasp that, one must look at what the ESG movement is in practice.

ESG advocates don’t call for granular consideration of each of the variety of practices that fall under the headings “environmental”, “social” and “governance”. No one disputes that some of those are of vital importance to some companies. No rational being would evaluate investment in a coal company without taking into account government hostility to the industry (and without also taking into account, one might add, that coal is one of the world’s most efficient and abundant energy sources, a fact that can frustrate governments’ hostile plans). On the other hand, it is doubtful that a coal company with a minuscule proportion of female miners could become more profitable by hiring a sexually balanced work force.

What ESG analysis typically does is aggregate all kinds of disparate practices to produce ratings whose objective is to influence investment decisions. As the DOL noted in the preamble to the proposed version of the Trump regulation, there has been “a steady upward trend in use of the term ESG among institutional asset managers, an increase in the array of ESG-focused investment vehicles available, a proliferation of ESG metrics, services, and ratings offered by third-party service providers, and an increase in asset flows into ESG funds”. To the best of my knowledge, none of the “ESG metrics, services, and ratings” weights its factors by their importance to the individual companies under review. A high or low rating can flow from elements that are of no consequence for the bottom line.

As a further complication, “There is no consensus about what constitutes a genuine ESG investment, and ESG rating systems are often vague and inconsistent, despite featuring prominently in marketing efforts” – another point that the Trump DOL made in the preamble to its proposed regulation. In other words, there’s no way to be confident that an “ESG rating” genuinely rates ESG performance.

ESG evaluations are an expensive exercise. The evaluators must assemble data that don’t appear in financial statements and that can’t be easily acquired from other sources. Once acquired, the data must be updated regularly to watch for significant changes. Somebody must pay for those exertions, and that cost is inevitably passed on to the users of the evaluations. As the Wall Street Journal observes, “According to Morningstar, the asset-weighted average expense ratio of U.S. ‘sustainable’ funds was 0.61% in 2020 compared to 0.41% for all open-ended mutual and exchange-traded funds and 0.12% for passive funds.”

As already noted, ESG has been a non-factor in ERISA litigation to date, but that could change if it continues to make inroads among investment decision makers. Both the dubious linkage of ESG ratings to factors pertinent to particular companies’ performance and the high cost of producing those ratings raise ERISA red flags, and plaintiffs throw red flags with increasing frequency these days. Lawsuits alleging that plans acquiesce in excessive fees for inferior performance have become commonplace over the past several years. One of them, Hughes v. Northwestern University, is on next term’s Supreme Court docket. (It has no ESG angle; the Court will consider pleading standards for complaints that charge plan fiduciaries with allowing the payment of excessive investment fees.)

The Biden Administration wants to encourage greater use of ESG. ERISA-governed retirement plans are one of the world’s largest sources of investment capital. Unhappily for the ESG battalion, ERISA isn’t particularly favorable to the concept, nor does its categorical language leave room for an “ESG exception” to plan fiduciaries’ duties to participants.

For want of a better alternative, the Biden regulators have resorted to erecting a cardboard façade. Their proposed regulation implies that letting ESG factors influence investments is a great idea but doesn’t succeed in turning it into an idea that can be lawfully pursued. The reaction of the trade press, which has overwhelmingly reported the proposed regulation as a retraction of restrictions on ESG investing (restrictions attributed to the Trump Administration in 2020 rather than the Congress that enacted ERISA in 1974), suggests that the façade can withstand minimal poking by reporters who have trouble spelling “ERISA”.

Judges will be a bigger challenge. The proposed regulation doesn’t approve evaluating an investment on the basis of an aggregated rating that includes factors that both do and do not have a bearing on performance. Nor does it authorize paying fees for advice of dubious value. We’re probably a few years away, though, from the first ERISA ESG case. Until it arises, the purveyors of ESG ratings – I’ll take wild guesses that many of them make substantial campaign contributions and that little of that money goes to Republican candidates (well, maybe to Liz Cheney) – have received a boost to their industry.

Is This Cramdown Necessary?

Finding contradictions in the Obama Administration is about as shocking as finding gambling at Rick’s Café, but here is a point that I haven’t seen elsewhere.

The Administration is working hard to put 40 percent of General Motors and 55 percent of Chrysler into the hands of trust funds to provide medical benefits to retirees. As has been widely noted, these trusts will be effectively controlled by the United Auto Workers union, which will appoint half the trustees. The other half will ostensibly be “independent”. It will be an immense surprise if most or all of them don’t see eye-to-eye with the UAW, and just one will be enough to give the union appointees a majority, by the exercise of which they will be able, as a practical matter, to direct the management of both companies.

These trusts were set up some time ago in an effort to cap the auto companies’ open-ended obligation to pay for gold-plated health insurance for retired union members. The deal was that GM, Chrysler and Ford would each contribute several billion dollars but after that would have to put in nothing more. The trustees would then attempt to match benefits to the available assets.

President Obama wants to keep as much of this arrangement intact as possible, to the detriment of creditors who would ordinarily rank higher. Well, he feels empathy for elderly auto workers, I suppose, but is this cavalier attitude toward creditors’ rights necessary? The President, as he frequently tells us, intends to enact fundamental reforms that will make health care cheaper, better and more abundant. His party has the votes to muscle his program through Congress. Why, then, can’t the funding of the GM and Chrysler trusts be cut back or eliminated altogether? Is the problem that they’re designed to address so pressing that it justifies stiffing individuals and institutions that lent to the companies in good faith reliance on the legal position previously accorded to secured creditors?

There are some obvious possibilities: The President is blindly loyal to organized labor, regardless of the merits of its demands. Or he has little confidence in his own health care ideas. Or he viscerally dislikes the “creditor class”. Or perhaps a bit of all three. If anyone has a more plausible explanation, I’d be happy to hear it.

How Much Fixing Can 401(k)’s Take?

Saturday’s Wall Street Journal worries about how to “fix” 401(k) plans. The article discusses two distinct, widely disparate problems. One is that financial markets go up and down, so that someone who puts money into a 401(k) account runs the risk that his savings will decline in value. That is, of course, the point that a sophisticated grasshopper would have made to the ant. It’s an argument for making retirement income the responsibility of each generation’s offspring, with private thrift no more than a way to acquire luxuries. (In the Jiminy Cricket version of the fable, the grasshopper sings, “The world owes me a living”, demonstrating that he understands the implications of his own philosophy.)

The second problem (one that ought not to trouble those who regard the first as intractable, but who says pundits have to be consistent?) is that many individuals either can’t or don’t accumulate much through the 401(k) route. They may not be employed, or their employers may not sponsor plans, or they may not be attracted by the 401(k) tax incentives, or they may dissipate their accounts for short-term needs before retirement.

Evaluating the success or failure of section 401(k) (along with its various cousins: IRA’s, 403(b)’s, 457(b)’s, SIMPLE’s and SARSEP’s – how they differ is part of my professional life but needn’t interest you) should begin by taking an accurate view of their role in the provision of retirement income. While it isn’t literally inaccurate to call 401(k)’s “the backbone of the nation’s private retirement savings system”, for most workers they are less important than Social Security, and that importance declines with income. For low earners, Social Security replaces a majority of preretirement income. For example, a worker whose wages are consistently about half the national average can retire with a Social Security pension nominally equal to around 55 percent of his prior income; its actual value is greater, because it is (for a taxpayer with little other income) exempt from income and FICA taxes. Not much support from other sources is needed to boost these folks’ tax-adjusted income replacement ratios to the roughly 80 percent level that financial advisors typically recommend. A modest employer-provided pension or a relatively small nest egg will fill the gap.

Supplementing Social Security grows more essential as one’s income rises. While the low earner starts retirement over two-thirds of the way to the 80 percent threshold, somebody who has always had earnings equal to the FICA taxable wage base ($102,000 in 2008) would retire this year with a Social Security benefit of only about $27,000 a year. If he is to live at all comfortably in retirement, he will have to find twice that amount elsewhere.

Retirement income is, then, a middle class (and even upper class) issue. That tax incentives for saving are skewed toward the more affluent should occasion no shock; that is where incentives are needed. Looked at another way, the government provides well (wisely is a separate question) for the retirement of the bottom half of wage scale. No one expects (or should want) it to do the same for others. On the other hand, it ought not to tax away their efforts to help themselves.

Nonetheless, the remedies suggested by the experts whom the WSJ’s reporter consulted – an expanded savers’ tax credit, automatic enrollment in 401(k) plans, automatic employer contributions to IRA’s, etc. – will do the most where the need is least.

The Bush Administration – remember them? – tried to tackle this problem six years ago with a proposal for a three-tiered set of tax-favored savings accounts. One tier would have been a mildly modified version of the present 401(k) plan (relabeled “employer retirement savings accounts”). The others were called “lifetime savings accounts” and “retirement savings accounts”. LSA’s and RSA’s would not have been linked to employment. Anyone could contribute up to a maximum of one-half the 401(k) limit to each. Updated to reflect the 2009 limitations for 401(k) plans, the maximums would be $8,250 for an LSA, $8,250 for an RSA and $16,500 for an ERSA ($22,000 at age 50 and older).

The difference between LSA’s and RSA’s is that withdrawals from the former would have been permitted at any time for any reason, while RSA withdrawals before age 58, death or disability would have been penalized. The theory was that the existing penalties for premature withdrawals discourage contributions. Under the proposal, even the least provident would have a strong incentive to hold all but their shortest term savings in LSA’s, where they would earn tax-free income.

These concepts deserve revival. My own notion would be somewhat more expansive: Decouple 401(k) plans and similar vehicles completely from an individual’s employer, replacing them with LSA’s and RSA’s. I would set the LSA contribution limit at $10,000 a year, the RSA limit at $40,000. Employers could continue to make nonelective contributions to profit sharing plans (and, of course, to sponsor defined benefit plans), while employees’ elective contributions would move to these new vehicles. To overcome inertia, five percent of employees’ wages would be remitted automatically to LSA’s (from which they could be immediately withdrawn, so no one would be compelled to save). To minimize the short-term impact on government revenues, taxation would follow the Roth pattern of nondeductible contributions and tax-free withdrawals. The present value of the taxes is the same, whether they are collected on the front or the back end.

Many liberals have never liked section 401(k) and its cousins. In line with the maxim of never letting a crisis go to waste, they may see the budding recession as an opportunity to cast these disagreeable vehicles out in favor of something like Teresa Ghilarducci’s scheme for converting 401(k) plans into forced loans to the government.

Unhappily, no one has yet figured out how to remove risk from investing without also eliminating reward. I’m surprised, and mildly appalled, that Alicia Munnell, who certainly knows better, can declare, “As a major source of retirement income, [the 401(k) system) has shown itself unreliable – a point the financial crisis has driven home”. Saving for retirement is properly a project for one’s full working lifetime, a period of 35 years or longer. Those savings are then typically drawn down over 25 or 30 years. Over intervals of those lengths, bull and bear markets are of trifling importance. The great danger is long-term stagnation brought on by foolish government policies, and that is a danger that no retirement system, except for Anthony Trollope’s Fixed Period, can overcome.

Turning 401(k)’s into Forced Loans

Expecting to be able to enact whatever they want next year, Congressional Democrats are already looking for ideas. One that hasn’t gotten the attention it deserves harks back to the progressive era of the Tudors and Stuarts. In those days, monarchs frustrated by Parliament’s reluctance to approve new taxes frequently resorted to borrowing from their subjects, without giving the lenders the opportunity to decline. A modernized version of that tactic has now drawn favorable attention from top House Democrats, who have floated the notion of repealing section 401(k) and, as a replacement retirement vehicle, forcing workers to buy government bonds. Some details [link may require free registration]:

House Education and Labor Committee Chairman George Miller, D-California, and Rep. Jim McDermott, D-Washington, chairman of the House Ways and Means Committee’s Subcommittee on Income Security and Family Support, are looking at redirecting those tax breaks to a new system of guaranteed retirement accounts to which all workers would be obliged to contribute.

A plan by Teresa Ghilarducci, professor of economic-policy analysis at the New School for Social Research in New York, contains elements that are being considered. She testified last week before Miller’s Education and Labor Committee on her proposal. . . .

Under Ghilarducci’s plan, all workers would receive a $600 annual inflation-adjusted subsidy from the U.S. government but would be required to invest 5 percent of their pay into a guaranteed retirement account administered by the Social Security Administration. The money in turn would be invested in special government bonds that would pay 3 percent a year, adjusted for inflation.

The current system of providing tax breaks on 401(k) contributions and earnings would be eliminated. . . .

“I want to spend our nation’s dollars for retirement security better. Everybody would now be covered” if the plan were adopted, Ghilarducci said.

She has been in contact with Miller and McDermott about her plan, and they are interested in pursuing it, she said.

“This [plan] certainly is intriguing,” said Mike DeCesare, press secretary for McDermott.

“That is part of the discussion,” he said.

While Miller stopped short of calling for Ghilarducci’s plan at the hearing last week, he was clearly against continuing tax breaks as they currently exist.

The Ghilarducci scheme wouldn’t, however, “spend our nation’s dollars for retirement security”. For private assets it would substitute an unfunded government promise. Uncle Sam’s cash flow would increase by five percent of the nation’s aggregate payroll (a de facto tax of the same species as FICA), money that would then be available to subsidize Barack Obama’s massive spending programs.

Someday the bonds would come due. Then the Treasury would have to find cash to redeem them, by raising taxes, cutting other spending programs, borrowing from somebody else or, in a pinch, changing the terms of the loan. The end result will be reduced private savings, increased dependence on the government and heightened insecurity among the elderly. Of course, for many on the Left, those are the proposal’s virtues.

Another Schultz-Francis Pension Deception

As regular readers of the Wall Street Journal know, the paper’s conservative editorial page is more than balanced by its left-wing newsroom, and the furthest left corner of that newsroom is occupied by Ellen Schultz and Theo Francis, a duo whose only visible activity is penning screechy op-eds about pension matters under the guise of “news”. Monday brought a typical mixture of ignorance and deception under the title, “Companies Tap Pension Plans To Fund Executive Benefits”. The lead is typical Schultz-Francis bombast:

At a time when scores of companies are freezing pensions for their workers, some are quietly converting their pension plans into resources to finance their executives’ retirement benefits and pay.

In recent years, companies from Intel Corp. to CenturyTel Inc. collectively have moved hundreds of millions of dollars of obligations for executive benefits into rank-and-file pension plans. This lets companies capture tax breaks intended for pensions of regular workers and use them to pay for executives’ supplemental benefits and compensation.

The practice has drawn scant notice. A close examination by The Wall Street Journal shows how it works and reveals that the maneuver, besides being a dubious use of tax law, risks harming regular workers. It can drain assets from pension plans and make them more likely to fail. Now, with the current bear market in stocks weakening many pension plans, this practice could put more in jeopardy.

A layman who reads to the end of the article will never quite learn how the “maneuver” works, so here is an explanation:

Tax-qualified pension plans are forbidden to provide benefits that “discriminate” in favor of “highly compensated employees” (approximately, those who earn over $100,000 a year). The IRS has prescribed rules for evaluating discrimination, which have grown more rigorous and limiting over the years. By these standards, the benefit formulas of most large corporate plans are not merely free of the taint of prohibited discrimination, but affirmatively discriminate in favor of lower paid employees. It is this fact that makes it possible to move “obligations for executive benefits into rank-and-file pension plans”.

Qualified plans are a minor part of the retirement packages of top executives at big firms. At most, a qualified defined benefit pension plan can provide the equivalent of about a $2,000,000 lump sum at age 62 – not peanuts but not what a Fortune 500 CEO counts on for his golden years. Hence, there is, or has been in the past, little incentive to utilize qualified plans fully, and “reverse discrimination” in benefits has been the upshot.

Various developments, particularly changes in accounting rules, have altered that calculus. Liabilities for executive retirement benefits are now less onerous if they are funded, and the only practicable way to fund them is via qualified plans. A secondary factor, which will become more important as tightened funding standards generate pension assets in excess of liabilities, is that surpluses are effectively locked into the plan, recoverable by the employer only at the cost of severe tax penalties. Shifting nonqualified benefits to a company’s qualified plan is one way to utilize part of a surplus.

All that a shift involves is calculating how much higher executives’ benefits would be if they had, all along, been as large as possible without violating the nondiscrimination standards. They are then increased to that extent, and nonqualified benefits are correspondingly cut back. (Executive retirement plans usually provide for an automatic offset for anything received from qualified plans. If they don’t, the shift won’t work.) Sometimes benefits have to be increased for some lower level employees in order to accommodate all of the executive increases that are desired. Schultz-Francis seem to regard that as a bad thing.

