by J.C. Pate

“Borrowers who devote a decade of their lives to public service should be able to rely on the promise of Public Service Loan Forgiveness.”

U.S. Secretary of Education Miguel Cardona, Oct. 6, 2021

Introduction

Democrats are very fond of government programs to forgive student loans, but they especially love schemes that direct lucrative government handouts to “public servants.”  This favoritism is evident when looking at the income-based loan forgiveness schemes currently in place for new borrowers inside and outside of the public sector.  Private sector workers have to pay 10% of their income for at least 20 years before they can receive forgiveness on their student loans.  But for public servants, the deal is much better.  The special program for public servants also requires they pay 10% of their discretionary income, but they will have their student loans forgiven after only 10 years.   

This special treatment for public servants seems unfair to private sector workers.  It’s kind of like getting a bicycle for Christmas while your sibling gets a new car.  So, what’s driving this discriminatory program?  There are a variety of motivations, none of them good.  

Overview of the Public Service Loan Forgiveness Program

The Public Service Loan Forgiveness Program (PSLF) was established in 2007 to provide forgiveness on certain direct federal loans for borrowers who have made 10 years of qualifying monthly loan payments while working full-time for U.S. federal, state, local, or tribal governments or for qualifying not-for-profit organizations.   

Originally, the PSLF program was restricted to borrowers that had elected an income-based repayment program, a scheme which limits a borrower’s legal repayment obligations to between 10% and 15% of their discretionary income.  When this program was launched, borrowers who had chosen traditional loans with fixed repayment schedules were not eligible.  

But like most government programs, this one expanded over time.  In October of 2021, the U.S. Department of Education (DOE) announced a range of changes to significantly ease the requirements for loan forgiveness under the PSLF program, including expanding the types of loans which are eligible to include all direct federal loans, not just loans covered by income-based repayment programs. 

In addition, the DOE expanded the definition of what would count toward the requirement for 10 years of loan payments, including relaxing the original rules that required borrowers make loan payments on time to qualify for forgiveness.   As described on the studentaid.gov website: “Under the new rules, any prior payment made will count as a qualifying payment, regardless of loan type, repayment plan, or whether the payment was made in full or on time.”  As a result of these modifications, the DOE estimated that more than 550,000 borrowers would benefit from an increase in the number of loan payments qualifying under the PSLF, with the average borrower experiencing an increase of two years of progress towards eligibility for forgiveness.  

Congress has also established four slightly different income-based repayment (IBR) plans that are available for borrowers who work in the private sector, but with much less generous terms than the PSLF.  When this program was set up in 2007, it required private sector borrowers to pay 15% of their discretionary income for 25 years.  In 2014, the government softened the terms for some new borrowers, lowering required debt payments to 10% of discretionary income with debt cancellation after 20 years.  Still, the options for private sector borrowers were much less attractive than the PSLF program in which public sector workers could be eligible for debt forgiveness after only 10 years.  

All of this adds up to a pretty sweet deal for public sector workers, but it gets even better for them.  Loan forgiveness received by borrowers under the PSLF is not taxable.  Private sector borrowers are not so lucky.  Any forgiveness they receive on their student loans is taxable, just like the forgiveness of other types of debt like mortgages or car loans.  

The PSLF is Poorly Designed 

In addition to its inherent unfairness, the PSLF program suffers from design flaws.  First, the PSLF definition of “public servant” is not even limited to government workers.  Rather, the definition is so broad it includes anyone working for a 501(c) (3) not-for-profit organization.  There are over a million of these types of organizations in the United States, so this significantly increases the number of individuals eligible for student loan forgiveness under this program.  This raises some curious inconsistencies in outcomes.  For example, a teacher at a public school would qualify while a teacher at a private for-profit school would not.

Another design problem in this program is that its short tenor weakens the logic behind IBR plans.  The basic concept underlying these plans is for the government to function like a partner of the borrower – taking less in debt payments when incomes are low (early in a borrower’s career) in exchange for receiving more when incomes are higher (later in a borrower’s career).  This theory is weakened if borrowers aren’t required to keep making loan payments long enough to progress to their higher earning years.   In this regard, the longer tenor of the private sector IBR plans is much more consistent with the foundational principles of income-based repayment plans in general. 

The PSLF program also suffers from the disadvantages that plague loan forgiveness proposals in general.   Loan forgiveness giveaways disadvantage people who don’t have outstanding student loans, including those who worked their way through college, borrowed money from their parents, chose to attend less expensive colleges, or missed out on college altogether.  Furthermore, there is no means testing in the PSLF, so a significant portion of the value goes to people who are not needy.  In fact, because college graduates are generally better off than the average American, a significant amount of the benefits of this program are directed to wealthier-than-average individuals.  This is a very bitter pill for the American taxpayer to swallow.  Also, this program does nothing to address the underlying causes of excessive student borrowing.

What’s worse than the PSLF Program?  The motivations behind it

Why do some politicians go to such lengths to direct these valuable benefits to public servants?  There are several motivations, all with serious drawbacks.  The one most often cited publicly by PSLF proponents is that these workers somehow deserve extra payoffs because of all the sacrifices they make by working in the public sector.  This rationale does not hold up upon examination because public sector workers already have significant advantages relative to private sector workers, often including higher wages, more generous benefits, enhanced job security, and more predictable promotions. 

Public sector workers are a diverse bunch, but here are some data points that illustrate how they are often better situated than private sector workers:

• In a 2017 study, the Congressional Budget Office examined the 2.1 million employees in the federal government and found they received 17% more in total compensation (including benefits) than similar workers in the private sector with comparable qualifications.

• A similar dynamic is evident when looking at the much larger group of 16.4 million state and local government workers.  For this group, the Bureau of Economic Analysis found they received 16% more in total compensation in 2020 than workers in the private sector.

• Defined benefit plans are a significant driver of the lucrative compensation packages enjoyed by public sector workers.  In 2019, 86% of state and local workers had access to defined benefit plans while only 16% of private industry workers did.  Also, public sector workers generally have access to better health care plans than private sector workers.  

• Public sector workers have a high degree of job security while private sector workers are much more exposed to the ups and downs of the economic cycle and the performance of their individual employers.  This can be seen by looking at the level of layoffs and discharges in the public sector, which is less than one-third of that in the private sector.  In addition, public sector workers often get wage increases based on pre-set schedules and receive promotions in a lockstep manner.

So, the trope of the long-suffering public sector worker does not stand up to scrutiny.  The combination of generally higher compensation, enhanced job security, more stability in pay, and greater predictability of promotion results in a much more attractive employment proposition for public sector workers relative to private sector workers.  This is demonstrated by the fact that public sector workers stay in their jobs to a much greater extent than private sector workers.  This can be seen in the quit rate for government workers, which is consistently less than half the rate for private workers.  

But perhaps the most powerful motivation behind the PSLF is the most pernicious.  Fundamentally, the PSLF program is an effort on the part of certain politicians to secure the political support of those who stand to benefit.  And because these types of politicians never tire of commandeering taxpayer money to fund their vote-buying schemes, you can rest assured the long-term plan is to use the PSLF as a beachhead to further expand similar types of giveaways.  We can already see this strategy of incrementalism at work, most recently in 2021 when the DOE significantly expanded the scope of this program.

