Exploiting Discounting for Fun and Profit

One of the reasons that pensions are so common – and such a problem – is because of time inconsistency.  Public-sector unions will often negotiate for pensions instead of raises because they can get much more, and they can get much more because it’s easier to promise two dollars tomorrow than pay a dollar today.  The inevitable result has been massive pension burdens that came crashing down around governments’ ears in the 2008 crisis.  Of course, time inconsistency goes two ways…

It should seem obvious, but pension-holder time inconsistency also exists; pensions-holders are willing to accept straight cash in lieu of their promised pensions.  Not only do they accept buyouts, they accept buyouts at very steep discounts; in general, roughly 20 cents on the dollar.  While Adam Ozimek is oddly angry about this, this presents a great opportunity for relatively-well-managed municipalities.  During good times, governments can take advantage of their employees’ time inconsistency to discharge their pension obligations at far below face value.  This means they should face fewer crises during bad times, when both their revenues are hammered and pension funds’ investments take a simultaneous beating.

But that would require a degree of foresight it’s hard to imagine coming from local governments. Still, if ever put into practice pension buyouts seem like a solution that would leave both government finances and public employees better off.

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