They also insinuate that this process takes place in the dark of the night, without any checking to see whether the enhanced benefits actually comply with the nondiscrimination rules:

Companies don’t explicitly tell the IRS that an amendment is intended to shift supplements executive benefits obligations into the regular pension plan. “They hide it,” a Treasury official said. “They include the amendment with other amendments, and don’t make it obvious.”

With too little staffing to check the dozens of pages of actuaries’ calculations, the IRS generally accepts the companies’ assurances that their pension plans pass the discrimination tests, the official said.

Having a lot of experience in this area, I can state bluntly that either Schultz-Francis or their anonymous source is lying. An IRS determination letter covers nondiscrimination issues only if the plan sponsor specifically requests a ruling concerning them, so there is no way to “hide” what is being done. Nor, in my experience, do IRS agents passively accept employer assertions. There may indeed be “dozens of pages of actuaries’ calculations” attached to the submission, but there must also be a clear explanation of how the actuarial methodology fits within the regulations. There are some hyper-aggressive practitioners, but their schemes don’t sail through without resistance. In any event, there is plenty of room in most plans for benefit increases that comply with the most cautious interpretation of the law.

What about the claims that increasing benefits for executives “risks harming regular workers” and “can drain assets from pension plans and make them more likely to fail”? A pension plan can’t “fail”, for practical purposes, unless its sponsor goes into bankruptcy (an eventuality that the reduction in nonqualified benefit liabilities makes modestly less likely). If that happens, then, as the article itself notes, executives’ benefits above a fairly low threshold ($51,750 a year in 2008 for participants who retire at age 65) have last claim on the plan’s assets, behind the “regular workers”, who get exactly the same pensions as if the shift had never taken place.

Shifting liabilities from nonqualified to qualified plans is, on the whole, beneficial to stockholders and thus to employees, whose jobs ultimately depend on their employer’s fortunes. Naturally, we shouldn’t be surprised that Miss Schultz and Mr. Francis, more or less overt socialists, don’t like it.

The PBGC and the Stock Market: Moral Hazard or Socialism or Both?

In an attempt to ameliorate its financial strains, the Pension Benefit Guaranty Corporation recently announced a major change in its investment strategy. In place of the fixed income securities that have dominated its portfolio since its inception, it will now invest up to 55% of the assets received from terminated plans in stocks. Total stockholdings could reach $30 billion under this policy.

The motive is obvious: The single-employer insurance fund needs much higher returns if it is to have any hope of overcoming a $14 billion deficit. The PBGC is also confident that adding equities to its investment mix reduces its long-run risk “in the 99th percentile worst-case scenario”.

Investment professionals can argue about whether this benign risk-reward tradeoff is reality or illusion. Today’s Wall Street Journal takes exception on more fundamental grounds:

Risk-taking is the mother’s milk of capitalism. But private sector risk-taking with public sector backing can be a recipe for trouble. Which is why news that the Pension Benefit Guaranty Corporation will diversify its portfolio to include more equities ought to concern taxpayers. . . .

The editorial highlights two issues. First, the PBGC has “an implicit claim on tax dollars” despite the absence of any explicit federal guarantee. The government thus has an incentive to prop up corporations in which the PBGC has significant holdings, lest investment losses prompt an overt bail-out of the insurance fund. If, for instance, the fund had held a couple of hundred million dollars of Bear Stearns stock last week, might not the Fed have taken a tenderer view of the interests of Bear shareholders? At the very least, it would have had a nagging worry in addition to the overall health of the credit markets.

Second,

There’s also the problem of the government owning significant portions of the private sector. At one point a few years back, PBGC had 25% of United, 15% of Delta and 15% of Kaiser Aluminum. The last thing Americans should want is government owning huge chunks of corporate America, because with ownership eventually comes control.

President Clinton once proposed that the U.S. Treasury begin investing its then surpluses in stocks in order to provide hard assets to back up Social Security. Fear of the de facto nationalization of major companies was one of the factors that short circuited that idea. (It had other flaws, too.) The PBGC is admittedly a pigmy compared to the budget surpluses of the late 1990’s, but $30 billion isn’t insubstantial, and there would inevitably be pressure to deploy it for politically defined “good” ends.

The Journal’s conclusion is that putting the PBGC on a sound footing requires looking in a different direction entirely.

We realize Mr. Millard is in a tight spot and his options are limited. The most prudent way to fix what’s wrong with PBGC, aside from getting rid of it, would be for the agency to promise less or collect more – that is, reduce the amount of the pension guarantee or charge higher premiums that bear some relation to actual risk.

But enacting those changes requires Congressional action, and lawmakers – no surprise – have typically refused to properly fund the agency or to demand higher premiums from the companies that are insured.

It wouldn’t have been unfair to have added that the PBGC bears some responsibility for its unsatisfactory premium income. In the mid-1980’s, acting on a Grace Commission recommendation, it accelerated premium collections by establishing a system of estimated payments. That was an unpopular step with employers and has over the years mostly fallen into abeyance. Under the latest regulations, plans don’t have to pay most premiums until 9½ months after the beginning of each coverage period. The due date for plans with fewer than 100 participants is later yet: 16 months after the start of the year. The upshot is, of course, a great deal of forgone investment income. No private insurance company – certainly not one with a huge actuarial deficit – would operate that way.

Confused Leftist Reporters Denounce Corporate Do-Gooders

If one wishes to stay informed about pension issues, not reading the Wall Street Journal’s Ellen Schultz and Theo Francis is a must. They aren’t merely left-wing; they are astonishingly ignorant of their subject matter. It’s as if sports reporting were assigned to a couple of guys who can’t tell home runs from touchdowns.

The pair’s latest piece [link probably for subscribers only] is, even by their standards, a classic. It editorializes about Revenue Ruling 2008-7, released last Friday, which addresses two issues that arise when a traditional pension plan is converted into a cash balance plan. The first is whether a technique known as “wearaway” is (or, to be precise, was – the law was recently changed to prescribe a different preservation method for conversions occurring after June 29, 2005) a proper method for preserving benefits that accrued before the conversion. The second is whether a plan may offer participants the better of a cash balance or a traditional benefit formula.

Issue one isn’t very controversial, except in the minds of a few leftists, like the Schultz-Francis duo, who really and truly hate cash balance plans, and would like to punish companies that install them. The ruling needs only a couple of paragraphs to dispose of the legal objections that have been raised against wearaway, agreeing with the court decisions that have rejected such arguments (and go unmentioned by Schultz and Francis; Register v. PNC Financial Services Group, Inc., 477 F.3d 56 (3d Cir., Jan. 30, 2007) and Custer v. Southern New England Telephone Co., 2008 U.S. Dist. LEXIS 5067 (D. Conn., Jan. 24, 2008)).

Issue two is trickier. A great many converted plans allow some or all of the employees who were participants at the time of the conversion to take advantage of either the cash balance or the traditional formula, whichever produces the higher pension at the time of retirement. For a young participant, the cash balance accrual is ordinarily faster. As he ages, the gap diminishes until it reaches a crossover point, after which the traditional formula is superior. The “greater-of” technique adjusts benefits upward for participants who start on one side of the crossover and work long enough to reach the other.

Owing to a glitch in the regulations under section 411(b) (commonly called the “backloading” rules), this benign practice is legally dubious. The IRS noticed the problem last year when it began reviewing cash balance plans’ determination letter applications, which had been in limbo for several years awaiting legislative action on various politically delicate issues. Over a thousand plans were threatened with disqualification on this ground. Revenue Ruling 2008-7 outlines the basis of the IRS’s position (which is, much as I hate to admit it, entirely cogent), then announces its intention to amend the regulations to eliminate the problem.

Schultz-Francis seem unaware that the two issues are not identical. Instead, they describe wearaway (intelligibly, though not with complete accuracy), then claim that it was the target of the IRS’s displeasure. They treat the new ruling as a reversal of front in response to “a volley of lobbying, enlisting more than two dozen lawmakers to ask the agency to back off”. The volley was real, but it related only to “greater-of” formulas, not to wearaway.

So these two veteran pinkos lambaste the IRS for letting employers adopt a technique that can only increase workers’ pensions. The reason may be simple ignorance, but isn’t there also likely to be a smidgeon of reflexive left-wing anger: If Big Business wants this, it must be evil. Never mind the facts.

Hillary the Goldwater Girl?

James Taranto thinks, either mischievously or optimistically, that Hillary Clinton is reverting to her teenage ways. On both Social Security and Iraq, she sounds “fairly conservative” – well, sort of, at least for low values of “fairly”.

Her retirement savings proposal – tax-financed matching contributions for people (excluding the evil “rich”, naturally) who put money into IRA’s – is nominally unrelated to Social Security, but it is only cosmetically different from a timid form of privatization. A couple of years ago, House Republicans urged that surplus FICA taxes be put into individual accounts, as an add-on to Social Security, instead of subsidizing unrelated government programs. Democrats objected furiously. Senator Clinton’s idea is essentially the same, except that she makes no overt link to the FICA surplus, and her plan would benefit only those who also save on their own.

On Iraq, Mr. Taranto quotes a number of statements suggesting that the prospective Democratic Presidential nominee recognizes that abandoning our friends is a bad idea. Compared to John Edwards, Barack Obama or Bill Richardson, she could be mistaken for – not a hawk, but a mildly combative sparrow. Certainly she stands too far to the right to please the Angry Left. No doubt she calculates that, once the general election comes, the Krazy Kossack Kidz and their ilk will prefer power to purity and fall quietly in line.

Unfortunately, disdaining the Kidz is only a necessary, not a sufficient, qualification for the Presidency. The stands that cheer Mr. Taranto, however mildly, furnish further proof of the Tin Lady’s disastrous incapacity for the office she seeks.

In both cases, she recognizes a problem, then shies away from confronting it. The Social Security system in its present form is demographically unsustainable, and correcting the imbalance will become more painful the longer it is put off. Senator Clinton has, however, ruled out every serious remedy. She is against converting the public liability into private assets, against raising FICA taxes, against reducing promised benefits in any way whatsoever. Having rejected all medicines, she offers a placebo. And, in putting it forward, she didn’t even give primary emphasis to the need for enhanced retirement savings; her pitch was largely a rationale for the retention of that liberal idol, the death tax.

Her Iraqi stance similarly displays a glimmering of support for sound ends, coupled with a shrill rejection of adequate means. Keeping troops in Iraq isn’t an objective. Those soldiers will be of no use unless they are fighting our enemies, as they are doing right now. Senator Clinton has made it clear that she would, if she had her way, scale back their employment against the mufsidun. Her expressed preference is for fewer men, fewer missions, less violence, more attention to the “rights” of our enemies and much more “diplomacy”, with whom and about what to be filled in later. In other words, she is willing to fight hard enough to irritate but not hard enough to win.

All in all, the Tin Lady’s policies in both of these areas (it would be easy to extend the list) are “moderation” of the worst kind: short-sighted, faint-hearted, and aimed at smoothing over political bumps rather than dealing with national problems. Her husband was much the same way, but he had the good fortune to reign during a vacation from history. The next President will not have that advantage.

John Edwards Is Too Right-Wing for Me

Tonight several of the Democratic Presidential candidates (Clinton, Edwards, Richardson, but not Obama) appeared at a panderfest debate sponsored by the AARP. As it was almost completely unpublicized, Jim Geraghty calls it “the hidden Democratic debate” but assures us that “absolutely nothing that you haven’t heard before” was said.

Not quite. He records this line from the lovely and talented John Edwards: “We oughtta have a law that every CEO’s pension, golden parachute, and everything else will be treated the exact same way as the lowest-paid worker’s pension.”

Well, Senator Edwards pals around with rich people, so it isn’t surprising that he is pushing their selfish interests. If the law treated every CEO’s nonqualified deferred compensation “the exact same way as the lowest-paid worker’s pension”:

• The CEO’s benefits would be insured by the PBGC.

• Benefits would have to be funded by his employer in a trust beyond the reach of the employer’s bankruptcy creditors and in accordance with the recently tightened minimum funding standards.

• Benefits would also be protected from the CEO’s own creditors.

• Benefits would be taxed only when actually received, without regard for the doctrine of constructive receipt.

• Benefits would become fully vested after no more than six years of service.

• Section 409A, which subjects nonqualified plans to a set of hyper-technical, trap-laden rules, whose violation is punished by a 20 percent penalty tax, would be repealed.

Except for the last, I don’t think much of any of those ideas. It appears, then, that I’m to the left of the left-most top-tier Democratic hopeful (well, if one stretches the meaning of “top-tier” – Gallup currently has him 36 points behind the Tin Lady). Who would have thought it?

The Mollohan-Jefferson Amendment

OpinionJournal Political Diary (only $3.95 a month, direct to your e-inbox) offers further insight into how determined Congressional Democrats are to clean up corruption:

Last Friday, Democratic leaders were shepherding to passage a routine bill that bars convicted members of Congress from getting Congressional pensions when the legislation was suddenly yanked off the floor. When Congress reconvened on Monday, the bill had been mysteriously changed – its effective date was moved back almost two years, to January 1, 2009. Democrats claimed since the bill would change the compensation of some former members of Congress, it would fall afoul of the 27th Amendment, which prevents any Congressional pay change from taking effect until the next Congress.

Republicans, noting that the criticism had never come up in any of the bill’s hearings in the last Congress, were skeptical. “Who are they trying to protect?” one staffer wondered, noting that Democrat Alan Mollohan of West Virginia is under active FBI investigation and Bill “Freezer Cash” Jefferson of Louisiana is expected to be indicted on corruption charges.

What this means is that, if Reps. Mollohan and Jefferson move from Capitol Hill to Camp Fed during the next two years, they will receive taxpayer-funded income for life. (Under the bill passed by the Senate, any member of Congress convicted of a crime after enactment of the statute would lose his pension rights.) The Constitutional scruple is risible. It turns the 27th Amendment into a pension vesting provision, which couldn’t have been within the contemplation of the Congress that proposed it in 1789. Somebody was obviously searching hard for an excuse to make sure that certain malefactors’ last years are indeed “golden” ones.

Misunderstanding FICA

Ramesh Ponnuru has, let me note at the outset (though irrelevantly to this post), written a terrific book on abortion and related controversies (over-provocatively titled The Party of Death). Nonetheless, he misunderstands FICA, a misunderstanding that he shares with far too many people who opine about tax policy. He writes,

The income tax has gotten more progressive, but not necessarily the “tax system” generally. Since income taxes are more progressive than payroll taxes, cutting income taxes but not payroll taxes makes the system as a whole less progressive. This observation is usually made by people who aren’t really interested in lightening the load of the payroll tax, but it's still true.

This statement is mostly true about the two small components of payroll taxes, namely, those that fund Medicare and the federal portion of unemployment insurance (“FUTA”). For the big piece, Social Security (“FICA”), it is mostly false.

FICA is not a tax; it is a forced loan to the government. Repayment of the loan comes in the form of a government-promised annuity. The size of the annuity depends upon the amount of the loan. The differences from an ordinary loan stem solely from the government’s ability to dictate the terms without bargaining. Most notably, the larger lenders receive a poorer rate of return than those with lower wages and lower FICA contributions, a state of affairs that wouldn’t arise in transactions entered into freely.

If FICA were a tax and Social Security a mere welfare program, paying the former wouldn’t be a condition for entitlement to the latter, just as paying FUTA isn’t a precondition to receiving unemployment benefits. There is only one respect in which FICA can be viewed as tax-like: To the extent that the lender’s rate of return is less than he could have gotten in the market, the government deprives him of potential earnings without any commensurate quid pro quo. (Yes, I realize that “taxes are the price we pay for civilization”, but I don’t get more or better civilization by paying more tax.)

This implicit tax is steeply progressive, because the Social Security annuity formula is weighted in favor of low wage-earners and benefits paid to low-income retirees are exempt from income tax. Viewed properly, then, Social Security makes the U.S. tax structure proportionately more burdensome as one’s earnings rise up to the FICA wage base ($94,200 in 2006). Added to the income tax, the result is an overall tax structure that Karl Marx could almost admire.

Not Smoking Is Harzardous to Your Pension Plan

The Daily Telegraph has, I suspect, “sexed up” its report on a Hewitt Associates study of the effect of Britain’s coming smoking ban on pension costs.

Hewitt Associates, a human resources group, said the ban, which is expected to encourage around 600,000 of the nation’s 13m smokers to quit, will substantially increase people’s life expectancy and therefore their pension costs.