This is a strategy commonly used by big government politicians.  The general idea is to choose a certain subset of individuals and give them preferential treatment as a way of buying political support.  In the selection process, priority is given to groups that can most easily be portrayed in a sympathetic light, even if that characterization is misplaced.  Getting a proposal like this through Congress is made easier because the plan can be presented as relatively limited, at least in the beginning.  Eventually, the plan is broadened in a self-reinforcing feedback loop.  Politicians use the program to buy political influence which is leveraged into expanding the group of beneficiaries who become more numerous, politically powerful, and better positioned to defend the program. 

Conclusion

The PSLF program is a highly valuable benefit for public sector workers.  Private sector workers must wonder what makes public sector workers deserving of this special treatment.  Advocates of loan forgiveness for public sector workers like to paint the recipients as noble martyrs who deserve rewards for all their sacrifices for the public good.  Upon examination, this portrayal is very misleading.  In fact, a comparison of workers in the public sector versus similar workers in the private sector indicates that public sector workers often have higher compensation, more job security, and greater predictability of promotions.  The handouts from the PSLF program only serve to exacerbate the advantages enjoyed by public sector workers.  This cynical favoritism is a deeply unfair insult to the Americans who are excluded from this giveaway even as they foot the bill as taxpayers.  Every worker is deserving of respect, and public servants are no more meritorious than private sector workers.

Why then would politicians devote scarce taxpayer resources to such a flawed program?  Their motivation is part of a two-pronged strategy.  First, trade loan forgiveness for the political support of a favored group.  Next, use the initially narrow program as a launching pad from which it can be incrementally expanded.  This becomes an ever-expanding cycle of vote buying as politicians use the political power emanating from the beneficiaries of the plan to continually broaden the scope of the program.  In this process, ordinary citizens find that their tax payments are being used against them.  Not only are taxpayer resources unfairly directed to politically favored special interest groups, this is done in a way that is corrosive to the democratic process.  

by J.C. Pate

Originally published August 6, 2020

What is the proper role of the corporation?  This question is currently a hot topic in the world of investing and corporate governance.  Should a corporation prioritize the growth of shareholder value or, as suggested by advocates of “Stakeholder Capitalism,” should it work to improve outcomes for other stakeholders such as employees, customers, suppliers, the community, and the environment?  

While many of the tenets of Stakeholder Capitalism sound appealing, the application of these proposals can create a host of problems by imposing social or political goals on corporations at the expense of shareholders.  This is inefficient, unfair, and anti-democratic.  

There is a better way to achieve the outcomes advocated by the proponents of Stakeholder Capitalism.  It is more equitable and efficient for a society to achieve socio-political goals through a democratic process that weighs costs and benefits to prioritize objectives and creates a transparent framework that is applied fairly to all members of society, including corporations.

The Corporation:  A Value Creation Machine

As a starting point, it is important to understand the corporation and its purpose. The corporation is an impressively beneficial organizational structure that allows large numbers of individual investors to pool their resources and pursue business opportunities.  Shareholders are not just wealthy individuals.  They include pension funds and individuals saving for things like housing and retirement.  For many small investors, buying shares in corporations is the best way to access diversified investment opportunities.  

A corporate board of directors hires a management team and tasks them to run the business with the goal of increasing value for shareholders.  For this arrangement to work properly, management needs to have a clear mandate to focus on the single objective of maximizing shareholder value.  Otherwise, they will have a hard time balancing different priorities.  This division of labor is so important that the board of directors is charged with a fiduciary duty to act in the best interests of the shareholders.  

Not only does the corporation create value for shareholders, it creates value for society by providing goods and services at fair market prices.  By operating this way, corporations have been a huge contributor to economic growth and improvement in the standard of living around the globe.   

The mandate to maximize shareholder value is often misunderstood.  It does not mean corporations should operate with a short-term view or take advantage of employees or other stakeholders.  Maximizing shareholder value requires management to operate with a long-term perspective and run their business in a sustainable manner.  Corporations should always operate in compliance with the law and behave ethically with honesty and integrity.

Some voices argue that corporations should not seek to optimize shareholder value.  Rather, corporations should pursue “Stakeholder Capitalism” and direct more resources to improving outcomes for customers, employees, and the community.  These proposals create significant problems, so they should not be imposed lightly.  Implementation of stakeholder-focused mandates can be unfair and can introduce inefficiencies into the operation of corporations, resulting in value destruction for both shareholders and the broader economy.

What is Stakeholder Capitalism?

Stakeholder Capitalism has multiple manifestations with different points of emphasis, but generally proponents say that a corporation should not focus solely on increasing shareholder value but should also consider the interests of certain “stakeholders,” namely employees, customers, suppliers, the environment, and society in general.  There is a growing trend in the investment world that emphasizes Environmental, Social, and Governance (ESG) factors.  The scope of ESG-driven investing is wide-ranging.  For example, environmental issues can include greenhouse gas emissions or water management while social factors may focus on topics such as diversity and employee compensation.   The governance category analyzes how the business is run by the board of directors and management and how they interact with shareholders. 

Most of the advocates of Stakeholder Capitalism maintain that a focus on stakeholder interests is important for a business to be “sustainable.”  Consequently, they say this approach will ultimately benefit shareholders in the long run.  Sometimes this is true, sometimes not.  Other supporters of Stakeholder Capitalism explicitly acknowledge their objectives will impose a cost on shareholders, but they believe this is justified as a way to achieve social or political goals.  Some proponents say certain mandates on companies are warranted as a way to address negative externalities imposed by businesses onto society at large.  To better understand Stakeholder Capitalism, it is helpful to break the discussion into these four categories:

1.  Objectives aligned with shareholder value
2.  Objectives incorrectly claimed to be aligned with shareholder value
3.  Objectives that would explicitly use shareholder value to achieve socio-political goals
4.  Negative externalities   

1. Objectives Aligned with Shareholder Value

Most advocates of Stakeholder Capitalism maintain that a focus on stakeholders such as employees, customers, suppliers, and society at large will ultimately be more “sustainable” and therefore beneficial for long-term shareholder value.  Much of this is common sense and is already established practice for corporations.  Businesses will struggle if they do not treat their employees fairly and pay them market wages.  Delivering value for customers is critical for companies to succeed and good relations with suppliers and the surrounding community are also helpful.  Likewise, robust corporate governance practices are healthy for corporations and their shareholders.  

To the extent shareholder value is actually enhanced by directing corporate resources to improve stakeholder outcomes, well-run companies should already be doing this.  These types of stakeholder considerations can be categorized into the first type of Stakeholder Capitalism: “Objectives aligned with shareholder interests.”  All parties, including management and shareholders, should be in violent agreement that pursuing these sorts of goals is a good idea.

2.  Objectives Incorrectly Claimed to be Aligned with Shareholder Value

Problems quickly arise when various parties reach different conclusions regarding which stakeholder considerations are in the long-term interests of shareholders.  For example, some may argue that corporations should reserve a certain number of board seats for employee representatives and that this practice would be improve shareholder value over the long-term.  Company management may disagree.  Implicit in these types of arguments is the assumption that Stakeholder Capitalism advocates are somehow in a better position than management to determine what is in the best interests of shareholders.  Since management teams are hired for their expertise and are evaluated by the board of directors on a regular basis, this seems highly unlikely.  And if it is the case that a management team is missing opportunities to increase shareholder value by directing shareholder resources to improve stakeholder outcomes, the best solution would be to replace management. 