Figures compiled by the company show an average improvement of just one year in life expectancy will increase the average deficit of the FTSE 100’s pension funds by £15 billion to £20 billion.

And the increase in annual pension costs could reduce profit before tax for the FTSE 100 companies by around £1 billion a year. . . .

Kevin Wesbroom, a Hewitt Associates pensions consultant, said: “The numbers do highlight just how sensitive profit and loss charges, deficits and hence cash funding requirements are to assumptions made about future morality rates.

“Companies and Trustees that are responsible for defined benefit schemes need to recognise that this announcement is likely to affect the company’s financial statements as well as how their schemes are funded.”

An overall one-year life expectancy increase from a five percent reduction in the smoking population is implausibly huge, but the general point is a good one. Smokers are, on the whole, an economic boon. Harvard Law School Professor Kip Viscusi’s empirical studies make that claim unarguable. For example,

To be sure, smokers do incur higher medical costs—about five cents per pack in Massachusetts in the mid-1990s. Yet, because smokers have a shorter life expectancy than nonsmokers, smokers incur a cost of 11 cents per pack less in nursing home costs and nine cents per pack less in pension costs. On balance, smokers incur about 14 cents less per pack in costs paid by Massachusetts, while contributing an additional 51 cents per pack in excise taxes.

That doesn’t mean that we ought to encourage people to light up, but it does suggest that the smoking habit harms only its victims, not society at large. Why, then, is there such fervor to stamp it out?

My theory is that mankind labors under an Iron Law of Puritanism. The quantity of busybody interference in other men’s lives is a constant. It can be redirected but not diminished. Since society no longer feels inclined to discourage adultery, promiscuity, homosexuality, pornography, vulgarity, public indecency, etc.,the impulse to control others’ lives has migrated to a minor personal pleasure. Once tobacco is stamped out, I wonder what the next target will be.

First they came for the smokers, but I didn’t complain, because I don’t smoke. . . .

But what did it matter? My pension plan was broke, and I couldn’t afford to go on living.

A Darwin Award for Lobbyists

During my period of government service, I was subjected to occasional professional-grade lobbying and wasn’t highly impressed. A lot of the “pros” struck me as ill-informed and more eager to present a congenial image than back their clients’ positions with persuasive arguments. Still, their worst efforts tended to be merely ineffective, not seriously counterproductive – unlike one currently being pushed by the life insurance industry’s leading trade group.

As reported by the OpinionJournal Political Diary (subscription-only but more than worth $3.95 a month),

Sometimes it seems that the real purpose of the federal estate tax is to create jobs for accountants, lawyers and insurance agents who are employed to help Americans find clever ways around paying the tax. So it should be no surprise that the life insurance industry is engaged in a full-court press to lobby for retention of the tax. The Association for Advanced Life Underwriting (AALU) has engaged in a campaign to save the death tax by urging its members to warn Congress of the worrisome “fiscal implications” of the death tax repeal. “Our lobbyists have been busy communicating our important message,” says an “URGENT” memo to all AALU members. “Senate offices repeatedly tell us that pro-repeal forces are drowning them in constituent communications. It is crucial that our voices be heard!”

“Fiscal implications” may not be the most cogent argument for repeal of a levy that produced, before the EGTRRA phase-out began, about one percent of federal revenue and has since trended downward. What makes the AALU a Darwin Award candidate is that tax breaks for life insurance cost the feds as much as the estate tax raises. If the estate tax should be retained, despite its negative impact on small business and the economy, why shouldn’t income credited to life insurance policies be taxed currently, just like earnings on most other individual investments?

Were Congress to entertain the idea of fundamental changes in the tax treatment of life insurance (not at all inconceivable), the AALU would be quick to assert that all sorts of factors other than “fiscal implications” ought to enter into the policy equation, and I would agree with them. I wonder, though, how the group would or could respond to quote-backs from its own pro-estate tax propaganda.

I was sorry when former Oklahoma governor Frank Keating, who now heads the AALU, was passed over by the Bush Administration. If his organization’s latest campaign is indicative of his political savvy, maybe the Bush vetting crew knew its job.

A PBGC/UAL Correction

Like many other people who follow pension matters, I have assumed that the Pension Benefit Guaranty Corporation’s assumption of $6.6 billion in United Airlines pension liabilities will aggravate the $23.3 billion deficit reported as of September 30, 2004, bringing the total to $30 billion. A fact sheet from the American Academy of Actuaries points out that such is not the case.

The PBGC includes, in their deficit, certain probable terminations (i.e., companies for which PBGC anticipates taking over pension plans in the near future). In its 2004 annual report, the PBGC included $16.9 billion for certain probable terminations, which included United Airlines’ unfunded guaranteed benefits. Therefore, despite some reports to the contrary, PBGC’s deficit does not increase with United’s termination. In fact, the $1.5 billion in securities from UAL could decrease the PBGC deficit.

We should also bear in mind a fact that the Academy doesn’t mention: that the PBGC uses rather conservative assumptions to value its liabilities. If its investment results are better than assumed, as they generally have been in the past, the actual liability may turn out to be considerably less than currently reported.

There’s no denying that the PBGC’s financial condition and the moral hazard that pension insurance creates for the economy are serious problems, as I have discussed elsewhere. We shouldn’t, however, exaggerate their magnitude.

The Academy offers one other interesting tidbit: A third of the benefits promised by the UAL plans ($3.2 billion out of $9.8 billion total liabilities) are not covered by PBGC guarantees. While I don’t have statistics at hand, that’s a much higher percentage than in a typical plan. (When I was at the PBGC, non-guaranteed benefits ran in the range of ten percent.) To a large extent, then, UAL has been paying its employees with unfunded pension promises. Since those promises aren’t insured, they can’t be attributed to moral hazard. The explanation also isn’t likely to be employer deviousness or worker stupidity. No work force in the world has paid closer attention to pensions than the airlines’. It makes more sense to seek an explanation based on economic rationality.

Ever since they were deregulated, the airlines have been running a high risk/high reward business. They now seem to have come a cropper, but it’s easy to picture the opposite outcome. If 9/11 had not occurred, and if oil prices had peaked a few dollars a barrel below their present level, the media would be full of complaints about unconscionable airline profits. Offering employees a lavish pension plan while not setting aside cash to fund it was a way of giving them a quasi-equity stake in the success of the enterprise. The workers (or, to be precise, their union representatives) accepted this offer instead of taking current compensation of equivalent risk-adjusted present value. When we talk about what UAL pensioners have lost, we should think in terms of the (probably small) paycheck increments that they could have had, not the profits that they hoped to earn if the airline business proved to be a bonanza.

The Perils of the PBGC

Since the financial plight of the Pension Benefit Guaranty Corporation is in the news these days, I suppose that, as a PBGC alumnus (director of policy and regulations, 1984-87), I ought to weigh in. A good starting point is Dartmouth economist Andrew Samwick’s diagnosis and proposed cure:

Pension insurance – not the idea but its implementation, and certainly not the dedicated people who work at the PBGC – is a complete joke. There are three problems with the PBGC’s setup:

1) The premium amounts are too low. On average, companies do not pay enough to cover the risk to which they expose the PBGC.

2) The premium formula is inadequately linked to underfunding. Pension sponsors whose plans are underfunded do pay slightly more in premiums than pension sponsors whose plans are fully funded, but the amount of additional premiums does not adequately compensate the PBGC for the added risk of a claim.

3) The premium formula is unrelated to the PBGC's risk exposure – the portfolio allocation between stocks and bonds and the bankruptcy risk of the company. . . .

With PBGC insurance, the company has an incentive to invest in a portfolio heavily weighted toward stocks. If the stocks do well, the company can cut back on future contributions. If the stocks do poorly, then in some cases, the company can terminate the plan and leave the liability with the PBGC. Classic moral hazard. When the economy goes through a period of weak stock market returns (so the pension fund’s assets fall in value) and low interest rates (so the present value of the future liabilities rise in value), we get tremendous underfunding. And the laws governing minimum pension contributions don't require pension sponsors to make up the difference quickly enough.

What to do? Impose a levy on each DB pension plan sponsor that is proportional to the current value of all past PBGC premiums paid for current participants. Impose the levy based on 2004 data, so there is no rush to the exit. The levy should be enough to put the PBGC at a zero balance position. Then retire the PBGC and allow companies to obtain pension insurance privately if they so desire. For current sponsors, pass a law that moves pension participants’ claims in bankruptcy ahead of all unsecured creditors. If this means that fewer firms offer DB pensions, then so be it. Unhealthy companies – like United – ought not to be making promises to pay beneficiaries decades into the future.

Professor Samwick’s view of the roots of the PBGC’s problems is the same as the PBGC staff’s back when the insurance program was reformed in 1987. At its inception in 1975, the PBGC charged a flat premium that bore no relationship to exposure or risk of loss. As the initial rate was only a dollar per participant per year, trying to apply insurance rate-setting principles would have been fiddly. Nor was that low number pulled out of thin air. It was based on a Department of Labor study of participant losses in plan terminations in the 1960’s and early 1970’s. One reason why Congress enacted pension insurance, brushing aside “moral hazard” objections, was that it looked like an inexpensive fix for a small-bore problem.

Now it is thirty years later, and moral hazard has proven to be more than a theoretical concept. Had Congress anticipated that premium revenue would rise from $30 million to $1.46 billion a year, without any significant increase in the number of workers covered by insured plans, and that the program would nonetheless find itself nearly $30 billion in the red, the whole idea would have been aborted.

The original program carried even more moral hazard than the present one. What the PBGC provided was not insurance but a put option against the federal government: A company could rid itself of its pension liabilities by paying the PBGC the present value of guaranteed benefits. Since not all benefits were guaranteed, that was prima facie an attractive proposition: Paying x dollars relieved x+y dollars of liability.

That this system was not catastrophically abused was due primarily to three factors: (i) good luck (economic circumstances were such that pension overfunding was a much bigger issue than underfunding throughout the 1970’s and 1980’s); (ii) the assumptions used to value liabilities, which were more conservative than most companies would use for internal projections (so that the cost of exercising the put option was artificially high); and (iii) the PBGC’s inhospitable attitude toward companies that terminated plans in conditions short of extreme financial distress. Still, it was obvious by the early 1980’s that the existing structure was unsound. The reforms that the PBGC wanted then sound like Professor Samwick’s in several respects: Among them were higher premiums to eliminate the existing deficit, a change from a flat-rate premium to one related to risk, and an eventual shift to private pension insurance.

The package that Congress was willing to enact was less radical. Premiums were increased and based partly on underfunding (9/10ths of one percent of unfunded vested benefits), though without regard to the likelihood that claims would arise (i. e., the employer’s financial condition), and companies were effectively forbidden to terminate underfunded plans (and thus impose costs on the PBGC) unless they were in bankruptcy. The put option was thus replaced by a program of bankruptcy insurance.

The obvious flaw in a company’s buying insurance against its own insolvency is that paying the premiums deprives it of capital and increases the probability that the undesired event will come to pass. That dilemma is compounded if premiums escalate with financial weakness. Naturally, as Professor Samwick observes, premiums that compensated the PBGC for the full risk that it bore were politically impossible. It was also impossible to charge healthy plan sponsors the amount needed to cover claims likely to arise from weaker companies’ plans. If that had been possible, it in any case wouldn’t have been a wonderful idea: Making profitable firms pay the debts of those that fail is a classic perverse incentive.

So I’m not at all sure that I agree with Professor Samwick that the weakness of pension insurance is “not the idea but its implementation”. In anything like its present form, implementation is unfeasible, which suggests that the idea isn’t a sound one. Certainly, there is no real prospect of private alternatives. The PBGC’s staff and its outside advisory committee devoted quite a bit of effort to trying to devise a privatization scheme in 1985 and 1986. We could never surmount the hurdle of formulating a product that companies would voluntarily buy or insurers willingly underwrite.

Professor Samwick’s proposal is dramatic: Zero out the PBGC by imposing a one-time levy on current plan sponsors to fund the current deficit; accept no new claims from plans that terminate in the future; give pension claims priority over other unsecured creditors in bankruptcy; and leave pension insurance to the private market.

As a realistic political scenario, that is about what one expects from an academic economist. The deficit-closure levy would be nearly $1,000 a participant, an intolerable imposition, though it could be reduced a bit by valuing the PBGC’s liabilities on a less conservative basis. United Airlines’ competitors would denounce the unfairness of letting one company escape liabilities that the rest of the industry must continue to bear. Critics would rightly point out that secured claims take almost all of the assets available in most business bankruptcies, leaving only pennies on the dollar for unsecured debts. Private pension insurance is no more attractive to carriers or plan sponsors in 2005 than it was in 1987.

The Bush Administration’s proposal, which I have described elsewhere, would raise premiums sufficiently to eliminate the PBGC’s deficit over a period of years, but its principal feature is severe tightening of minimum funding standards. It would come very near to mandating that plans be fully funded for accrued benefits at all times, which would make contributions extremely volatile. All commentators expect a regime like that to discourage companies from maintaining defined benefit pension plans, and the Administration doesn’t seem to disagree. For all practical purposes it has given up on this form of retirement plan and is looking only for a PBCG exit strategy.

Now, it may be that traditional pension plans have no niche in the current marketplace environment. On the other hand, it may not be coincidental that their decline follows a significant expansion of government regulation, beginning in a modest way with ERISA in 1974, then accelerating with the Retirement Equity Act of 1984, the Tax Reform Act of 1986 and the deluge of legislation in the 1990’s. Regulation of individual account plans has increased, too, but beginning from a lower base and to a far lesser extent. If, as I have suggested before, pension plans were subject to less federal micromanagement, they might spring back to life. If they didn’t, we would at least know that genuine market forces rather than government intrusions were responsible for their demise.

A pension plan revival would give the PBGC a larger base of premium payers and ease the amortization of its deficit. I don’t deny that the moral hazard posed by pension insurance would remain worrisome. Fundamental reform or disastrous collapse are the PBGC’s only possible long-run fates. While we wait to see which will occur, I suggest that we do what we can to make the short run less bleak.

Briefly Noted: Charlock, Simonsen, Social Security

■ The way that blogs come and go, I feared the worst when The Charlock’s Shade, a delightful blend of book notes and curmudgeonly observations on the state of culture, came to an abrupt halt last December 6th, while “Enoch Soames” was “out as well as about in Chicago, Illinois, U.S.A.” An ominous place to disappear! Happily, Enoch has reappeared just as abruptly. I take his harrowing account of his hiatus cum grano salis.

■ Redmond Simonsen, whose maps, counters and cover art for SPI have influenced wargame graphics ever since, died of heart failure on March 8, 2005, at the sadly young age of 62. He hadn’t worked in the wargaming industry for 20 years, but we old-timers remember him well. Operational Studies Group has posted reminiscences (page 1, page 2) from inter aliis Greg Costykian, David Isby, Jim Dunnigan, Jack Greene, Rodger MacGowan, Brad Hessel, John Prados, Eric Lee Smith and Kevin Zucker.

Update (4/24/05): The Charles S. Roberts Awards site has posted a detailed appreciation, Alan Emrich & Rodger B. MacGowan, “Our View is Better Because We Stood on the Shoulders of a Giant: Redmond A. Simonsen”.

■ Brendan Miniter’s description of the Democrats’ inchoate Social Security pseudo-reforms, which I noted when it appeared in the subscription-only OpinionJournal Political Diary, is now publicly available, with additional commentary, under the fitting heading, “Worse Than No Reform”. At least a few clever Dems have come up with ways to “save” Social Security that ignore its demographic imbalances while “improving” it in ways that would expand both the scope of the welfare state and the power of the federal government to influence the private economy. Not surprisingly, their ideas are Bill Clinton retreads.

Passing Breezes, With Music

■ Harvard profs can’t get into Rock’n’Roll heaven, so where do they go instead?

■ Power Line has continued to cover the so-called “GOP talking points” on Terri Schiavo. The likelihood that they had any official standing is now in the range of nil, that they were a plant by Democrats or the media very high. The latest updates are here (signs of forgery to substantiate forgery) and here (further evidence that the document was not circulated among Republicans and originated with someone not completely at home with Senate procedures).

■ Let me direct your attention to a comment posted this morning in response to my “Social Security Reform: Patrience, Please”. The substance is feeble: an argument that the present system is better for poor workers than individual accounts, because it includes disability benefits and skews its formula toward beneficiaries with low lifetime earnings. Those are unimportant advantages, because (a) President Bush doesn’t propose to alter the disability program; (b) individual accounts would provide an additional source of income for those who suffer disability; (c) low income is a predictor for shorter-than-average life expectancy at retirement, which offsets the advantage of the progressive benefit formula; and (d) it doesn’t take spectacular investment returns for an individual account to surpass the most favorable Social Security formula (and whatever is left in the account can be passed on to one’s heirs).

What’s significant about the comment, however, is not its unimpressive reasoning but its racist rhetoric. It has the appearance of a mass mailing, probably spammed to other sites that have written about Social Security reform. The racism is black, rather than white, and can’t be imputed to all reform opponents. On the other hand, if white racists were spewing this kind of stuff in favor of the President’s proposals, it would be trumpeted by the media as loudly as the dubious Schiavo memorandum.

■ The latest book on “Who Really Wrote Shakespeare?” is a rare entry on the side of sanity: The Case for Shakespeare : The End of the Authorship Question by Scott McCrea, a playwright who teaches at SUNY’s Conservatory of Theatre Arts and Film. It will take a while for Amazon to deliver my copy. Meanwhile, here are comments posted on an anti-Stratfordian newsgroup by vocal Oxenfordian Richard F. Whalen:

McCrea’s book needs to be addressed because it’s a book-length, direct attack on the Oxfordian proposition by someone at a university. (Maybe that’s a compliment?) He probably spent 3-5 years researching and writing it, and he got a major academic-oriented publisher for it. . . . He accuses Oxfordians in detail of poor scholarship and selective use of evidence, and relying on totally implausible conspiracy theories. He raises some interesting challenges, eg. the WS works refer solely and many times to grammar school education but never to universities – challenges that will appeal to the unwary .

Having read Mr. Whalen’s magnum opus, I doubt his ability to evaluate the cogency of opposing arguments, so I’ll wait and see before hailing Mr. McCrea as the vanquisher of the infidels.

If, by the way, the book argues that the absence of university scenes in the plays is evidence against Oxenford’s authorship, it is straining too far. Despite the fantasies of folks like Richard Whalen, the earl attended a university for only a few months, as a Cambridge boarder at age eight. He left after his father grew tired of paying charges for broken windows. So he knew quite as little about Oxbridge as the man from Stratford.

■ Tomorrow I’m off to Minicon 40 (or “Fortean”), which I can do because my Easter weekend is still five weeks away. Posting will be either interrupted or incessant, depending.

First Whispers: The Democratic Social Security Plan

Yesterday the editors of the Wall Street Journal had a session with Rep. Steny Hoyer (D-Md.), minority whip and leading Democratic spokesman on Social Security. An account in the OpinionJournal Political Diary (subscription-only, but cheap at $3.95 a month) foreshadows what the Dems will say about the program once they stop insisting that absolutely nothing is wrong:

Mr. Hoyer said Democrats will offer their own plan when the time is right, and that the model for compromise will be the deal Ronald Reagan struck in 1983 to raise the retirement age. He further hinted at benefit cuts by noting that the government isn’t obligated to keep paying what it currently pays out. Dropping the Democratic talking points for a few minutes, he also suggested that Social Security should have the “ability to invest” in the stock market. And he declared: “I am for private accounts,” though “as an add-on” to Social Security.

So, after months of denouncing President Bush for proposing future benefit reductions, sweetened by being able to keep all of the gains from one’s own investment account, Democrats are prepared to offer future benefit reductions, sweetened by nothing at all. No wonder they’ve been reluctant to go public with that brainstorm!

Investing the Social Security trust fund in stocks and “adding on” taxpayer-funded private accounts are two of the Clinton Administration’s bad ideas, whose flaws I discussed long ago. In brief, the former would make the U.S. government the country’s largest stockholder, potentially owning $7 trillion in securities at the trust fund’s peak. That sort of government intrusion into the private sector would be unhealthy. Moreover, it would not address Social Security’s long-term demographic dilemma in any meaningful way.

The other element, add-on accounts paid for by other taxpayers, is no more than an income transfer scheme. Its appeal to crypto-socialists is obvious, but one hopes that they won’t fool the rest of us.

I expect to hear many invocations of 1983 as the debate continues, with the aim of convincing the public that higher taxes (only on “the wealthy”, of course) and lower benefits are the “Reaganesque” approach to reform. That isn’t the real history. In 1983 Social Security faced near-term cash flow shortfalls because of imprudent revisions to the benefit formula a few years earlier. All of the changes adopted then were directed toward resolving that problem. Private accounts weren’t on the table, because everyone still regarded Social Security as Washington’s highest-voltage third rail, one that not even Ronald Reagan dared to touch. It’s a pity that our leaders weren’t bolder back then. If they had been, the transition of the system from public liabilities to private assets could have been nearly complete by now. That an opportunity was missed once is not, however, a good reason to spurn it when it comes again.

Reasoned Discourse From the AFL-CIO

A little over 25 years ago, two loony leftists, Jeremy Rifkin and Randy Barber, published a book called The North Will Rise Again: Pensions, Politics and Power in the 1980’s. It reads quaintly today. The first chapter hymns the inevitable demise of capitalism; within a generation, it will vanish from the earth. The rest of the volume stridently urges labor unions to help the inevitable along by wielding their power over pension plan assets for left-wing political ends. The authors are aware that federal law prohibits investing those assets other than for the “exclusive benefit of participants and beneficiaries”, but they scorn the law, in a couple of instances commending conduct that landed union officials in jail. It’s clear that they think of the fiduciary standards of ERISA as just another reactionary plot – doomed, of course – to thwart the march of Progress.

The strategy advanced by Rifkin and Barber did not lead to socialism in the 1980’s. Not only were the labor leaders of that era insufficiently radical, but union influence over pension investments is less formidable than often imagined. It can be exerted only over collectively bargained, multiemployer plans, which account for a small minority of total plan assets. Moreover, the Taft-Hartley Act requires that employer appointees comprise at least half of every multiemployer plan’s board of trustees, providing a check, though often not an especially vigorous one, on union appointees’ schemes. Nonetheless, as organized labor has lost much of their demographic strength (only about one in 12 private sector workers is now represented by a union), its chieftains turn to the weapons that remain in their arsenal. Thus we see a Rifkin-Barber-style campaign to stifle support for Social Security reform by threatening investment managers with the loss of multiemployer clients.

Today’s Wall Street Journal reports on union financial intimidation in “Social Security Change Faces Labor Muscle” [link for on-line subscribers only]. The focus of the story is William Patterson, head of the AFL-CIO Office of Investment, who, at age 55, belongs to the generation of then-young radicals who swallowed books like The North Will Rise Again. Echoing Rifkin and Barber, he has contempt for legal technicalities that interfere with the progressive (that is, reactionary) agenda. He “has been warning financial firms that embracing President Bush’s top domestic priority could become an issue when pension trustees review fund managers”, blandly asserting that giving politics priority in portfolio management is “not illegal for us. We have a responsibility to support Social Security against efforts to weaken it.”

Mr. Patterson probes for ways to push financial firms away from supporting the White House plan to overhaul Social Security through private investment accounts. . . . [His] tactics begin quietly with an exchange of letters, but can escalate quickly into old-fashioned, noisy street demonstrations.

Next week, the AFL-CIO plans more protests in California, Pennsylvania and elsewhere outside the offices of Charles Schwab Corp. and Wachovia Corp., which both belong to lobbying coalitions backing Mr. Bush's Social Security approach. . . .

The pressure isn’t subtle. Three New York City Employees’ Retirement System trustees warned J.P. Morgan Chase & Co. and five other investment houses that their positions on revising Social Security may be considered in reviews of fund managers.

The article reports that pressure of this kind has achieved a degree of success in muting its targets.

The effort has had an impact. At the Alliance for Worker Retirement Security, an umbrella group of Bush backers, Director Derrick Max says his original pool of investment firms now contributes about 8% of his budget, roughly half of the percentage before labor went on the offensive. Mr. Max says, however, that he has more than made up the lost revenue with bigger checks from other coalition members and new recruits from the investment industry.

“This campaign is ill-conceived but it’s to our benefit,” Mr. Max says. He and other Bush supporters call Mr. Patterson’s effort tantamount to blackmail.

Of course, Mr. Patterson and his buddies deserve no credit for being ineffective. They want to stifle their opponents, just as their more grandiose predecessors wanted to establish socialism. When AFL-CIO officials prate about democracy (which they still profess to support outside of Iraq), we should keep in mind what they think of free and open debate on issues of public interest.

Addendum: An amusing sidelight on labor-backed demonstration, from National Review’s Beltway Buzz, attributed to an “Administration source”:

While the president was traveling through the Southwest a few weeks ago promoting Social Security reform, the White House team encountered a group of about a dozen protestors outside an event in Albuquerque.

“There were twelve to fifteen of them outside. They were holding signs and heckling us as we went into the event. I didn’t think much of it, because you see this sort of thing happens almost anytime you are traveling for town hall type events.”

But what happened next is what caught our source’s attention:

“I was walking through the Dallas airport with some colleagues and one of them recognized two of the same protestors we had seen outside the event in Albuquerque. We had some extra time, so we decided to talk to them. They were very polite and explained to us they had just come from protesting an event nearby. One of them very quickly identified themselves as professional protestors.”

“Not that they just liked to protest, but that they actually got paid by liberal interest groups to travel the country protesting. Here they were, sitting in the airport TGI Friday’s having a burger and getting ready to travel to New Orleans for another protest. They were good kids and wanted to talk. We tried discussing some of the benefits of Social Security reform. They listened, but weren’t too interested. Not because they had opposing views, they just said they weren’t too educated on the details. They even admitted they didn’t know who it was they were going to protest in New Orleans.”

Fresh Face, Stale Mind

Barack “Lucky” Obama is routinely portrayed by the media as a fresh new face in the Senate. Well, the face may be fresh, but the mind isn’t, as he demonstrated yesterday by rotely accusing President Bush of presenting racially “offensive” arguments for Social Security reform.

The President has been pointing out regularly that private accounts would be a boon to retirees who die prematurely. Under the present system, they receive less than they have paid in FICA taxes. Basing Social Security on capital accumulation would make it possible for them to leave an estate. The greatest beneficiaries of this change would be black males. Not only do they have significantly shorter life expectancies at retirement age than other groups, but they inherit less from their parents, who typically have had little opportunity to accumulate savings during their own lifetimes.

The present state of affairs is thus disadvantageous to both the current generation of blacks and their children. That is not the only, or the principal, argument for reforming Social Security, but it is certainly a consideration that policymakers ought not to overlook.

Well, Senator Obama does want to overlook it. In fact, he doesn’t think that it should be mentioned in polite society.

Instead, people should be talking “about how are we going to close the health disparities gap that exists, and make sure that African-American life expectancy is as long as the rest of this nation.”

Er, why can’t we talk about that in addition to working toward a more equitable Social Security program? The problem of poor health among black Americans isn’t going to be solved in a couple of years with a couple of government initiatives. It is a long-term effort that needs to be pursued on many fronts. Senator Obama, eager to keep the race card in play, insinuates that improving Social Security implies abandonment of all other efforts to ameliorate the problems of the black community:

“The notion that we would not be talking about lack of health insurance, and reducing diabetes, and reducing incidents [sic] of AIDS, and making sure that African Americans have the wealth and the income to save into retirement and supplement Social Security is stunning to me.

Not only is that a non sequitur, but it ignores the fact that private Social Security accounts, by making blacks richer in the future through savings and inheritances, will contribute to making them healthier.

It’s glaringly obvious that Senator Obama’s primary concern is not improving the health of black Americans but maintaining their allegiance to the Democratic Party by slandering beneficial Republican initiatives. That is the stale politics of the “liberal black plantation”, and denouncing arguments as “offensive” while refusing to engage them intellectually is the symptom of a stale mind.

A Prediction Edges Toward Fulfillment

Me, 3/6/05:

Confident that their media allies will outshout the Right, leftists are giving hostages to fortune in the form of arguments whose absurdity will become more and more evident as the public becomes more keenly aware of how Social Security operates. As the Left’s fictions are debunked, its spokesmen will lose credibility.

Rep. Nancy Pelosi (D-Cal.), House Minority Leader, 3/6/05 (quotations courtesy of Matthew Hoy):

The plan for solvency is to stop robbing Social Security of its money for other purposes. The plan is to return the money back to the trust fund as President Clinton did when he was president. In the Clinton years, in the closing years of the Clinton administration, there were three years of no deficit. Zero deficit. And with the surpluses that were created, President Clinton was able to put nearly $400 billion back into Social Security. . . . We must stop robbing Social Security’s trust fund of its money.

The New York Times, 3/8/05:

Under the current structure, payroll taxes will begin falling short of what will be needed to pay benefits in 2018, according to the latest estimates by the Social Security Administration. . . .

Once benefits exceed annual tax revenues, the government will have to increase taxes, cut spending elsewhere or issue more bonds if it decides to pay full Social Security benefits.

But trust fund or no trust fund, bonds or no bonds, Social Security is only one program with a claim on the federal budget.

There will be highways to build and, perhaps, wars to fight. There will be expenses for education and health care and many other government activities. And there will be citizens – voters – who do not want their taxes to be raised.

Maybe because of the trust fund, the politicians will decide that Social Security has the strongest claim.

But if so, that will be a political decision, not a legal one.

Some people have been saying exactly that for years. The Nancy Pelosis of the world either haven’t heard or don’t regard them as important. Perhaps hearing an accurate account of how Social Security operates from an ideological ally will lead them to stop talking nonsense about the “trust fund” and start addressing the program’s financial problems realistically. I would not, however, bet large sums on that outcome. More likely, the reactionary progressives will continue to wend their way into the fever swamps. It’s a sign of how far they’ve gone in that direction that they can no longer count on the Times to give them cover.

Social Security Reform: Patience, Please

A year ago, only the most optimistic conservatives did more than dream wistfully about turning Social Security into a capital accumulation program. “Privatization” was a long-term ideal, not a short-term, practical political goal.

Now, all of a sudden, adding private accounts to Social Security in some fashion or another – it hardly seems to matter how – is being treated as urgent business. We are warned that the President’s second term will be a failure unless something can be pushed through Congress prestissimo, and many are the criticisms leveled at the Administration’s “tactical blunders”, which, it is widely bemoaned, have already doomed the effort.

Shaking my head, I wonder whether folks aren’t confusing Social Security with Iran. “Faster, please” is the right cry for one situation, but not for both.

The longer that Social Security reform is put off, the harder the task will be, because demographics are ineluctably wearing down the program’s financial foundation. Still, the deterioration is slow and steady. The window for reform is a few years wide, not a few months. It will be better to construct a sound replacement in 2007 than a lame-brained version in 2005.

A virtue of Checks and Balances, remember, is that the nation can’t make a major directional change overnight at the whim of the majority at the moment. A corollary is that we are given time for careful consideration of measures like revamping the way in which most citizens provide for retirement. We don’t have to – in fact, we can’t – seize on the first idea that comes along, put it onto the statute books and move on the next problem in line.

The Administration’s proposal, in its current form, doesn’t cope fully with Social Security’s long-range imbalance. As a transition, it has good points, but where do we go next? Bush 1.0 leaves the next generation of retirees primarily dependent on the same inter-generational transfer concept as the present one. That is better than exclusively dependent; it isn’t a permanent fix.

Elsewhere I’ve offered my own idea of what the system ultimately should look like. There are doubtless other, perhaps better ways to reach the same objective, but so far very few are talking about what will come after the transition phase, or even showing awareness that the transition ought not to last forever.

Hence, I’m not upset by Democratic intransigence or the unlikelihood of overcoming a filibuster this year. Let the progressive reactionaries play a useful role by delaying action until the rest of us know what we really want.

So far as tactics go, complaints about the President’s performance are meaningless. Is there anything that he could have done that wouldn’t have run into the same left-wing insistence on the sanctity of the status quo or that would have stopped the media from echoing and reinforcing the do-nothing line? Not bloody likely.

Actually, the debate has been developing in a way that will in time prove highly advantageous to the pro-reform forces. Confident that their media allies will outshout the Right, leftists are giving hostages to fortune in the form of arguments whose absurdity will become more and more evident as the public becomes more keenly aware of how Social Security operates. As the Left’s fictions are debunked, its spokesmen will lose credibility. It’s amusing to see former economist Paul Krugman in the position of a physicist basing arguments on the properties of the luminiferous ether. The Social Security trust fund is just as imaginary. It serves a useful accounting function, but, as the date approaches when it must be turned into cash, anyone with a grain of sense will realize that it doesn’t postpone the need to deal with Social Security’s finances. In about 15 years, not the 50 that anti-reformers like to cite, promised benefits will have to be paid by increasing taxes, cutting benefits, cutting other government spending or taking on federal debt, just as if the trust fund didn’t exist.