Despite assertions to the contrary, the stakeholder objectives in this group are fundamentally similar to the next category of Stakeholder Capitalism where proponents openly seek to accomplish their socio-political goals at the expense of shareholders.  

3.  Objectives that Would Explicitly Use Shareholder Value to Achieve Socio-Political Goals

Some supporters of Stakeholder Capitalism are very explicit that the stakeholder-related obligations they want to impose on corporations are not aligned with the interests of shareholders.  Rather, these proponents openly seek to achieve some social or political goal at the expense of shareholders.  Often, these advocates of stakeholder capitalism seek to justify their attempts to commandeer shareholder resources as a sort of quid pro quo for the privilege of a corporation to do business.  While profoundly lacking in understanding regarding the value of free-market capitalism, at least the people in this category get credit for honesty.

It is quite possible some social or political objectives, such as improving compensation for the workforce, are worthy goals.  However, this misses an important point.  The threshold question is which objectives should be prioritized and who should bear the cost.

4.  Negative Externalities 

Negative externalities occur when the operation of a company generates costs that are not fully absorbed by that business itself but instead fall on the community to some extent.  One frequently cited example of a negative externality is the emission of pollution by businesses.  

It is entirely appropriate for a society to establish mechanisms to address negative externalities.  Challenges arise because there can be differences of opinion within a community regarding how best to deal with them.  For example, is the best way to reduce greenhouse gases through a carbon tax, increased nuclear power, or subsidies for renewable energy?  Well-meaning members of society can have sincere disagreements on these questions.

Stakeholder Capitalism Comes with Serious Drawbacks

While many of the objectives of Stakeholder Capitalism may be worthwhile, problems can arise when the proposed goals are not aligned with optimizing shareholder value.  To better understand these issues, the following discussion will exclude stakeholder objectives that are aligned with shareholder interests and will focus on the categories of Stakeholder Capitalism that seek to provide benefits to stakeholders at the expense of shareholders.  

One of the most troubling problems implicit in Stakeholder Capitalism is its unfairness.  It maintains that certain targeted shareholders should bear the burdens for initiatives intended to benefit other stakeholders or society in general.  It is also inefficient to outsource socio-political objectives to corporations – they are specialists in running their business, not achieving policy goals.   The situation is further confused because there are disagreements regarding which stakeholder objectives are more important.  Furthermore, Stakeholder Capitalism does not generally use a democratic process to prioritize various stakeholder objectives or to evaluate their costs and benefits.  Instead, the current operation of Stakeholder Capitalism is opaque and its costs are obscured.  

It is important to understand the drawbacks of Stakeholder Capitalism and to consider alternative ways to achieve the desired results.  Otherwise, Stakeholder Capitalism will become a recipe for the misallocation of resources, disadvantaging all members of society.

Stakeholder Capitalism is Inherently Unfair

Stakeholder Capitalism unfairly puts burdens on some businesses and not others.  Private companies are excluded from the requirements imposed on publicly listed corporations and businesses operating in different jurisdictions, such as sovereign-owned entities, are often not impacted.  Individuals who are shareholders in companies subject to these requirements are disadvantaged by effectively being required to fund socio-political goals while other citizens get a free ride.  Not only is this type of discriminatory value extraction unfair to shareholders, it puts the corporations subject to these requirements at a competitive disadvantage.  

Stakeholder Capitalism Hurts the Economy Through Hidden Value Destruction

It may seem like the shareholder is paying for the stakeholder benefits sought by Stakeholder Capitalism, but that is only part of the story.  There is no free lunch – it becomes a question of who picks up the tab.  If a company is required to pay above market wages, it will hire fewer workers.  Some higher costs will be passed along to consumers.  If shareholder returns are artificially reduced to fund socio-political goals, the cost of capital will increase resulting in less investment in the economy.  

Asking management to sacrifice shareholder value to achieve other objectives introduces confusion that is virtually unlimited.  Instead of focusing on running their business with a clear mandate to optimize shareholder interests, corporate management teams would be put in a position of negotiating competing demands with no clear guidance on how to balance priorities.  Since it is impossible to maximize two variables at once, it is important for management to maintain focus on one objective, namely optimizing shareholder value.  Losing this clarity of purpose will inevitably create inefficiencies that flow into the overall business environment.  These challenges are exacerbated because non-shareholders do not have “skin in the game” – they are seeking to appropriate benefits while bearing none of the costs, inevitably leading to suboptimal decisions regarding the allocation of resources.

Spread over an entire economy, these costs can be a significant drag on productivity, growth, and job creation.  When this happens, all members of society suffer.  What makes the situation worse is that the costs are often hidden, meaning it is difficult to evaluate trade-offs.

Stakeholder Capitalism is Fundamentally Anti-Democratic

Adding insult to injury, Stakeholder Capitalism often operates outside the traditional democratic process.  This is a significant problem because there are different points of view regarding how to prioritize various objectives and how to allocate the related costs.  For example, who gets to decide which social or political goals are the most important?  Is it the group with the loudest voice or the most effective lobbyist?  How should competing interests be weighed?  Is it more important for a corporation to pay above market wages or to buy energy at higher prices to expand its use of renewable energy?  What is the best way to address negative externalities?  How much of the shareholders’ resources should be taken to achieve these goals?  Ten percent?  Maybe half?  

These are difficult questions where legitimate differences of opinions exist.  As long as we live in a world with limited resources, there will need to be some trade-offs.   The process of a society reaching agreement on priorities is difficult and takes time.  This is one reason proponents of Stakeholder Capitalism seek to impose their desires on corporations and burden shareholders with the costs – they want to short circuit the hard work of making the case with the public for their preferred outcomes versus other objectives.  However, by operating outside the traditional political process, these efforts become fundamentally anti-democratic.  

Stakeholder Capitalism Undermines the Principle of Fiduciary Duty to Shareholders

Directors serving on a board of a corporation have a fiduciary duty of care and loyalty to their shareholders that requires corporate directors to act in good faith in the best interests of shareholders.  This principle is critical to the healthy operation of a corporation because it gives shareholders the confidence to delegate responsibility to others to manage the business.  Actions taken by corporations that sacrifice shareholder value to achieve other objectives are a breach of this fiduciary duty, a deviation that erodes the trust necessary for the corporate model to function effectively.  Ultimately, weakening the principle of a corporate fiduciary duty to shareholders in this way would adversely affect the growth potential of our economy.

Stakeholder Capitalism Wrongly Suggests Business is in Need of Redemption

Businesses should strive to create value for customers, maintain healthy operations, pay their taxes, follow the law, and behave ethically.  In doing so, corporations deliver essential products and services and create tremendous value for their community and the economy.  Despite all these benefits, there is often a notion underlying Stakeholder Capitalism that companies owe something more to society in exchange for the right to exist.  

The Sustainability Accounting Standards Board (SASB), one of the most prominent standard-setting bodies for Stakeholder Capitalism, is emblematic of this sentiment.   The SASB, in describing the scope of its Sustainability Framework, says it “relates to the expectation that a business will contribute to society in return for a social license to operate.”  

This type of thinking is deeply pessimistic about humanity in its assumption that individuals would prefer to extract unearned benefits from companies rather than have opportunities to realize their potential in a vibrant economy.  This mindset also misunderstands the inherent value of free-market capitalism.  By providing goods and services desired by people at market prices, business performs an important public function for society where both sides benefit.  

It is misguided to characterize profits as something that has been “taken” from the community.  Rather, business profits are the sum of the value generated for the public as determined by the people themselves in their everyday purchasing decisions.  Some proponents of Stakeholder Capitalism overlook the mutually beneficial relationship between business and society and suggest corporations need to further justify their existence.  This misguided notion undermines the legitimacy of free-market capitalism and harms an important pillar of the economy. 

Stakeholder Capitalism Suffers from Significant Implementation Problems 

Stakeholder Capitalism suffers from a variety of implementation problems that are in many ways related to the flaws in its unfair, anti-democratic approach.  Difficulties arise because different people have varying opinions about what Stakeholder Capitalism means, including what to prioritize and at what price.  Not surprisingly, these disagreements lead to confusion, inefficiency, and inconsistent treatment of different businesses.  

Much of Stakeholder Capitalism is built upon an approach that emphasizes corporate disclosure of certain selected items, for example greenhouse gas emissions or workforce diversity.  Supporters often justify such disclosure requirements by invoking the argot of good corporate governance, citing the importance of “transparency” and disclosure of “material risks.”  The strategy of building on the well-established concept that “material” risks should be disclosed by corporations may be designed to capture the high ground and make it difficult to object to additional stakeholder-related disclosure requirements.  What could possibly be wrong with requiring more disclosure?  Upon examination, quite a lot.

Public companies are already required to disclose material risks, an important principle to ensure that investors have the information necessary to fully understand investment opportunities.  Proper assessment of materiality includes the analysis of potential risk and return.  To do this correctly, risks should be probability weighted and future events should be discounted back to today’s dollars.  A risk that is highly unlikely to occur or that would happen far in the future may not be material at all.  Or the cost of addressing a potential risk may far outweigh the benefits.  Without a complete analysis of all the aspects of risk and return, materiality cannot be assessed accurately.  This process is helpful to enable businesses to focus on the most impactful issues.  On the other hand, the disclosure of immaterial risks can be distracting and misleading for investors. 

Supporters of Stakeholder Capitalism can have different opinions about which objectives to prioritize and how to measure progress, resulting in quite a bit of confusion.  In response, many organizations have emerged that specialize in providing ratings that purport to assess corporate compliance with the objectives of Stakeholder Capitalism, particularly in the world of ESG-driven investing.  According to Bloomberg, by 2019 there were over a dozen major ESG rating companies providing ratings on businesses and their compliance with ESG objectives.  All of these ESG rating companies have different standards and approaches.  To perform this function, the ESG raters often ask corporations to provide a range of information above and beyond their normal public disclosures.    

Compliance with these supplemental reporting requests puts a significant burden on corporations.  Hester Peirce, Commissioner of the Securities and Exchange Commission, recounted that, “a senior counsel from a major insurance company reported her experience…  Her company had received approximately 55 survey and data verification requests from ESG rating organizations in the prior year. By her company’s estimate, it took 30 employees and 44.8 work days to respond to just one of these surveys.”  Multiply this drain on resources across all the different rating companies and the companies they survey, and the result can be a meaningful drag on economic productivity.

Given the large number of ESG rating companies and their different standards and approaches, it is not surprising that their rating results can be inconsistent.  A recent paper from MIT found that ESG rating organizations can reach quite different ratings for the same corporation, reflecting differences in which factors are rated, the weightings of the different factors, and how they are measured.

In addition to the ESG rating companies, there are a number of organizations that seek to establish guidelines for sustainability reporting.  These include the SASB, the Global Reporting Initiative (GRI), and the Task Force on Climate-Related Financial Disclosures (TCFD), among others.  Unfortunately, the profusion of different reporting standards has created confusion and inefficiency.  In 2019, the International Organization of Securities Commissions (IOSCO) conducted a survey of securities regulators and market participants regarding sustainability reporting requirements.  The IOSCO concluded the results found “a need to improve the comparability of sustainability-related disclosures. The lack of consistency and comparability across third party frameworks could create an obstacle to cross border financial activities and raise investor protection concerns.”

Burdensome reporting requirements can make it less attractive for a business to choose to operate as a public corporation as opposed to remaining a private company.  Public markets have already seen an example of this dynamic.  Since the peak in the 1990s, the number of publicly listed companies in the U.S. has fallen by almost half.  Many observers attribute this decline in part to new governance requirements and expanded reporting obligations applicable to public companies included in the Dodd-Frank Act of 2010.  These changes added to the increased corporate regulations contained in the Sarbanes-Oxley Act of 2002.  Additional reporting requirements make it more onerous for companies to participate in the public markets, thereby damaging the efficiency of the capital markets, reducing economic potential, and limiting the investment opportunities for ordinary Americans.

There’s a Better Way:

Use the Democratic Process and Apply Requirements Fairly

Stakeholder Capitalism promotes a range of worthy objectives such as improving the outcomes for employees, customers, and the community.  Many of these goals are naturally consistent with increasing shareholder value and good management teams should already be pursuing them.  Problems start to arise when the mandates of Stakeholder Capitalism are not aligned with shareholder interests.  In these cases, Stakeholder Capitalism amounts to the appropriation of shareholder resources to achieve socio-political goals.  It is unfair to target certain shareholders while others get a free ride.  And shareholders are not the only ones who suffer when this happens.  Stakeholder Capitalism’s approach of outsourcing socio-political goals onto corporations is inefficient, reducing the productivity and health of the overall economy.  The resulting economic friction adversely affects all members of society and is all the more insidious because it is often obscured. 

This damaging outcome is made worse because it is often implemented outside the traditional democratic process.  Special interests should not be permitted to impose their socio-political preferences on corporations and the economy while other members of society are excluded from the debate.   

Instead, society should use an open democratic process to agree on socio-political priorities and develop a framework to implement them with a set of operating rules that apply fairly and transparently to all members of society.  This framework should include an equitable plan to allocate the related costs, such as taxes or behavioral mandates.  If the objectives of Stakeholder Capitalism are valuable and compelling, proponents should make their case in the political arena.  

The good news is that this democratic approach has significant advantages over the current incarnation of Stakeholder Capitalism.  Involving all members of society in the process of deciding priorities and weighing the related costs will more accurately reflect the true desires of the citizenry and give the outcome more legitimacy.  Additionally, a renewed focus on shareholder value will allow businesses to concentrate on what they do best – providing goods and services at attractive prices.  Applied across the business landscape, this focus will improve productivity and benefit everyone by producing a healthier, more dynamic economy.

What is the proper role of the corporation?  This question is currently a hot topic in the world of investing and corporate governance.  Should a corporation prioritize the growth of shareholder value or, as suggested by advocates of “Stakeholder Capitalism,” should it work to improve outcomes for other stakeholders such as employees, customers, suppliers, the community, and the environment?  

While many of the tenets of Stakeholder Capitalism sound appealing, the application of these proposals can create a host of problems by imposing social or political goals on corporations at the expense of shareholders.  This is inefficient, unfair, and anti-democratic.  

There is a better way to achieve the outcomes advocated by the proponents of Stakeholder Capitalism.  It is more equitable and efficient for a society to achieve socio-political goals through a democratic process that weighs costs and benefits to prioritize objectives and creates a transparent framework that is applied fairly to all members of society, including corporations.