Similarly, it will become increasingly clear that the default liberal remedy of a quick tax hike won’t improve the system’s future financial condition. Taxes collected today are spent today. They give future retirees no assurance that their benefits won’t be slashed and do nothing to ease the government’s future fiscal dilemma.

As the facts sink in, the Krugmans will either backtrack (denying furiously that they are doing any such thing) or migrate to the oddball fringe of politics, out in the wilds with the anti-fluoridationists and single taxers. Liberals whose brains aren’t addled by Bush hatred will, I foresee, figure out that there is nothing especially non-liberal in a program that requires individuals to save money during their working years. (The genuinely right-wing position is that the government should let people save or not as they wish.) A more supple Left than we suffer nowadays would already be criticizing the Bush proposals as timid and insufficient. Sooner than seems plausible, that may well become the mainstream liberal approach.

All in all, then, the Great Social Security Debate is proceeding quite satisfactorily. The best counsel for the present is patience. Panic and recriminations are the only things that reformers have to fear.

Soaking the Rich to Save Social Security?

Highly popular among Social Security status quoists is the idea of eliminating the cap on earnings that are subject to FICA tax. At present, only the first $90,000 of wages is subject to the 12.4 percent levy (half on the employer, half on the employee) that “funds” Social Security retirement benefits. The cap, originally $3,000 (just under $40,000 in current dollars), is indexed to the increase in average wages. (Social Security Online has further information.)

The reason why wages in excess of $90,000 aren’t taxed is that they are not taken into account in computing benefits. If the cap were simply eliminated, without any other alteration in the system’s structure, high earners would see their entitlements rise with their taxes. They wouldn’t break even, because the benefit formula is heavily weighted toward workers with low lifetime earnings, but the long-term effect on Social Security finances would be far less favorable than the advocates of unlimited FICA assume.

If, on the other hand, the cap were removed for taxes but not for benefits, the measure would be nothing but a large increase in the marginal tax rate on earned income. The highest tax bracket would go up de facto from 35 to 47.4 percent. That would, of course, delight the “soak the rich” crowd and would be comparable to the marginal rate hike that Bill Clinton pushed through in 1993 (from 28 to 39.6 percent). We can leave till another time arguments about whether it would be good for the economy.

For present purposes, it is sufficient to observe that the boost would not improve the health of Social Security in any substantive way. The current surplus of Social Security taxes over benefit payouts would be enlarged; the extra money would, as now, be used to pay the government’s other expenses; eventually – a few years later than now projected but no less inevitably – money would have to be found to meet benefit commitments. At that point, the choices would be unchanged: renege on the promises, raise taxes, cut other expenditures, or borrow money. Those who moan that private accounts are “risky” should reflect on the risk that a future electorate will decide that reducing benefits is the most palatable alternative. Perhaps our descendants will not even be willing to keep payroll taxes at the level decreed by the present generation. Private property is safeguarded by the Constitution and deeply ingrained American traditions. Government pledges rest on rather shakier foundations. Raising taxes today will not make them any more reliable.

Social Security Reform: The End Product

Firmly as I support the principles of the President’s Social Security reform plan, I expect to be lukewarm about their initial instantiation. Most of the work of filling in the details will fall to young “policy wonks”, who are at least as strongly attracted to complexity and compromise as to the opposite sex. Reform, Mark I, is likely to be a confusing blend of the old system and the new, phased in over a generation, never fully attaining the goal of “privatization” and replete with anomalies created to skirt this or that short-term problem (often converting it into a long-term problem in the process). We have a foretaste in the incomprehensible Medicare prescription drug benefit, which succeeds in displeasing everybody.

A major difficulty in formulating programs of this magnitude is that the wonks tend to be more interested less in where they are going than in how they will get there. It may be useful to begin with the objective. Once the transition has been completed, what would a sustainable retirement income system look like?

The key to reform is to minimize the dependence of each generation of retirees on the generosity of its successor. Workers should set aside a portion of their income for consumption after they leave active employment. A libertarian regime would let them figure that out for themselves, but we are taking government paternalism for granted here. Saving and investment will be mandatory, just as income transfer between generations is today.

An individual who consistently saved and invested the 12.4 percent of his wages that he currently pays in FICA taxes would be very likely to accumulate over his working lifetime enough capital to provide a decent basic provision for retirement. For the median worker, Social Security benefits under the present system equal 40 percent of pre-retirement income. How difficult would it be to match that through individual investment?

As an illustration, I did calculations for someone who begins working at age 25 and retires at 65. I assumed that his pay would increase over time but at a decreasing rate, reflecting the typical pattern of rising through the ranks followed by attainment of a plateau (7.5 percent annually, in constant dollars, for 10 years, then 5 percent, 3 percent and one percent for each of the next ten). I applied the rule of thumb that ten dollars at age 65 is sufficient to buy one dollar of lifetime income. Based on those assumptions, a real investment return of a mere 1.4 percent per annum produces a 40 percent replacement of income at age 65. The historical real rate of return for stocks over the past 75 years was 6.5 percent. If our sample worker enjoyed that result, he would have more income in retirement than while he was working.

Figures like these suggest that substituting private capital accumulation for unfunded government promises is not an absurd idea. We may, however, wish to add a few “safety nets” to take account of the vagaries of the financial markets and the variety of career patterns.

One precaution, already put forward by Administration spokesmen though obscurely described, is the establishment of what is called in the private sector a “floor-offset plan”: At the time of retirement, a notional benefit would be calculated based on the factors currently used by Social Security (essentially, wage history and length of service). The value of that benefit would then be compared to the balance in the worker’s private account. If the account was smaller, the government would add money to bring it up to the “floor” benefit.

This protection against downside risk for workers carries risks for the government. A market downturn could generate unexpected liabilities at an inopportune time, and individuals would have incentives to make excessively adventurous investments, on the theory that the government was insuring them against catastrophic loss.

Steps can be taken to minimize these hazards. First, the floor benefit can be set at a level where it is a true safety net, that is, somewhat lower than the present level of Social Security benefits. While Social Security, as originally conceived, was an equal leg of a “three-legged stool” (along with employer-provided pensions and voluntary savings), it has developed into by far the longest leg for most retirees. With private accounts, it still would be, but the guaranteed floor ought to serve the more modest original purpose of warding off destitution. (Note that, because the Social Security formula is graduated downward, the safety net is strongest for the lowest wage earners, who of course are most likely to need it.)

Second, investment options can be constrained to weed out high-risk choices. That policy would in any case be congruent with the paternalism of the system as a whole. The limitations don’t need to be draconian, just enough to enforce diversification, with perhaps a little attention to duration (e. g., minimum investments in stock funds for younger workers and bond funds for older). Dollar averaging, the other pillar of sound investing, is already enforced by taking contributions from every paycheck.

Third, the ups and downs of the market can be smoothed by converting accounts into annuities over, say, a ten-year period before retirement age, thus reducing the risk of retiring at a moment when the value of one’s account is at a temporary low point.

The outline that I have just given is what Social Security might have looked like had it been designed in a time of prosperity rather than in the midst of the most severe depression in our nation’s history, when the prime consideration was getting checks out to impoverished oldsters. As others have pointed out, FDR himself did not see the structure fashioned under emergency conditions as permanent. When he introduced the concept, he said that it “ought ultimately to be supplanted by self-supporting annuity plans”, which is simply the 1935 lingo for personal accounts funded by workers’ own contributions.

It’s a sign of how hidebound liberalism has become that President Roosevelt’s epigones cling tenaciously to an accident of history as if it represented a profound principle. No longer, it seems, are conservatives the ones standing athwart history yelling, “Stop!” or elevating ideology about the best interests of the elderly.

Oderint dum cogitent

I don’t know whether my congressman, Rahm Emanuel (D-Ill.), joined his party in booing President Bush’s remarks on Social Security last night, but his rapid reaction e-mail to constituents amounted to the same thing: the intellectual equivalent of a mindless raspberry.

“Rahm Reports!” begins with a snarky, “Tonight the President did a good job of staying on message”, a way of insinuating that he just recited canned talking points. After that opening, Rep. Emanuel ought to have tried to be less obvious about the canned talking points that he himself was reciting. He is supposed to be one of the brightest of the up-and-coming generation of Democratic legislators. If this statement represents the best of his thinking about long-term retirement security, it shows how dim the bulbs are among his partisan colleagues. Boos may well be the closest that they can come to rational thought.

Here is what passes for analysis in Rep. Emanuel’s universe:

The President’s plan would require a 40 percent cut in current benefits

What that means is that the President wants to do something about the fact that, as time goes on, Social Security taxes will fall further and further short of the amount needed to provide the benefits promised by the current formula: by roughly 12 percent in 2025, 25 percent in 2050, 34 percent in 2075, 40 percent in 2100 (Congressional Budget Office, “The Outlook for Social Security” (June 2004)). Anybody’s plan has to take that shortfall into account. The President would straightforwardly promise less while giving workers the advantages of personal capital accumulation and the possibility of higher returns through favorable investment experience. The Democratic line so far is that we should leave the promises in place and hope that the tomorrow’s work force will choose to tax itself more heavily (or cut other government programs or run up debt) for the sake of keeping them. Does the term “risky scheme” come to mind?

while adding $2 trillion to our federal debt – driving up interest rates and further weakening the dollar.

It should be elementary that the promises made by the Social Security System are government debt, exactly like Treasury bonds. The only difference is that the latter commitment is reported as part of federal financial statements while the former is kept “off the books”. As proponents of reform keep pointing out, on-the-books debt incurred to replace the FICA taxes channeled into private accounts will reduce pro tanto the off-the-books Social Security debt. The government’s aggregate liabilities won’t go up by a dime, and, whatever the relationship among deficits, interest rates and the strength of the dollar, the substitution of one class of debt is a neutral factor.

That is not a prescription for greater savings or long-term economic health. It is an ideologically-driven solution in search of a crisis.

As ideology goes, government-mandated retirement saving is not exactly a libertarian wet dream. President Bush is doing what liberals used to claim they did: looking at a problem without preconceived ideas and coming up with a pragmatic answer, one that was not too right wing for Sweden, which in 1999 began phasing in private accounts as a partial substitute for a U.S.-style system.

Rep. Emanuel and his fellow liberals, by contrast, sound like Louis XV conservatives: “Après moi, le deluge”. As I have discussed before, Social Security is not on the brink of collapse, but it does face a “crisis” in the true sense of the word. It is at a moment of decision, where we can either begin to deal with its long-term problems or leave them to fester until an unambiguous crisis overwhelms our children or grandchildren.

We should supplement Social Security rather than try to supplant it. A better alternative is for Congress to promote policies to help Americans save for their retirement, such as encouraging companies to automatically enroll new employees in their 401(k) plans; helping taxpayers deposit their refunds directly and automatically into IRAs; creating a “Universal 401(k)” that is portable from job to job; and making the “saver’s credit” refundable to help moderate income families save more money for retirement.

Of these small bore measures, the first was enacted administratively by the IRS in 1998, when it approved negative elections in 401(k) plans (vide Revenue Rulings 98-30 and 2000-8), and the others would have a trivial impact. One might note, too, that the great majority of Democrats have consistently voted against liberalizing the contribution limits for IRA’s and 401(k) plans and also were against President Bush’s 2001 tax bill, which instituted the saver’s credit.

The most important consideration, though, is that maintaining the present Social Security formula through tax increases would undermine “policies to help Americans save for their retirement”. Income drained away by higher taxes can’t be saved, no matter how simple the mechanics of saving may be.

We should protect Social Security AND help Americans save more. The plan the President announced tonight will add $2 trillion to our debt without accomplishing either.

The President’s plan could be less than a stunning success. A full evaluation is impossible until we see the details. Rep. Emanuel’s, however, is already fully detailed and is certain to fail, for it is simply to do nothing and to hope, like that other fine conservative Mr. Micawber, that “something will turn up”.

Social Security: What Is a “Crisis”?

At the risk of sounding Clintonian, I think that the dispute over whether Social Security is in a state of “crisis” can be rescued from sterility by closer attention to the meaning of words.

“Crisis” is vulgarly used as a synonym for “imminent peril”. By that standard, the current financial state of the Social Security system is not a “crisis”, for it collects substantially more in taxes than it pays out in benefits, and may never deserve that moniker. At least, the burden imposed by a steadily increasing ratio of retired to active workers may not reach the point where the latter cannot fulfill the promises made to the former. Taxes will have to rise, or other expenditures be cut, but a moderate optimist can forecast, without being absurd, that Social Security obligations will not “bankrupt America”. Well, not as fast as they will bankrupt the European Union and Japan. One could say that there is no crisis so long as we can look forward to being the last cripple standing.

The real meaning of “crisis” is, however, the moment when a decision must be made. Munich was a crisis, because the English and French governments had to choose the path that they would follow in confronting Nazi aggression. The panzers were only on the outskirts of Prague, not Paris. But, when they reached Paris, the situation was past being a crisis; it was the consequence of the democracies’ failure at the moment of crisis to judge wisely.

In that sense, saying that Social Security is “in crisis” is not hyperbolic. Reform – the substitution of private savings for public liabilities – is a generation-long process, one that will grow more daunting as the population ages and the transitional generation grows smaller in relation to the retirees who rely on it for support. The window for fashioning a structure that will serve the real needs of the elderly, rather than simply mimic the state of the art in retirement plan design c. 1930, is closing rapidly.

Suppose that, way back in 1953, when Republicans controlled Congress and the White House, they had enacted Social Security reforms along the lines that President Bush now seeks, channeling younger workers’ payroll taxes into private accounts while maintaining promised benefits for those who were nearing retirement. From the 1950's through roughly the 1970's, Social Security would have needed supplementary funds to offset the taxes retained by their payers. In hindsight, it is a safe presumption that the government would have run a bigger deficit. In the long run, the additional borrowing would have been insignificant: the increase in on-budget liabilities would have been matched by a decrease in off-budget Social Security obligations. In the short run, there would have been more than zero impact, but it would have been a mere blip in budgetary math. By now Social Security would be predominantly a capital accumulation program, and liberals would doubtless be claiming it as their own invention, just as they now claim to have been in the forefront of fighting the Cold War.

As demography grows less favorable, switching from the system cobbled together on an emergency basis in 1935 to anything else will become steadily more difficult. What could have been done almost painlessly in the 1950’s will take a palpable effort in the 2000’s. By the 2020’s, the transition may well be too onerous too undertake. Inaction will have led to an irreversible decision: that a major part of the retirement income of most Americans will forever depend upon the willingness (and ability) of the next generation to support them.

Self-sufficiency for senior citizens ought to be among the most uncontroversial of aspirations. The reactionary liberals who murmur “no crisis” are not themselves ready to renounce it. In time, though, their resistance to reform can make it impossible to achieve.

Private Pensions: A Failure of Imagination

Less noticed than the Bush Administration’s still forming Social Security proposals are its ideas for private sector pension reform. What the two have most in common is that both have drawn ferocious denunciations. It’s not just that the President wants to “destroy Social Security”. According to Alan Reuther, legislative director for the United Auto Workers, he also backs measures that “would have a devastating impact on the retirement income security of millions of workers and retirees and would undermine the entire defined benefit pension system”.

For me there is a lot of dejà vu here. I can remember the same Mr. Reuther hyperventilating the same hyperbole during the runup to passage of the Single Employer Pension Plan Amendments Act of 1987. (I was policy director at the Pension Benefit Guaranty Corporation and must confess to having played a role in devising SEPPAA.) Actually, the rhetorical rerun isn’t surprising when one reads the Administration’s jejune “Fact Sheet”. Save for updated statistics, it follows the 1987 pattern. These words could have been written then:

Although the PBGC will be able to pay benefits for some years to come, large and rising deficits undermine the long run financial solvency of the pension insurance system. Underfunding in the pension system must be corrected to protect worker benefits and to ensure taxpayers don’t risk paying for broken promises.

The remedies are likewise similar, administered in stronger doses: tighter minimum funding standards, plus higher PBGC premiums, particularly companies with weak balance sheets and large unfunded pension liabilities. Added to the mix is one new element: mandatory limitations on the benefits that can be provided by severely underfunded plans.

Though the fact sheet is rather sketchy, the Administration has been circulating a PowerPoint presentation that fills in high-level details. In outline, the key concepts are these:

1. A new method of valuing plan liabilities would be prescribed, with two key innovations. First, the valuation interest rate would depend on the age of the covered work force; as the percentage of participants near retirement age increased, the rate would go down. Second, plans whose sponsors’ credit ratings were below investment grade would have to use conservative assumptions about when participants would retire and what form of benefits they would elect. Both of these changes would increase the value of liabilities, and hence minimum funding requirements, for plans that cover relatively old work forces or are maintained by financially weak employers.