The Corporation:  A Value Creation Machine

As a starting point, it is important to understand the corporation and its purpose. The corporation is an impressively beneficial organizational structure that allows large numbers of individual investors to pool their resources and pursue business opportunities.  Shareholders are not just wealthy individuals.  They include pension funds and individuals saving for things like housing and retirement.  For many small investors, buying shares in corporations is the best way to access diversified investment opportunities.  

A corporate board of directors hires a management team and tasks them to run the business with the goal of increasing value for shareholders.  For this arrangement to work properly, management needs to have a clear mandate to focus on the single objective of maximizing shareholder value.  Otherwise, they will have a hard time balancing different priorities.  This division of labor is so important that the board of directors is charged with a fiduciary duty to act in the best interests of the shareholders.  

Not only does the corporation create value for shareholders, it creates value for society by providing goods and services at fair market prices.  By operating this way, corporations have been a huge contributor to economic growth and improvement in the standard of living around the globe.   

The mandate to maximize shareholder value is often misunderstood.  It does not mean corporations should operate with a short-term view or take advantage of employees or other stakeholders.  Maximizing shareholder value requires management to operate with a long-term perspective and run their business in a sustainable manner.  Corporations should always operate in compliance with the law and behave ethically with honesty and integrity.

Some voices argue that corporations should not seek to optimize shareholder value.  Rather, corporations should pursue “Stakeholder Capitalism” and direct more resources to improving outcomes for customers, employees, and the community.  These proposals create significant problems, so they should not be imposed lightly.  Implementation of stakeholder-focused mandates can be unfair and can introduce inefficiencies into the operation of corporations, resulting in value destruction for both shareholders and the broader economy.

What is Stakeholder Capitalism?

Stakeholder Capitalism has multiple manifestations with different points of emphasis, but generally proponents say that a corporation should not focus solely on increasing shareholder value but should also consider the interests of certain “stakeholders,” namely employees, customers, suppliers, the environment, and society in general.  There is a growing trend in the investment world that emphasizes Environmental, Social, and Governance (ESG) factors.  The scope of ESG-driven investing is wide-ranging.  For example, environmental issues can include greenhouse gas emissions or water management while social factors may focus on topics such as diversity and employee compensation.   The governance category analyzes how the business is run by the board of directors and management and how they interact with shareholders. 

Most of the advocates of Stakeholder Capitalism maintain that a focus on stakeholder interests is important for a business to be “sustainable.”  Consequently, they say this approach will ultimately benefit shareholders in the long run.  Sometimes this is true, sometimes not.  Other supporters of Stakeholder Capitalism explicitly acknowledge their objectives will impose a cost on shareholders, but they believe this is justified as a way to achieve social or political goals.  Some proponents say certain mandates on companies are warranted as a way to address negative externalities imposed by businesses onto society at large.  To better understand Stakeholder Capitalism, it is helpful to break the discussion into these four categories:

1.  Objectives aligned with shareholder value
2.  Objectives incorrectly claimed to be aligned with shareholder value
3.  Objectives that would explicitly use shareholder value to achieve socio-political goals
4.  Negative externalities   

1. Objectives Aligned with Shareholder Value

Most advocates of Stakeholder Capitalism maintain that a focus on stakeholders such as employees, customers, suppliers, and society at large will ultimately be more “sustainable” and therefore beneficial for long-term shareholder value.  Much of this is common sense and is already established practice for corporations.  Businesses will struggle if they do not treat their employees fairly and pay them market wages.  Delivering value for customers is critical for companies to succeed and good relations with suppliers and the surrounding community are also helpful.  Likewise, robust corporate governance practices are healthy for corporations and their shareholders.  

To the extent shareholder value is actually enhanced by directing corporate resources to improve stakeholder outcomes, well-run companies should already be doing this.  These types of stakeholder considerations can be categorized into the first type of Stakeholder Capitalism: “Objectives aligned with shareholder interests.”  All parties, including management and shareholders, should be in violent agreement that pursuing these sorts of goals is a good idea.

2.  Objectives Incorrectly Claimed to be Aligned with Shareholder Value

Problems quickly arise when various parties reach different conclusions regarding which stakeholder considerations are in the long-term interests of shareholders.  For example, some may argue that corporations should reserve a certain number of board seats for employee representatives and that this practice would be improve shareholder value over the long-term.  Company management may disagree.  Implicit in these types of arguments is the assumption that Stakeholder Capitalism advocates are somehow in a better position than management to determine what is in the best interests of shareholders.  Since management teams are hired for their expertise and are evaluated by the board of directors on a regular basis, this seems highly unlikely.  And if it is the case that a management team is missing opportunities to increase shareholder value by directing shareholder resources to improve stakeholder outcomes, the best solution would be to replace management. 

Despite assertions to the contrary, the stakeholder objectives in this group are fundamentally similar to the next category of Stakeholder Capitalism where proponents openly seek to accomplish their socio-political goals at the expense of shareholders.  

3.  Objectives that Would Explicitly Use Shareholder Value to Achieve Socio-Political Goals

Some supporters of Stakeholder Capitalism are very explicit that the stakeholder-related obligations they want to impose on corporations are not aligned with the interests of shareholders.  Rather, these proponents openly seek to achieve some social or political goal at the expense of shareholders.  Often, these advocates of stakeholder capitalism seek to justify their attempts to commandeer shareholder resources as a sort of quid pro quo for the privilege of a corporation to do business.  While profoundly lacking in understanding regarding the value of free-market capitalism, at least the people in this category get credit for honesty.

It is quite possible some social or political objectives, such as improving compensation for the workforce, are worthy goals.  However, this misses an important point.  The threshold question is which objectives should be prioritized and who should bear the cost.

4.  Negative Externalities 

Negative externalities occur when the operation of a company generates costs that are not fully absorbed by that business itself but instead fall on the community to some extent.  One frequently cited example of a negative externality is the emission of pollution by businesses.  

It is entirely appropriate for a society to establish mechanisms to address negative externalities.  Challenges arise because there can be differences of opinion within a community regarding how best to deal with them.  For example, is the best way to reduce greenhouse gases through a carbon tax, increased nuclear power, or subsidies for renewable energy?  Well-meaning members of society can have sincere disagreements on these questions.

Stakeholder Capitalism Comes with Serious Drawbacks

While many of the objectives of Stakeholder Capitalism may be worthwhile, problems can arise when the proposed goals are not aligned with optimizing shareholder value.  To better understand these issues, the following discussion will exclude stakeholder objectives that are aligned with shareholder interests and will focus on the categories of Stakeholder Capitalism that seek to provide benefits to stakeholders at the expense of shareholders.  

One of the most troubling problems implicit in Stakeholder Capitalism is its unfairness.  It maintains that certain targeted shareholders should bear the burdens for initiatives intended to benefit other stakeholders or society in general.  It is also inefficient to outsource socio-political objectives to corporations – they are specialists in running their business, not achieving policy goals.   The situation is further confused because there are disagreements regarding which stakeholder objectives are more important.  Furthermore, Stakeholder Capitalism does not generally use a democratic process to prioritize various stakeholder objectives or to evaluate their costs and benefits.  Instead, the current operation of Stakeholder Capitalism is opaque and its costs are obscured.  

It is important to understand the drawbacks of Stakeholder Capitalism and to consider alternative ways to achieve the desired results.  Otherwise, Stakeholder Capitalism will become a recipe for the misallocation of resources, disadvantaging all members of society.

Stakeholder Capitalism is Inherently Unfair

Stakeholder Capitalism unfairly puts burdens on some businesses and not others.  Private companies are excluded from the requirements imposed on publicly listed corporations and businesses operating in different jurisdictions, such as sovereign-owned entities, are often not impacted.  Individuals who are shareholders in companies subject to these requirements are disadvantaged by effectively being required to fund socio-political goals while other citizens get a free ride.  Not only is this type of discriminatory value extraction unfair to shareholders, it puts the corporations subject to these requirements at a competitive disadvantage.  

Stakeholder Capitalism Hurts the Economy Through Hidden Value Destruction

It may seem like the shareholder is paying for the stakeholder benefits sought by Stakeholder Capitalism, but that is only part of the story.  There is no free lunch – it becomes a question of who picks up the tab.  If a company is required to pay above market wages, it will hire fewer workers.  Some higher costs will be passed along to consumers.  If shareholder returns are artificially reduced to fund socio-political goals, the cost of capital will increase resulting in less investment in the economy.  

Asking management to sacrifice shareholder value to achieve other objectives introduces confusion that is virtually unlimited.  Instead of focusing on running their business with a clear mandate to optimize shareholder interests, corporate management teams would be put in a position of negotiating competing demands with no clear guidance on how to balance priorities.  Since it is impossible to maximize two variables at once, it is important for management to maintain focus on one objective, namely optimizing shareholder value.  Losing this clarity of purpose will inevitably create inefficiencies that flow into the overall business environment.  These challenges are exacerbated because non-shareholders do not have “skin in the game” – they are seeking to appropriate benefits while bearing none of the costs, inevitably leading to suboptimal decisions regarding the allocation of resources.

Spread over an entire economy, these costs can be a significant drag on productivity, growth, and job creation.  When this happens, all members of society suffer.  What makes the situation worse is that the costs are often hidden, meaning it is difficult to evaluate trade-offs.

Stakeholder Capitalism is Fundamentally Anti-Democratic

Adding insult to injury, Stakeholder Capitalism often operates outside the traditional democratic process.  This is a significant problem because there are different points of view regarding how to prioritize various objectives and how to allocate the related costs.  For example, who gets to decide which social or political goals are the most important?  Is it the group with the loudest voice or the most effective lobbyist?  How should competing interests be weighed?  Is it more important for a corporation to pay above market wages or to buy energy at higher prices to expand its use of renewable energy?  What is the best way to address negative externalities?  How much of the shareholders’ resources should be taken to achieve these goals?  Ten percent?  Maybe half?  

These are difficult questions where legitimate differences of opinions exist.  As long as we live in a world with limited resources, there will need to be some trade-offs.   The process of a society reaching agreement on priorities is difficult and takes time.  This is one reason proponents of Stakeholder Capitalism seek to impose their desires on corporations and burden shareholders with the costs – they want to short circuit the hard work of making the case with the public for their preferred outcomes versus other objectives.  However, by operating outside the traditional political process, these efforts become fundamentally anti-democratic.  

Stakeholder Capitalism Undermines the Principle of Fiduciary Duty to Shareholders

Directors serving on a board of a corporation have a fiduciary duty of care and loyalty to their shareholders that requires corporate directors to act in good faith in the best interests of shareholders.  This principle is critical to the healthy operation of a corporation because it gives shareholders the confidence to delegate responsibility to others to manage the business.  Actions taken by corporations that sacrifice shareholder value to achieve other objectives are a breach of this fiduciary duty, a deviation that erodes the trust necessary for the corporate model to function effectively.  Ultimately, weakening the principle of a corporate fiduciary duty to shareholders in this way would adversely affect the growth potential of our economy.

Stakeholder Capitalism Wrongly Suggests Business is in Need of Redemption

Businesses should strive to create value for customers, maintain healthy operations, pay their taxes, follow the law, and behave ethically.  In doing so, corporations deliver essential products and services and create tremendous value for their community and the economy.  Despite all these benefits, there is often a notion underlying Stakeholder Capitalism that companies owe something more to society in exchange for the right to exist.  

The Sustainability Accounting Standards Board (SASB), one of the most prominent standard-setting bodies for Stakeholder Capitalism, is emblematic of this sentiment.   The SASB, in describing the scope of its Sustainability Framework, says it “relates to the expectation that a business will contribute to society in return for a social license to operate.”  

This type of thinking is deeply pessimistic about humanity in its assumption that individuals would prefer to extract unearned benefits from companies rather than have opportunities to realize their potential in a vibrant economy.  This mindset also misunderstands the inherent value of free-market capitalism.  By providing goods and services desired by people at market prices, business performs an important public function for society where both sides benefit.  

It is misguided to characterize profits as something that has been “taken” from the community.  Rather, business profits are the sum of the value generated for the public as determined by the people themselves in their everyday purchasing decisions.  Some proponents of Stakeholder Capitalism overlook the mutually beneficial relationship between business and society and suggest corporations need to further justify their existence.  This misguided notion undermines the legitimacy of free-market capitalism and harms an important pillar of the economy. 

Stakeholder Capitalism Suffers from Significant Implementation Problems 

Stakeholder Capitalism suffers from a variety of implementation problems that are in many ways related to the flaws in its unfair, anti-democratic approach.  Difficulties arise because different people have varying opinions about what Stakeholder Capitalism means, including what to prioritize and at what price.  Not surprisingly, these disagreements lead to confusion, inefficiency, and inconsistent treatment of different businesses.  

Much of Stakeholder Capitalism is built upon an approach that emphasizes corporate disclosure of certain selected items, for example greenhouse gas emissions or workforce diversity.  Supporters often justify such disclosure requirements by invoking the argot of good corporate governance, citing the importance of “transparency” and disclosure of “material risks.”  The strategy of building on the well-established concept that “material” risks should be disclosed by corporations may be designed to capture the high ground and make it difficult to object to additional stakeholder-related disclosure requirements.  What could possibly be wrong with requiring more disclosure?  Upon examination, quite a lot.

Public companies are already required to disclose material risks, an important principle to ensure that investors have the information necessary to fully understand investment opportunities.  Proper assessment of materiality includes the analysis of potential risk and return.  To do this correctly, risks should be probability weighted and future events should be discounted back to today’s dollars.  A risk that is highly unlikely to occur or that would happen far in the future may not be material at all.  Or the cost of addressing a potential risk may far outweigh the benefits.  Without a complete analysis of all the aspects of risk and return, materiality cannot be assessed accurately.  This process is helpful to enable businesses to focus on the most impactful issues.  On the other hand, the disclosure of immaterial risks can be distracting and misleading for investors. 

Supporters of Stakeholder Capitalism can have different opinions about which objectives to prioritize and how to measure progress, resulting in quite a bit of confusion.  In response, many organizations have emerged that specialize in providing ratings that purport to assess corporate compliance with the objectives of Stakeholder Capitalism, particularly in the world of ESG-driven investing.  According to Bloomberg, by 2019 there were over a dozen major ESG rating companies providing ratings on businesses and their compliance with ESG objectives.  All of these ESG rating companies have different standards and approaches.  To perform this function, the ESG raters often ask corporations to provide a range of information above and beyond their normal public disclosures.    