2. In place of the present funding methods, unfunded liabilities, as defined by the new standard, would have to be amortized over a “reasonable”, but brief, period. The Fact Sheet suggests seven years; the PowerPoint offers no specific number. On the other side of the ledger, the maximum deductible contribution would be increased to the amount needed to bring assets to 130 percent of the value of liabilities, a major liberalization of current law.

3. Sponsors of underfunded plans would lose some of their freedom to set benefit levels, with the constraints growing steadily more drastic as the funded status and employer credit worthiness declined. The restrictions would escalate: first limits on benefit increases, then a prohibition against the distribution of benefits in lump sum form, lastly cessation of benefit accrual.

4. The flat rate PBGC premium would be raised immediately from $19 to $30 per participant and thereafter indexed to reflect wage growth. The variable rate premium for underfunded plans would be set by the PBGC rather than by statute, meaning that it would almost certainly rise steeply from the current level of $9 per $1,000 of unfunded liability.

What is most striking about these proposals is not their specific content but their narrow focus. The PBGC used to be a minor factor in the defined benefit pension plan universe; now it is the black hole at the center. Absent are any ideas for encouraging the growth of defined benefit plans, easing administrative burdens or otherwise addressing widely recognized problems. Suppose that all plans miraculously achieved full funding tomorrow. Does anyone fantasize that employers would rush to start new ones or reverse the trend toward the predominance of 401(k) and other individual account plans? Policymakers, including those in the Bush Administration, routinely praise defined benefit plans as a cornerstone of retirement policy and bemoan their stagnation. If those opinions are sincere, it is time to think about what can be done to spark a DB revival, not merely about how to keep the remaining plans from turning into burdens on the PBGC. A new Hewitt Associates survey finds the half of large employers are contemplating eliminating defined benefit coverage either for new hires or for all employees. Stricter funding standards and higher PBGC premiums won’t change their minds.

Within its perimeters, the Administration proposal is like a frontal assault on a World War I trench, expending disproportionate effort for uncertain gains. At the present moment, pension plan funding is at an historically low ebb. At the end of 2004, according to a Towers Perrin study, the Fortune 100’s plans were only 88 percent funded on average. Yet just a few years ago, the same plans were substantially overfunded, by about 20 percent at the end of 1999 and 2000. In fact, surpluses rather than deficits have been the norm for non-collectively bargained plans for at least the past quarter-century. When I was at the PBGC, the hottest policy disputes stemmed from companies’ efforts to claw back overfunding.

The unsatisfactory status quo is not the product of some abrupt employer impulse to eviscerate their plans. The chief culprit is the anomalous behavior of interest rates during the past several years. Very low rates lead to high valuations of benefits and an appearance of financial distress. For the great majority of plans, however, the distress is largely illusory. Benefits don’t have to purchased today at unfavorable prices. They will be paid out over a span of decades, and a reversion to more typical market conditions would quickly restore the surpluses that existed in the recent past. The disease that worries the PBGC – poor funding and an imminent risk of termination stemming from employer bankruptcy – afflicts only a small minority of plans. Some of those, particularly in the airline and steel industries, have extremely severe infections, but (i) they are too far gone to be helped by the proposed antibiotic and (ii) it isn’t at all obvious that the rest of the population needs to be cured.

That is not to say that nothing ought to be done. In fact, the UAW’s objections illustrate why the PBGC’s existing structure is unsound. The key reason that Mr. Reuther has never liked strict funding standards is that, blunt instruments though they be, they reduce the moral hazard associated with pension insurance. An employer can’t as readily pay wages in the form of pension improvements, with the confidence that, if it proves unable to pay for them, the PBGC’s premium payers, i. e., the country’s other private defined benefit plans, will have to foot the bill.

The only way to make the moral hazard go away completely would be to abolish the PBGC, an idea that wouldn’t be able to must 20 votes in Congress. Realistically mitigating it requires a more subtle approach than massing the artillery. I’ve previously offered by own indirect approach to PBGC solvency, which, if not a panacea, would, I think, materially improve the agency’s long-term prospects.

On Social Security, the Bush Administration has displayed daring, imagination and an appreciation of the issues that lie at the core of retirement policy. Would it be overly demanding to ask that those qualities be applied to the private sector, too?

In re Reid v. Thomas

The eminent legal scholar and Democratic Senate Leader Harry Reid of Nevada has opined that Justice Clarence Thomas should not be elevated to the position of Chief Justice, because he is “an embarrassment” to the Supreme Court. It’s not that the only black Justice is a conservative, mind you; Senator Reid’s denigration rests on a neutral criterion: “I think that his opinions are poorly written.”

Pressed for an example of a inferior writing, the Senator singled out a routine reversal of a Ninth Circuit decision, Hillside Dairy Inc. v. Lyons (2003). The Left Coast Loony Circuit had upheld California’s attempts to compel out-of-state producers to abide by its milk price-fixing scheme. A unanimous Supreme Court vacated and remanded. Justice Thomas wrote a one paragraph concurring opinion in which he dissented from one part of the majority opinion. Those few sentences drew this dispraise from Senator Reid (transcription errors corrected):

In that case you had a dissent written by Scalia and a dissent written by Thomas. [It’s] like looking at an eighth-grade dissertation compared to somebody who just graduated from Harvard.

Scalia’s is well reasoned. He doesn’t want to turn stare decisis precedent on its head. That’s what Thomas wants to do. So yes, I think he has written a very poor opinion there and he’s written other opinions that are not very good.

Except that, as James Taranto noted yesterday, Justice Scalia didn’t write an opinion in Hillside Dairy. Influential lawblogger Eugene Volokh has asked the Senator’s office to explain. I imagine that an intern in Reno is right now frantically searching Lexis for a Thomas opinion that can be substituted as the centerpiece of the attack. (He might try the uncharacteristically off-the-point dissent in General Dynamics Land Systems, Inc. v. Cline.)

Hallucinating a Scalia opinion is not Senator Reid’s only mistake. Brief though it is, the Hillside Dairy concurrence illustrates one of the reasons why Mr. Thomas is a first rate judge: When his legal analysis clashes with his political opinions, he follows the former.

The substantive question on which he differed from the majority was the impact of the Commerce Clause on the states’ regulatory powers. Supreme Court precedent holds that Congress’ authority to regulate interstate commerce almost completely excludes state regulation, so that the Commerce Clause rather than the Import-Export Clause is the true guarantor of free movement of goods and services in the national market. The leading cases espousing this position were handed down by what are now viewed as right wing, laissez-faire Courts zealous to restrain state legislatures from interfering with freedom of contract. They have long been popular with conservatives and libertarians. I’d be extremely surprised if Justice Thomas didn’t share that agreement with the doctrine’s results. Nevertheless, he (and Justice Scalia, equally spurning stare decisis) have argued that the Court’s view of Congress’ “dormant commerce power” is unsupported by the text of the Constitution and ought to be abandoned. When was the last time that a liberal Justice put judicial principle above political preference?

My own evaluation of Justice Thomas’ work is based primarily on his opinions in ERISA and employee benefits cases, the area of law in which I practice. It is a good test of jurisprudential acumen, for no member of the Court has much ERISA expertise. Ability to make sense when venturing into unfamiliar legal terrain is a vital skill for Justices, who are the final arbiters of all statutory and common law but cannot possibly possess antecedent mastery of the whole.

By this criterion, Justice Thomas is one of the Court’s best jurists. His ERISA opinions are, with rare exceptions, clear, pithy and accurately reasoned. I particularly recommend for perusal his majority opinions in Hughes Aircraft Co. v. Jacobson (1999), which swept away years of confusion about the meaning of ERISA’s exclusive purpose rule, Egelhoff v. Egelhoff (2001), which strengthened and clarified ERISA’s prohibition against state interference with employee benefit plan administration, and Aetna Health Inc. v. Davila (2004), which reduced the murkiness of the Court’s conflicting rulings on the scope of ERISA preemption, his dissents in John Hancock Mutual Life Ins. Co. v. Harris Trust & Savings Bank (1993) and Varity Corporation v. Howe (1996), and his concurrence in Raymond B. Yates, M.D., P.C. Profit Sharing Plan v. Hendon (2004), where he catches a fellow Justice in egregious circular reasoning and displays his talent for close reading of the statutory text. I don’t think that any fair observer, including one who disagreed with Justice Thomas’ conclusions, can deny that he argues well and writes forcefully. The contrast with many of his colleagues’ blurry, meandering forays into employee benefits law is striking.

Whether Senator Reid has ever read a Thomas opinion is doubtful. The natural stance for a hostile commentator who was acquainted with the Justice’s oeuvre would run along the lines of “well-written nonsense” (the sort of thing that people like me say about people like Michael Kinsley). The Democratic leader simply assumes his target’s semi-literacy.

It isn’t hard to figure out why he does that. Years of “affirmative action” have ingrained in many minds the presumption that any black man who holds a position that requires high intellectual ability isn’t genuinely qualified; he must be the beneficiary of racial preference. Unfortunately, the presumption is occasionally correct. This is not one of those occasions. While Clarence Thomas’ résumé may have been thinner than most Court nominees’, his record demonstrates that the first President Bush chose him for his ability rather than his skin color. He deserves better than what Jim Geraghty sharply characterizes as “the hard bigotry of impossible expectations”.

Update (1/20/05): Apparently never having heard the maxim about holes and stopping digging, Senator Reid has compounded his offense with a new round of highly dubious statements about Justice Thomas. Eugene Volokh has details.

Debate on the Merits, the Big Labor Way

Now that it’s down to about 10 percent of the private sector work force, I’m not sure that we should call it “Big” Labor any more. Be that as it may, the left-wing chiefs of the nation’s labor unions have picked up their notions of free and fair debate from the foreign socialists whom they so admire. From Knight Ridder:

Unions, which control billions of dollars in pensions, have suggested that pension fund trustees stop doing business with investment firms that advocate individual retirement accounts for Social Security. In 2001, the AFL-CIO targeted State Street Corp., a financial-services firm that had been leading the drive for individual retirement accounts. Within months, State Street reversed its position.

In a letter to 46 financial firms this week, AFL-CIO President John Sweeney leveled a veiled threat: “I encourage your firm to follow State Street’s example,” he wrote.

Actually, “unions” don’t “control billions of dollars in pensions”. They select members of boards of trustees that are supposed to make plan investment decisions in accordance with the fiduciary standards of ERISA. Selecting plan service providers on the basis of their political views is a pretty clear breach of the duty of loyalty to the interests of plan participants. Maybe Mr. Sweeney would grasp that point if the employer trustees (who must by law comprise at least half of the board) began refusing to deal with, say, investment bankers who contribute heavily to Democrats.

The High Price of Envy-Based Taxation

Today the IRS released Notice 2005-1, its initial guidance on new section 409A, about which I have said denigratory things before. The notice has unexpected good points and fully expected bad ones. On the one hand, it allows most stock appreciation rights plans to continue, though new plans will become unfeasible for nonpublic companies. That is a better result than the hints dropped over the past several weeks had foreshadowed. Less happily, though not surprisingly, deferral of gain on stock option exercise, a time-hallowed, nonabusive technique, was firmly ruled out, despite the fact that it does not conflict in any discenible way with the policy behind the statute and Congress had explicitly rejected proposals to bar it.

I’ll forbear trekking through the details. What most struck me as I read the document was how silly and pointless all of these new rules are. They don’t close revenue-draining loopholes; the estimated increase in federal revenues is $1 billion – over the next ten years. That is about as close to zero as revenue estimates ever get. Moreover, the estimate ignores the cost of compliance. I’ll be very surprised if companies don’t spend billions of dollars, in the aggregate, on lawyers’ and consultants’ fees as they redesign and rewrite their plans. Those fees will of course be tax-deductible. Meanwhile, the only people likely to pay additional taxes are those who don’t hear about the new law and blunder into one of its traps. All in all, resources will be diverted to unproductive ends, the government will lose money, and the only gainers will be people like me. I’m grateful for the subsidy but can’t quite understand why you all should be willing to provide it.

Social Security Misdirection

As the debate over Social Security reform begins its escalation, I hope (but don’t expect) that liberals, instead of just shrieking, will bear in mind that the program’s current design was not the product of careful ratiocination based on progressive principles. FDR’s brain trust simply copied the features that were most common in private pension plans of the 1920’s. Hence, the system is a defined benefit plan based on career average compensation and funded on a pay-as-you-go basis by both employer and employee contributions. The main reason why it did not include individual accounts is that plans of that sort were extremely rare at the time. The best known was the Sears Roebuck plan, which invested only in employer stock. “Privatization” was not an option that was analyzed and rejected; it was never on the table.

Pension plan design concepts have advanced since 1933. Individual capital accumulation is rapidly becoming as important as employer promises, for reasons that are not completely different from those that impel Social Security reform: Offering a guaranteed lifetime income to retirees becomes a risky business as life expectancy lengthens and the ratio of active to former employees shrinks.

The way that Social Security is set up makes the effects of demographic change particularly acute, for it promises more than most other plans: a lifetime retirement income indexed to current workers’ wages. A corollary is that a decline in the number of workers per retiree necessarily increases the percentage of the workers’ income needed to support the program; higher wages stemming from improved productivity don’t fully mitigate the burden, because the wage rise increases benefits.

Reform would, in broad outline, refashion the present structure in this manner: Nothing would change for current retirees and workers within a few years of retirement. For younger workers, a share of current FICA taxes (12.4 percent of wages up to an inflation-indexed maximum ($90,000 in 2005)) would be deposited in individual accounts, which could be invested in an array (but not an infinite array) of mutual funds and insurance company pooled investment accounts. The individual account portion would be larger for younger workers. The remaining taxes would be applied, as at present, to pay current benefits. Future entitlements would be reduced by the economic equivalent of the private accounts’ anticipated future value, using reasonable actuarial assumptions. Eventually, government promises would be eliminated, except perhaps for a “longevity insurance” benefit beginning at, say, age 85, to reduce the risk that account owners will outlive their capital. Once the transition is complete, no generation will rely primarily on the generosity of the next as support for its old age.

The reason why Social Security needs repair is not that it faces an imminent threat. The current scheme can lumber along for another generation or so before it grows as costly as some of the European systems are today. But, barring a halt to current longevity trends, it is not self-sustaining in the long run. At its inception, the U.S. had 41 workers per retiree. Today there are three; 25 years from now, there will be two. Roughly speaking, people working in 2030 will have to shell out 50 percent more per capita for Social Security, in some combination of payroll taxes, income taxes, federal spending reductions and borrowing, than we do today.

There is no way to avoid coping with that burden, and reform advocates don’t pretend otherwise. Their goal to prevent Social Security’s relative cost from rising indefinitely as the worker-to-retiree ratio spirals toward one-to-one or less. The problem is so large and long-term that any solution has to begin now. If we wait until, say, 2050, the only options will be breaking commitments to newly retiring workers, stripping the active cohort of a huge share of its earnings or stopping medical progress. Liberals who coo over “the children” might want to think about those choices.

The preference of most left-of-center commentators so far has been not to think but to engage in misdirection, often tinged with hysteria. Four lines of mal-argument (as an Austrian economist might style it) are prominent:

Who’s Against Death Taxes?

As we are in the Advent season, a time of forgiveness and joy, it seems right to call attention to evidence that politicians are not always the monsters of self-interest that cynics imagine. In an article in Tax Notes [links not permitted], Martin A. Sullivan writes,

In contrast to the clear majorities in both the House of Representatives and the Senate that favor permanent repeal of the estate tax, the wealthiest members of Congress favor extending the tax. At the other end of the spectrum, many Republicans leading the battle for repeal have relatively little wealth and would be unlikely to enjoy any direct financial benefit from repeal of the “death tax.” When it comes to fighting class warfare in Congress, the rich are for the poor and the poor are for the rich. . . .

Eight of the 10 wealthiest senators have voted against repeal. Six of the eight are Democrats. Ironically, the wealthiest and the third wealthiest Republicans in the Senate – [Lincoln] Chafee [of Rhode Island] and John McCain of Arizona – are the only Republicans opposed to estate tax repeal.

In the House, the wealthiest member is Rep. Jane Harman, D-Calif. ($117.1 million). And House Minority Leader Nancy Pelosi, D-Calif., is also very wealthy ($16.3 million).