Compliance with these supplemental reporting requests puts a significant burden on corporations.  Hester Peirce, Commissioner of the Securities and Exchange Commission, recounted that, “a senior counsel from a major insurance company reported her experience…  Her company had received approximately 55 survey and data verification requests from ESG rating organizations in the prior year. By her company’s estimate, it took 30 employees and 44.8 work days to respond to just one of these surveys.”  Multiply this drain on resources across all the different rating companies and the companies they survey, and the result can be a meaningful drag on economic productivity.

Given the large number of ESG rating companies and their different standards and approaches, it is not surprising that their rating results can be inconsistent.  A recent paper from MIT found that ESG rating organizations can reach quite different ratings for the same corporation, reflecting differences in which factors are rated, the weightings of the different factors, and how they are measured.

In addition to the ESG rating companies, there are a number of organizations that seek to establish guidelines for sustainability reporting.  These include the SASB, the Global Reporting Initiative (GRI), and the Task Force on Climate-Related Financial Disclosures (TCFD), among others.  Unfortunately, the profusion of different reporting standards has created confusion and inefficiency.  In 2019, the International Organization of Securities Commissions (IOSCO) conducted a survey of securities regulators and market participants regarding sustainability reporting requirements.  The IOSCO concluded the results found “a need to improve the comparability of sustainability-related disclosures. The lack of consistency and comparability across third party frameworks could create an obstacle to cross border financial activities and raise investor protection concerns.”

Burdensome reporting requirements can make it less attractive for a business to choose to operate as a public corporation as opposed to remaining a private company.  Public markets have already seen an example of this dynamic.  Since the peak in the 1990s, the number of publicly listed companies in the U.S. has fallen by almost half.  Many observers attribute this decline in part to new governance requirements and expanded reporting obligations applicable to public companies included in the Dodd-Frank Act of 2010.  These changes added to the increased corporate regulations contained in the Sarbanes-Oxley Act of 2002.  Additional reporting requirements make it more onerous for companies to participate in the public markets, thereby damaging the efficiency of the capital markets, reducing economic potential, and limiting the investment opportunities for ordinary Americans.

There’s a Better Way:

Use the Democratic Process and Apply Requirements Fairly

Stakeholder Capitalism promotes a range of worthy objectives such as improving the outcomes for employees, customers, and the community.  Many of these goals are naturally consistent with increasing shareholder value and good management teams should already be pursuing them.  Problems start to arise when the mandates of Stakeholder Capitalism are not aligned with shareholder interests.  In these cases, Stakeholder Capitalism amounts to the appropriation of shareholder resources to achieve socio-political goals.  It is unfair to target certain shareholders while others get a free ride.  And shareholders are not the only ones who suffer when this happens.  Stakeholder Capitalism’s approach of outsourcing socio-political goals onto corporations is inefficient, reducing the productivity and health of the overall economy.  The resulting economic friction adversely affects all members of society and is all the more insidious because it is often obscured. 

This damaging outcome is made worse because it is often implemented outside the traditional democratic process.  Special interests should not be permitted to impose their socio-political preferences on corporations and the economy while other members of society are excluded from the debate.   

Instead, society should use an open democratic process to agree on socio-political priorities and develop a framework to implement them with a set of operating rules that apply fairly and transparently to all members of society.  This framework should include an equitable plan to allocate the related costs, such as taxes or behavioral mandates.  If the objectives of Stakeholder Capitalism are valuable and compelling, proponents should make their case in the political arena.  

The good news is that this democratic approach has significant advantages over the current incarnation of Stakeholder Capitalism.  Involving all members of society in the process of deciding priorities and weighing the related costs will more accurately reflect the true desires of the citizenry and give the outcome more legitimacy.  Additionally, a renewed focus on shareholder value will allow businesses to concentrate on what they do best – providing goods and services at attractive prices.  Applied across the business landscape, this focus will improve productivity and benefit everyone by producing a healthier, more dynamic economy.

by J.C. Pate

June 18, 2019

It has been over a decade since the U.S. government takeover of Fannie Mae and Freddie Mac, the two government-sponsored enterprises (GSEs) that dominate the U.S. secondary mortgage finance market.   In the meantime, government gridlock has made it difficult to reach a consensus on what to do with the GSEs.  One approach which has been proposed is to treat the GSEs as public utilities where the federal government would provide an explicit guarantee to backstop the credit risk of the mortgages acquired by the GSEs.  Given the huge losses imposed on the American taxpayer as a result of the government bailout of the GSEs, it should be clear that it is unwise for the government to guarantee the risk underlying the U.S. mortgage finance market.  Applying a regulated utility model to the GSEs is not appropriate and will lead to economic inefficiencies and likely another taxpayer bailout.

Summary of the “Utility” Model for GSE Regulation

There have been many proposals to treat the GSEs as public utilities.  For example, the Federal Housing Finance Agency (FHFA), the main regulator and conservator for the GSEs, circulated such a proposal in 2018.  While the FHFA has since changed its leadership and approach to GSE reform, this “Utility Proposal” is a good example of the structures suggested to regulate the GSEs as utilities.  The core of the Utility Proposal is to reconstitute Fannie and Freddie from entities in conservatorship into privately owned “utilities” with regulated pricing to intended to produce a “fair return” to shareholders.  The other key aspects of the Utility Proposal include:

• Fannie and Freddie would be privatized (the Utility Proposal calls them “secondary market entities” or “SMEs”) and would be allowed to raise private capital.  The Utility Proposal expects there would be additional competitors joining the secondary mortgage finance market over time, but cautions that having too many SMEs could be counterproductive by resulting in a “race to the bottom” in terms of underwriting standards.

• The SMEs would be regulated and would have minimum capital and liquidity requirements.

• The SMEs would issue mortgage-backed securities (MBS) covered by an explicit government guarantee. The FHFA, as their regulator, would collect fees paid by the SMEs in exchange for the government guarantee and use the proceeds to create a mortgage insurance fund that would cover mortgage losses in excess of the private capital held by the SMEs, similar to how the FDIC’s insurance fund covers losses on insured bank deposits.  The cost of the government guarantee would be passed along to borrowers as part of the cost of mortgages.  

• The SMEs would issue a single type of MBS under the Common Securitization Platform (CSP) developed by Fannie and Freddie.  The objective of the CSP is to standardize the structure of MBS and aggregate and distribute mortgage data to achieve improved liquidity, pricing and execution in the MBS market.

• The SMEs would maintain the “cash window” which could be utilized by smaller lenders to sell their mortgages.

• The SMEs should have nationwide operations so they don’t focus solely on the best markets or leave some markets underserved.

• The Utility Proposal calls for an approach “comparable” to existing affordable housing requirements, including duty-to-serve obligations and funding for a housing trust fund. 

Challenges with Applying a “Utility” Model to Mortgage Finance

The heart of the Utility Proposal is to provide a government guarantee to backstop the credit risk on a large amount of the mortgage debt issued in the U.S.  The substantial amount of losses shifted to the American taxpayers during the recent financial crisis is evidence that this plan is extremely dangerous.  In order to mitigate this risk, the idea is to regulate the newly privatized Fannie and Freddie (along with any other new entrants) as “utilities”.  It is possible the FHFA hoped that the use of the utility characterization will evoke soothing feelings of stability as observers analogize to the relatively predictable world of electric utilities, water utilities and the like.  However, there are several problems with applying a “utility” model to the secondary mortgage finance market.