In sharp contrast, House conservative Republicans who will be leading the fight for repeal have relatively meager assets. After taking into account mortgages and legal bills, House Speaker J. Dennis Hastert, R-Ill., and House Majority Leader Tom DeLay, R-Texas, have an estimated net worth of only $120,000 and $40,000, respectively. House Ways and Means Committee Chair William M. Thomas, R-Calif., has a reported net worth of zero.

Mr. Sullivan is wrong, of course, to state that, in this dispute, “the rich are for the poor”. Mulcting estates does the poor no good, unless envy makes the process vicariously satisfying. Nor are “the poor” really “for the rich”. Death taxes don’t harm rich decedents in the slightest. They are, after all, dead and no longer interested, on anybody’s theory of the afterlife, in treasures laid up on Earth. Government seizure of a portion of their wealth (the residue left after a lifetime of taxes paid on income) merely takes resources away from their heirs, with the same ill effects on incentives and efficient resource allocation as other taxes levied at exorbitant marginal rates. And that is before considering the waste entailed in devising and implementing elaborate tax-saving gimmicks that generate the worst of all outcomes: minimal government revenue coupled with the immurement of funds in unproductive foundations and other tax shelters.

It is heartening that legislators of modest means can discern the evils of resentment-driven tax policy. If only their wealthier colleagues were equally clear-headed.

The Calpers Rally

Yesterday’s stock market surge is probably explicable, to the extent that market movements ever are, on the basis of the drop in oil prices or something of that sort. I’d like to imagine, though, that the real cause was a larger event, the unexpected removal of Sean Harrigan from the board of the California Public Employees Retirement System. As Calpers’ CEO, Mr. Harrigan was all that an investment manager shouldn’t be. Not only did he exhibit more zeal for political crusades than ROI, as when he tried to turn Abu Ghraib into a corporate meeting issue; he also had no qualms about blatant conflicts of interest, using Calpers’ resources to intervene against employers facing strikes by the United Food & Commercial Workers Union, of which he is a senior official.

Those flaws are widely recognized but were not perhaps overwhelmingly significant by themselves. The worst aspect of the Harrigan regime was one for which Calpers is frequently praised, even by savvy investors who ought to know better: its purported devotion to overseeing corporate management and taking action against incompetence. As a major Disney shareholder, Calpers was an early and persistent critic of Michael Eisner. More surprisingly, it tried to oust Warren Buffett from the Coca-Cola board, because it disapproved of his actions as a member of the audit committee. Overall, it has played the part of a well-heeled upgrade of the classic corporate gadfly, haranguing corporate leaders not just at annual meetings but all the year round.

Superficially, it may seem sensible for a fund that holds a large bloc of a corporation’s stock to kibbitz management actively. The shareholders own the company, their interests should be its managers’ foremost thought, etc. That is all true enough. But does it follow that the stockholders should substitute their judgement for management’s? While extraordinary cases may arise now and then, it is foolish to hire others to run an enterprise and then, on an ad hoc, amateur basis, without day-to-day familiarity with what is going on, question their decisions. If the results that they obtain are unsatisfactory, the modern system of corporate ownership furnishes the unhappy investor with an easy and adequate remedy: He sells his stock and buys into what he regards as a better run operation. If the market generally agrees with his valuation, the price of the poorly managed company’s stock will fall until it accurately reflects the quality of its executives.

Calpers’ preferred modus operandi has been the opposite: to hold onto its shares and try to use their influence to bludgeon management into performing better. Unfortunately, its board members lack the information, whether or not they possess the aptitude, to formulate business strategies. They can offer only specific ideas, some of which may be good but more of which are likely to be of secondary importance or, on account of their interaction with other, unrecognized factors, positively detrimental.

An instance is Calpers’ insistence that a company’s auditors should never, under any circumstances, be hired for non-audit duties. Disregarding that precept was Mr. Buffett’s mortal sin. Let us suppose arguendo that it is a sound principle (which I find rather doubtful, but that’s a debate for another day). Nonetheless, adhering to it in every conceivable case will mean sometimes obtaining lower quality services at a higher price. Sean Harrigan evidently believed that the sacrifice invariably brings compensating benefits. Warren Buffett, as a member of Coke’s audit committee and familiar with the company’s actual needs and the capabilities of the available consultants, disagreed. Did Calpers truly enhance shareholder value by insisting upon its principle?

This meddling approach is a bad idea even when it keeps clear of political fads. Once in a long while, the part-timer may be right and the full-time professional manager wrong. Much more often, “shareholder activism” wastes management’s time and, where it prevails, misdirects corporate resources to unprofitable ends.

The optimistic view of Mr. Harrigan’s departure is that it is the first sign of the demise of a foolish activism and a return by institutional investors to the concept of a division of corporate functions. It is the job of operating managers to attract capital and of managers of capital to discern which management teams will operate most profitably. Each of those roles depends upon different, to some extent incompatible, skills, as well as immersion in different kinds of data. The less they are commingled, the better for the economy. That prospect is a good reason for a stock market rally.

Today the market did nothing, so perhaps it isn’t so hopeful about the fate of the Calpers philosophy after all. Well, I can dream, can’t I?

An Indirect Approach to PBGC Solvency

In 1974 Rep. John Erlenborn (R-Ill.), one of the principal architects of that year’s pension reform legislation, argued in vain against setting up a government agency to insure pension benefits. He offered two objections: first, that empirical studies showed that participant losses from plans that terminated without being able to pay all benefits were insignificant (less than one percent of participants lost anything, and the present value of their average loss was $2,500); second, that an insurance program would create a mechanism for companies to run up large unfunded liabilities, then dump them into the lap of the federal government, giving an impetus to precisely the kind of behavior that ERISA’s minimum funding standards aimed to forestall.

Hardly anybody listened back then. Nowadays Rep. Erlenborn’s points are conventional wisdom, confirmed by the $23.3 billion deficit shown in the Pension Benefit Guaranty Corporation’s financial statement for fiscal 2004. The Wall Street Journal has called the PBGC “The Next S&L Crisis” [link for on-line subscribers only]:

The big problem is that the agency, by insuring private pension plans, has created its own moral hazard. Essentially, PBGC is writing a put option for which any private plan that is not fully funded is in-the-money; therefore, exercising the put by dumping liabilities onto the PBGC is attractive. Ultimately, of course, the put is written by taxpayers to the tune of tens of billions of dollars.

This slow motion train wreck is almost a perfect re-enactment of the thrift crisis in the 1980s. Back then, the government kept trotting out short-term fixes that deepened the problem until, finally, the thrift industry collapsed, presenting taxpayers with a $200 billion bill. Republicans in Congress are now promising a comprehensive overhaul early next year. They don’t have a moment to spare.

There is a mild degree of exaggeration here. Thanks to patches enacted in 1987, a plan sponsor can exercise its “put option” only if it is bankrupt – not the most attractive of financial strategies. Furthermore, the size of the deficit is somewhat overstated. The PBGC values its liabilities using interest rates of 4.8 to 5.0 percent, compared to 6.5 to 7.5 percent commonly used for FAS 87 valuations in the private sector. A valuation at a standard interest rate would lop several billions off the deficit (though one could counter-argue that FAS 87 assumptions are too sanguine). In any event, PBGC insolvency is not imminent. It has $39 billion in assets and cash outflow equal to only 25 percent of income. The Journal quotes a prognostication, “At the current pace of pension plan takeovers, PBGC could run out of money in 16 years.” Interestingly, when I headed the agency’s Policy and Regulations Department in the mid-1980’s, our staff prepared an estimate of how long the insurance program’s funds would last if then-existing trends continued. The answer was 16 years. That was 18 years ago.

Still, whether or not the PBGC is destined for a future bailout approximating the savings and loan industry’s, its situation promises no good cheer and demonstrates that “moral hazard” is not merely an economist’s shibboleth. In 1974 pension insurance looked like a cheap way to deal with a petty problem. The cure has, however, aggravated the disease.

Lawyerly Egoboo

Last Friday, the Seventh Circuit handed down the latest decision in Matz v. Household International Tax Reduction Investment Plan, a long-running case that turns on the criteria for determining whether a qualified retirement plan has undergone a partial termination within the meaning of section 411(d)(3) of the Internal Revenue Code. I am one of the very few people in the universe who cares about that issue, so I was delighted to see that the treatise that I co-authored on Pension Plan Terminations is extensively cited in Judge Posner’s opinion.

Though I would quibble with some parts of the exposition, the opinion reaches two important (well, important in this context) and, I believe, sound conclusions: first, that the familiar benchmark for the existence of a partial termination – a 20 percent reduction in plan participation – ought to be treated as a rebuttable presumption; second, that, for the purpose of determining the extent of the reduction, the numerator and the denominator should each include both vested and nonvested participants. These principles are particularly meritorious in light of the virtual obsolesence of section 411(d)(3). It was formulated in an era when long periods of service could be required for vesting. Nowadays any individual participant with benefits worthy of a court’s attention is fully vested without regard to the partial termination rule. Hence, the simpler the rule, the better, and Judge Posner has made matters as simple as they can be within the confines of the statute.

The Next Orders of Business

Having no special psephological expertise, I have no confident ideas about how the election will turn out. I think that President Bush will win, possibly by a surprising margin, for three reasons. First, it seems unlikely that, in the middle of a war, the electorate will dump the commander-in-chief in favor of someone who, according to polls, is considered by a substantial majority to be less fit for the office. Second, the economy is in good shape. Numbers no better than the current ones guaranteed Bill Clinton’s reelection in 1996. Finally, polls in close elections usually underpredict the performance of conservative candidates. We saw that in Australia, a country where accurate polling is much easier than here, just last month. The race was, said the pollsters, excruciatingly tight, with an edge to the Labour Party. Right-wing pundit Tim Blair was not alone in his pessimism. In the event, the right-of-center governing coalition won nearly 53 percent of the two-party vote, gained five seats in the House of Representatives and won control of the Senate for the first time in over a quarter-century.

Regardless of the outcome, however, American history will go on, and conservatives will need to cope with the future. (In our topsy-turvy new millennium, it is liberals who dwell incessantly on the past and angrily yearn for the restoration of a romanticized golden age of peace, prosperity and political correctitude.) Here, then, are what I regard as the most urgent tasks that face our country over the next several years.

First, needless to say, is to fight the War on Terror, preferably with enhanced aggressiveness. A Bush victory will be a superlative opportunity, because it will, at least for the moment, demoralize anti-Americans around the world and will suggest to waverers that waiting for the United States to retreat into an isolationist shell is not a profitable strategy. A Kerry win will have the opposite impact, of course, but it need not be fatal. George W. Bush will remain President for three more months. I’m sure that he won’t follow the Clinton course of making things as difficult as possible for his successor. Instead, he will most likely ease the way for a Kerry Administration by cleaning out Fallujah and other Islamofascist pockets in Iraq and making sure that the elections scheduled for January can take place on schedule. After that, a President Kerry will be on his own, but he will swiftly learn what he doubtless already knows in the nuances of his mind: that France, Germany and the U.N. won’t bail out the “hyperpower” and can’t be appeased by any concession that it is politically feasible for an American President to yield. Though he doesn’t want to and will do it badly, he would be fated to be as much a unilateralist war President as his predecessor. (David Frum made this point excellently yesterday, but it should be obvious. My 20-year-old niece has been saying the same to her college roommates.) The Left will in that case come to detest John Kerry as much as it once did Lyndon Johnson. It will be up to the Right to offer intellectual and moral support.

Second, the economy cannot be ignored. No one today, thankfully, is as fatuously optimistic as during the Clinton years, when the conventional wisdom seemed to be that the Business Cycle had been repealed and unending prosperity was a natural state of affairs. The problem is to find the right tonic to mitigate the fluxes. If one looks at the economic facts of the Clinton period, the one that stands out is that, from 1994 through 1998, federal spending declined in relation to the size of the economy, thus putting more economic decisions in the hands of utility-maximizing private parties and spurring expansion. Then the spending tide began to turn, and recession was in the air by the latter half of 2000, when the GDP contracted for a quarter, struggled through a couple more and definitively declined in early 2001. The Bush tax cuts provided the stimulus for a recovery, but the long-term way to limit the number and severity of downturns is spending discipline, which has not been a prominent feature of either party’s platform in recent years. Bringing rationality to discretionary spending, much less entitlements, is politically a daunting task, but an essential one.

Third, President Bush (assuming that is still President after next January) appears to be willing, though he may have trouble being able, to address our greatest long-term economic problem: liabilities for Social Security and Medicare. The current system is demographically unsustainable. It was designed for an era when the nonworking elderly were a small fraction of the population, not an emerging majority. Barring the discovery of an elixir of youth that enables us all to continue laboring productively into our 90’s (and is that what we really desire?), the day will come when retirees will have no choice but to live on their own accumulated capital. We can either prepare for that day by gradually converting Social Security and Medicare into private savings programs, or we can be grasshopper liberals, wait for the collapse and blame capitalism. Old Europe is on course for the latter, Latin America (oddly enough) for the former. It may be a century before the results are fully visible, but what they will be is scarcely in doubt. The United States has yet to make its choice.

Finally, it is essential to attend to the American democratic process itself. With luck tomorrow’s predictably massive fraud won’t tip the balance, but John Fund’s Stealing Elections assembles enough data to alarm any citizen who isn’t himself engaged in ballot theft. Congress made stabs at reform after the Florida contretemps, but they were worse than inadequate, as demonstrated already by widespread phantom voter registration – Philadelphia alone has 60,000 more voters on the rolls than citizens old enough to vote – and sure to be confirmed tomorrow. At a minimum, there ought to be a national data base of registrations, so that, for instance, 27,000 people cannot continue to be active voters in both Ohio and Florida, coupled with a requirement of photo ID at the polling place. In my eyes, the only motive that a politician can have for opposing those minimal measures is a belief that he or his party benefits from fraud and has the right to continue to do so.

It would also be nice to end the erosion of the secret ballot. Balloting by mail has become so commonplace that there can be no assurance in many states that the choices marked on the ballot represent the true opinions of the nominal voters. It may mean little to independent-minded denizens of the blogosphere that a domineering parent, spouse, social worker, employer, shop steward or other person with influence over the lives of others is in a position to demand to see how those others vote. Not too long ago, the effect of overt and covert pressure was confined by the fact that almost all ballots were cast on Election Day out of the sight of anyone but the individual citizen, who could solemnly promise to mark A and pick B instead. Have we so utterly forgotten why the 19th Century reformers insisted that the privacy of the voting booth could not be optional?

Oh, let’s also not forget another quaint 19th Century notion: freedom of speech. REPEAL McCAIN-FEINGOLD!. A democracy whose government controls what citizens can say for and against political candidates will not remain a democracy for long.

There are many other issues that can occupy our attention, but these are, I think, the big ones. Many Americans will prefer to shunt them aside; that is a way of pretending that the future will inevitably be sunny and serene. It is the spirit that animates the leadership of the Democratic Party, an illusion that our country and our civilization can no longer afford.

Libertarian Frolics and Detours

Walter Olson, whose commentary on litigation follies is invaluable, declares today that he is going to vote for the Libertarian Party Presidential candidate, who he concedes “appears to be a barking moonbat” (Seems, Wally? Nay, he is), rather than George W. Bush. He links to other small-l libertarians who share his sentiment, some of whom plan to go further and cast an ultimate protest vote for John Kerry.

Their complaint is one that I’ve heard often: that the Bush Administration “combin[es] aggressive social conservatism with uncontrolled spending and big new government programs”. Few of the complainers argue that Senator Kerry is any better, and Wally doesn’t try to make that case. Instead, the notion seems to be that a Bush defeat will lead to a Republican Party that takes small government principles more seriously and panders less to spending lobbies, after which all of the damage wrought by a Kerry Administration can be undone.

I’m not the one to tell libertarians what action is in their own best interests, but reasoning of this sort fits the stereotype of libertarianism as the philosophy of “We happy few – and the fewer, the happier.”

President Bush doesn’t have an admirable record of restraining federal spending, but he isn’t at all a hopeless case from a small government point of view. He has been remarkably successful in cutting taxes, has reduced trade barriers (despite the temporary folly of the now-lapsed steel tariffs), has proposed a sensible immigration reform (unfortunately stalled by closed borders sentiment in Congress) and is responsible for only one big new government program, the Medicare prescription drug benefit. The last is a wretched idea, sure to expand expensively. On the other hand, he insisted, at considerable political cost, on yoking it to health savings accounts, the first concrete step that the government has ever taken toward steering health care to a free market track.

Libertarian protest voters may wish to contemplate the policies that their protest will help produce: Senator Kerry advocates tax hikes (some of which he could, as President, obtain simply by vetoing extensions of the 2001 cuts), has promised to “renegotiate” trade liberalization agreements (his running mate is an outright protectionist), will pursue either higher immigration barriers or a utopian multiculturalist policy (depending on whether he is more swayed by his labor union or his Hispanic Left constituency) and has plenty of ideas for dramatically expanding the size and scope of government. Maybe a Republican-controlled Congress will keep him in check, but maybe he will hive off enough left-leaning GOP votes to enact much of his program. The “golden age” of Clinton inertia was largely the product of that President’s personal lack of interest in all issues except reelection. Anti-Bush libertarians are betting a lot on the hope that John Kerry is cast from the same mold.

But I don’t want to descend to the argument that W is the lesser of two evils. If one looks at issues central to liberty, he is a good, albeit not a perfect good.

First, whatever libertarians may think about the President’s conservative stands on abortion, homosexual rights and stem cell research, those controversies are less important than freedom of speech, freedom of the press and freedom of association, all of which are threatened by left-wing policies. Bush spokesmen haven’t been calling for restoration of the “fairness doctrine”, threatening retaliation against news media that present unfavorable views of their candidate, floating plans for “national service” for all high school graduates (temporarily played down so as not to conflict with the “Bush has a secret plan to restore the draft” smear) or assuring trial lawyers that they need not worry about significant tort reform. Nor has the Bush Administration given aid and comfort to campus speech codes, affirmative action racism or restrictions on the right of private organizations to determine their own membership. Aggressive social liberalism is a more serious danger to our rights at the present time than the President’s rather mild social conservatism.

Second, George Bush is the first President to take steps toward reversing the tide of Big Government in two of the areas that it most dominates: retirement policy and health care. Not even Ronald Reagan seriously suggested transforming Social Security’s public liabilities into private assets or increasing, rather than diminishing, the role of the patient in making choices about medical care. One reason why the Statist Left is so stridently anti-Bush is its fear that, within a couple of generations, Social Security reform and health savings accounts will create a new capitalist class of senior citizens, independent of the State and with an economic interest in limiting its impact on the economy.

A second Bush term will be a promising environment for pro-liberty initiatives. A Kerry victory will take them off the table for years. It could also lead to the demise of the small government wing of the Republican Party. If the President loses, the media will be quick to attribute the outcome to his “heartless right-wing policies”, and Republican opportunists will get lots of favorable coverage as potential “rescuers” of the party. In those circumstances, the likelihood that the next Republican nominee will be as libertarian as George Bush is close to nil. Libertarian purists who think that they have a lot to moan about now “ain’t seen nothing yet”.

Correction: Walter Olsen assures me that his statement was not meant to be read as a declaration that he intends to vote for the Libertarian Party candidate. I evidently read too much into it. At least, I didn’t misread as badly as some of his correspondents, who think that he endorsed John Kerry.

Further Reading: Hogberg’s Libertarian Guide to Bush Vs. Kerry considers a lot of issues in greater depth. I do disagree on some points, especially –

• The advantage that Mr. Hogberg gives to Kerry on “Government Spending” is wishful thinking. It assumes that Republicans will continue to control Congress throughout a Kerry Administration and will hold the line against government extravagance with virtual unanimity. To that I respond with three words: Ha, ha, ha.

• Abortion and same-sex marriage are far from unambiguous issues from the perspective of individual liberty. There is no libertarian principle that grants the right to kill very small human beings, so libertarian pro-abortionists rest their position on their understanding of biology or theology, not on the proper role of the state. The arguments in favor of state recognition of same-sex marriage are all grounded in equality, not liberty. So long as the government doesn’t persecute homosexuals, their liberty is unimpaired by a lack of state-conferred benefits.

• I’m surprised at how often libertarians omit freedom of speech, press and assembly from their lists of key political issues. Those freedoms are all under attack from the Left right now. I don’t think that there is much question about which Presidential candidate is more likely to defend them from the PC Police.

A Primer on Social Security Reform

For those not fixated on Osama bin Laden, international global tests or other such nonce issues, I recommend an excellent new article from the Heritage Foundation, “The Top Ten Myths About Social Security Reform”. The author, David C. John, lucidly summarizes the reasons why the present system is unsustainable in the long run and explains why a gradual shift to full or partial privatization will reduce the risk of a future collapse.

Within 15 years, Social Security retirement benefits will exceed the taxes collected to pay them. At that point, the system will begin drawing down its hypothetical trust fund, which holds nothing but I.O.U.’s on the U.S. Treasury. To meet those obligations, the government will have to raise taxes, cut spending or borrow money, just as it would if the trust fund did not exist. By about 2042 the I.O.U.’s will be gone, an event of no economic but some legal significance. Current law, with limited exceptions, forbids using general revenues to pay Social Security benefits, except to the extent that the trust fund cashes in its “assets”. Unless the law is changed, either Social Security taxes will rise sharply in the 2040’s, as people born in the late 1970’s and early 1980’s are reaching retirement age, or benefits will be cut back. Today’s twenty-somethings can look forward to one of history’s great inter-generational donnybrooks, pitting their elderly selves against younger workers who don’t want to bear a steadily escalating tax burden. (Amending the law to permit the use of general revenues will not, of course, ameliorate the burden; income taxes would simply go up instead of Social Security levies.)

If the present system remains unchanged, without benefit reductions, the government will have to collect additional revenues of $27 trillion (adjusted for inflation but not present-valued) over the next 75 years. The amount needed each year will rise steadily, e. g., from $280 billion in 2050 to $640 billion in 2075 (2004 dollars in each case). Those gaps won’t be as daunting then as they would be now, because the economy will presumably grow in the meantime, but they will never be small change.

The concept behind privatization is to substitute capital accumulation for a large portion of Social Security’s unfunded liability, thus making retirement benefits individual property that will not be at the mercy of younger taxpayers. That strategy does have to get over a short-term rough patch: Since reducing benefits already accrued is, quite rightly, politically impossible, there will be a phase-in period during which workers will have to continue paying the taxes needed to support grandfathered benefits and put funds into their own individual accounts. In effect, part of the system’s unfunded liability will be accelerated, but whatever hardship that entails will be more than offset by the long-run decrease in unfunded commitments and the creation of private wealth to replace public promises.

Mr. John’s analysis covers these and other issues in greater detail. At some point during the third Presidential debate (the one on domestic policy), Senator Kerry is bound to drag out privatization as a bogeyman. By reading a few pages now, you can be ready to skewer his arguments when he does.

Social Security Privatization: A Weird Objection

The Kerry campaign has seized on a new argument against allowing workers to invest part of their Social Security taxes for themselves. As summarized in today’s Washington Post:

President Bush’s push to create individual investment accounts in the Social Security system would hand financial services firms a windfall totaling $940 billion over 75 years, according to a University of Chicago study to be released today. . . .

[Austan] Goolsbee, an informal Kerry economic adviser, examined the [privatization] option that is often cited as the most realistic.

Under that plan, workers could invest as much as 2.5 percent of their earnings – or about 40 percent of their share of Social Security taxes – in private accounts, which Goolsbee anticipates would be managed by private investment firms once their balances reach $5,000. He estimated that annual management fees would be 0.8 percent, a conservative figure, he said, considering that management fees across the spectrum of mutual funds average 1.09 percent.

The result: Over 75 years, fees would total $940 billion, more than a quarter of the $3.7 trillion deficit the Social Security system will run over that time period. That would be the largest windfall in U.S. financial history, Goolsbee said, more than eight times the revenue loss that Wall Street suffered during the 2000-02 stock market collapse. [Does it matter that 75 years is 25 times as long as 2000-02? – ed]

Professor Goolsbee’s figure implies that, on average over the next 75 years, privatization will increase aggregate household wealth by $1.6 trillion (heavily backloaded in the later years, as investments accumulate). When more money is invested, investment managers naturally make more money, too. That is good for them, but it is not bad for investors. The higher fees are simply the product of the increase in the value of their assets.

If one wishes to see a real “windfall”, look at the last bull market. Between 1995 and 2000, the value of equities held by households rose by $3.3 trillion. If the average management fee was Professor Goolsbee’s “conservative” 0.8 percent, the bull market “handed financial services firms” over $26 billion in the year 2000 alone, twice the average annual “windfall” predicted for privatization. Is that an argument in favor of stock market stagnation? To be consistent, the Kerry campaign would have to say that it is.

As an argument for John Kerry’s ultraconservatism on Social Security – he promises to change absolutely nothing, notwithstanding that, within 15 years, benefits will exceed the taxes levied to pay them – this one is about as cogent as Michael Moore’s fantasy that the invasion of Afghanistan was undertaken to promote a gas pipeline. The issue that Senator Kerry ought to address is whether retirees will benefit by trading off government promises for increased pools of personal assets. Professor Goolsbee’s analysis, while a useful reminder that smart investors pay attention to management fees, plays a trivial role in answering that question.

Addendum: Ramesh Ponnuru observes that the Kerry campaign’s rollout of this theme attributed to Professor Goolsbee contentions that weren’t in his report. More hinges coming loose.

Ten Days, and All Is New

Having been distracted for ten days from the mundane world, I return with fresh eyes and a sense of how true it is that a week is a long time in politics. The last time that I looked, the Presidential election was supposed to be John Kerry’s to lose. While I wasn’t looking closely, he seems to have lost it, in quite a few senses of that phrase.

In the airport waiting area this afternoon, I heard the candidate rumble, in a voice that sounded 80 years old and terminally misanthropic, “George Bush is raiding the Social Security trust fund”, that last shibboleth of the desperate Democratic demagogue. Senator Kerry isn’t an ignoramus. He knows as well as I that the “trust fund” is a ledger of IOU’s that accumulate at precisely the same rate, regardless of the size of the federal deficit, and serve merely as an accounting device, not a store of value (a point that I have discussed in greater detail elsewhere).

Moaning about this illusory fund is the classic dodge to avoid confronting the fact that changing demographics have upset the assumptions on which the present Social Security system was founded. It was easy to maintain a defined benefit, pay-as-you-go scheme when the average worker stayed in the labor force for 40 years and lived in retirement for 15. The combination of earlier retirement and longer life spans makes the arrangement increasingly burdensome. We haven’t reached the state of affairs in old Europe, where taxes to pay for public pensions run as high as 40 percent of payroll in some countries, but that is the direction in which we are heading. The only preventatives are economic expansion, which makes Social Security more affordable, or transition to a system that relies on saving rather than income transfers, so that retirees don’t need to draw on taxes paid by their children and grandchildren. A perpetually booming economy would be ideal, but we can’t count on it. President Bush has proposed, under his Chestertonian “ownership society” rubric, the first steps toward the surer alternative. It tells us a lot that his opponent has responded not with reasoned analysis and solutions of his own, but with an effort to “scare the seniors”.

Looking more broadly at the campaign, Democrats seem to be divided into two groups. There are those who want to fan Bush Hatred and anti-war sentiment in the hope that some allegation or event – rumors about George W. Bush’s youthful irresponsibility, bad news from Iraq, new terrorist attacks – will decisively swing public sentiment. Susan Estrich has been the most prominently shrill, but far from the only, advocate of that strategy.

Others prefer to hunker down, take no risks and lose gracefully. They will be content if John Kerry winds up like Bob Dole, fearing that, if he adopts the Estrich route, he will be more like George McGovern. An unexciting election, focused on domestic issues that don’t really concern voters in the midst of a war, will limit the Democrats’ loss of Congressional seats and governorships while laying the groundwork for a comeback after the terrorist threat recedes. Bill Clinton, who urged that course from his hospital bed (and deserves credit for caring about the future of his party at a moment when his own was in doubt), knows that the aftermath of a victorious war is the most likely time for democracies to change their political course. Liberalism in general and the Democratic Party in particular had a splendid opportunity after the end of the Cold War. Mr. Clinton presumably realizes that it was bungled, largely owing to his own indecisiveness and egotism. He sees a second chance after the War on Terror and doubtless wants to preserve it for another Clinton.

John Kerry, characteristically, takes both sides of the argument. With “the wrong war in the wrong place at the wrong time”, he recruits for the Angry Left. Simultaneously, he devotes sound bites to outsourcing, budget deficits, tax policy and other issues that lower the temperature of the national debate. I make no claims to high ability as a political strategist, but isn’t he following the path to assured defeat? He isn’t flailing vigorously enough to convince 50-plus percent of the electorate that George W. Bush is an evil compared to which all others are lesser. Nor is he letting national security fade from the public’s consciousness in order to enhance the prospect that domestic concerns will dominate the voting. Rather, he reminds us all that his own “plan” for the war amounts to hoping that France, Russia and Germany will bail America out – hardly a promising approach when recent events have illuminated their incapacity to protect their own interests. He also highlights a fatal question: If John Kerry doesn’t know, even in hindsight, how he would have fought the war so far, how can we trust him to conduct it in the unknown future?

There remains the remote, but not unreal possibility that eight weeks of attritional warfare in the Democratic candidate’s behalf by a nearly unanimous media establishment will push him to victory. Today we see a reprise of stories about young George Bush’s laxness in meeting his commitments during his last year of Air National Guard duty, at a time when the decreasing American presence in Vietnam left the Guard with a surplus of pilots and no particular interest in men near the end of their terms. Whether Lieutenant Bush slacked when the slacking was easy is of no significance – he has never insisted that we should vote for him as a reward for this military service – but reporters can always hope to stir up embers of hostility with a lukewarm version of an AWOL smear. I’m confident that we will also hear more about how much George drank, whether he ever used cocaine, what went wrong with his early business ventures. . . . A while back I noticed on a left-wing blog (link forgotten now) the claim that he cheated at undergraduate rugby. When will the Associated Press pick that up and dribble it?

If a week is a long time, eight are more like a millennium. Perhaps the race will alter so vastly between now and November that these reflections will be shown up as naïve and ridiculous. For today, though, I have no hesitation about saying that the man whose actions will not decide the outcome of this election is John Forbes Kerry.

The Social Security Un-Fund

This being an election year, we have already begun hearing laments about how tax cuts drain money from the Social Security trust fund and thus threaten the retirement income of future generations. I've tried to explain elsewhere that the "trust fund" is merely an fiction designed to account for the fact that Social Security payouts will one day (2019 is now the estimated year) exceed FICA taxes, at which point the government will have to fill the gap by raising taxes, cutting other spending, reducing benefits or borrowing. Those choices will be the same - and will be of the same magnitude - regardless of the size of the federal budget deficit in 2004. David Hogberg ("Trust Fund Babies") makes a stab at getting the same point across. It isn't abstruse. Maybe, if enough of us repeat it, it will sink in.

Media Bias and Cash Balance Plans

If you pay any attention at all to news about employee benefits, but don't have a professional interest in the area, then you "know" that cash balance pension plans are a dubiously legal scheme for bilking workers out of promised retirement benefits. You have certainly read about Cooper v. IBM Personal Pension Plan, in which a District Court judge (in Madison County, Illinois, the country's most plaintiff-friendly jurisdiction) ruled earlier this year that cash balance plans violate the Age Discrimination in Employment Act and that IBM owes plan participants a gigantic, not yet calculated sum. The Wall Street Journal, New York Times, Washington Post and every other major newspaper ran the story as front page news, and it was reported by all the networks. The general tone of the coverage was that the case was a major legal landmark, even if a few "employer representatives" were stubbornly resisting Judge Murphy's self-evidently irrefragible logic.

On June 10th, another District Court, this one in Maryland, addressed the same issue and reached the opposite conclusion. In Tootle v. ARINC Inc. [PDF file], Judge Catherine Blake rejected the arguments that had so impressed her Illinois colleague and held that ARINC's conversion of its "traditional" pension plan into a cash balance plan was perfectly legal.

This morning I checked Nexis. No publication in that massive database has carried even one story about Tootle. A search on the Wall Street Journal site likewise uncovered no coverage, though that paper's crusading anti-cash balance reporter Ellen Schultz had much to say about Cooper.

Is there reason to suspect that media bias extends beyond Iraq?

Further Reading: ERISA Industry Committee, "Hybrid Plan Research Studies" (a summary of empirical research on cash balance plans, showing that companies have been adopting them to meet employees' needs, not to cut costs surreptitiously)

Update: On July 11th, the Washington Post got around to mentioning Tootle v. ARINC, at the tail end of an article about privacy rules for medical records. I have been told by someone in a position to know that the reporter had previously prepared a separate story about the case, but the Post never ran it. The silence of the Wall Street Journal, the New York Times, Business Week et al. remains impressively uniform.