The public utility framework with regulated rates of return is an inappropriate model for the mortgage finance market.   The optimal scenario for creating a regulated public utility is when a “natural monopoly” exists, meaning it would be prohibitively costly and economically wasteful for two or more entrants to develop duplicative infrastructure.  Some common examples of natural monopolies are electrical power systems and water systems.  This dynamic does not exist in the American secondary mortgage finance market.  There are no structural features in this market that would preclude multiple providers.  Of course, some upfront investment would be required for new entrants and scale would improve efficiency, but not to a materially different degree than in other types of businesses.  Indeed, the Utility Proposal anticipates additional entrants into the secondary mortgage finance market.  

Furthermore, the underlying mortgage business is quite different from businesses that are traditionally regulated as utilities.   The delivery of electricity or water is a fairly predictable business segment while the mortgage market, on the other hand, can be quite volatile especially during asset bubbles or times of economic stress.   Due to its operational characteristics, the secondary mortgage finance market does not seem well-suited for the application of a regulated utility model.  

Given this lack of suitability, trying to force a regulated utility model on the secondary mortgage finance market would cause significant problems in practice.  In the case of traditional public utilities, a key part of the regulator’s role is to determine the profit that shareholders are allowed to earn.  At a high level, this involves the regulator setting an approved revenue amount for the utility that will generate a rate of return on investment.  When implementing this model for the secondary mortgage finance market, regulators would face several key questions, including:  what is the appropriate rate of return for investors, and how should the regulator determine the revenue level for the SMEs in order to generate those returns for investors? 

A critical threshold question related to the “utility” model would arise in determining the targeted rate of return for investors.   While traditional public utility regulators have decades of experience in determining appropriate levels for investor returns, this would be a new market segment for regulators with considerable room for error.  Furthermore, there would be a lack of directly comparable risk/return data points available to regulators to help them determine an appropriate level of return.  Given the size of the mortgage finance market, mistakes in setting the rate of return for investors could have serious repercussions.

In the case of the SMEs, determining the revenue level necessary for the targeted rate of return effectively means regulating the fees charged by the SMEs to provide a guarantee for the MBS that they issue.   To do this job properly, the regulator would need to take into account fairly detailed considerations regarding the credit quality of different mortgage types.  If the guarantee fee is too low for the related risk, losses will arise.  Conversely, if the guarantee fee is too high, investors will earn returns in excess of expectations for a “fair” return.   The difficulty of this job for the regulator would be magnified because the guarantee fee would need to be set in advance of any mortgage acquisition.  At the inception of a mortgage, the regulator is unlikely to be able to accurately forecast and analyze the risk of potential credit losses on long-term mortgages (e.g., 30 years).

This process would be complicated further by the significant amount of political influence that would inevitably arise as a result of the government’s backstop combined with the continued imposition of public policy missions on the SMEs, such as affordable housing goals.  Simply put, as long as the government is relying on the SMEs to deliver politically motivated housing benefits, we must expect government interference that will cause the SMEs to make non-economic decisions in operating their businesses.

History has demonstrated that government involvement in private markets inevitably results in unintended consequences.  In this case, we can foresee problematic ways this situation could develop.   Let’s say a recession occurs and the SMEs start realizing unexpected credit losses on the mortgages they have acquired and securitized.  Would the government make the private investors whole by allowing increases in the guarantee fee charged to future borrowers?  If this happens, private investors would be rewarded for failure and future borrowers would be penalized for losses arising from past borrowers.  Alternatively, if the government reneged on its commitment to investors in the SME “utility” to provide a fair return on the mortgages previously acquired, that could throw the secondary mortgage finance market into confusion and disarray.  The SMEs would likely reduce their acquisition of mortgages until the rules were clarified.  Likewise, private capital would be hesitant to continue to invest in SMEs in light of such uncertainty.  Such a reversal on the part of the regulator could create serious damage to a “utility” model.  It is quite possible such circumstances would result in yet another bailout of the secondary mortgage finance providers. 

Conclusion

The regulated utility model is not a good fit for the secondary mortgage finance market for a variety of reasons.  The secondary mortgage finance market is not the type of natural monopoly that would typically require a regulated utility framework and the mortgage finance business, with its inherent volatility, is not well-suited to a regulated utility approach.  Implementation of this plan would encounter serious practical challenges.  In a utility model, the regulator would need to be able to accurately price in advance the long-term credit risk related to mortgage debt, a task that recent history has shown to be quite difficult.  These challenges would be aggravated by inevitable government interference in SME business operations.  As long as the government is relying on SMEs to achieve politically motivated social policy objectives, such as affordable housing goals, the SMEs will suffer from the consequences of non-economic decision making driven by government interference.  Until these issues are resolved, it could be difficult for the SMEs to attract significant private capital at reasonable rates of return.  It does not take much imagination to think of examples of how this dangerous combination of factors implicit in a “utility” model could end up saddling taxpayers with losses in the future.  

Massive Federal Borrowing is a Threat, 

But Structural Burdens Can Be Even More Dangerous

By J.C. Pate

Introduction

After months of battering from the coronavirus pandemic and government-mandated shutdowns, our economy and the American people are suffering badly.  The response from the federal government has been unprecedented, with over $3 trillion in emergency spending approved so far and Congress contemplating an additional $1 trillion.  These outlays will be financed with additional borrowing, pushing the level of federal debt to alarming levels.  According to the Congressional Budget Office, government debt held by the public is currently projected to grow to around 101% of GDP, up from about 78% of GDP in 2019.   Even more increases are expected in the future as deficit spending continues to exacerbate the problem.

The soaring level of federal debt is a serious long-term problem our country must address, but at least we can easily track it.  Perhaps more insidious are proposals for legislative and regulatory changes that would adversely affect the structure of our economy.  These ideas are particularly concerning because their negative impact is harder to identify and quantify than a straightforward increase in federal debt, making the consequences more difficult to evaluate and manage.  And once implemented, these types of changes can be very difficult to reverse.  

This dangerous trend is evident all around us as politicians use the current crisis as a pretext to promote anti-growth initiatives that would never be able to gain support in normal times.  We must vigilantly guard against policies that damage the structure of our economy and weaken our country’s ability to return to a growth trajectory.  A healthy economy will provide our best chance to pay down the enormous amount of post-pandemic government debt we will face.  

The following examples are representative of some of these counterproductive proposals.  They include anti-growth regulations, burdensome mandates on businesses, policies that undermine the rule of law, and government interference in the free-market.  Unfortunately, this discussion of harmful proposals is not comprehensive, but it provides a sense of the detrimental consequences these policies would have on the economy.

Discriminatory Interference in Markets:  Government Picking Winners and Losers

Returning with a vengeance is the old saying popular among the big government crowd: “Never let a crisis go to waste.”  This is clearly front of mind for many cynical politicians who see the pandemic as an opportunity for large scale interference in the economy to achieve their partisan objectives or to benefit their favorite special interests.  Examples include proposals that would provide tax-payer funded subsidies to certain types of renewable energy while at the same time artificially impeding other less expensive sources of power, including low-carbon alternatives such as natural gas.  

These plans can be extraordinarily wide-ranging.  The Biden campaign is currently proposing to “enact a national strategy to develop a low-carbon manufacturing sector in every state.”  The price tag for these government programs would be massive, adding billions and perhaps trillions to the federal debt.  Other costs would flow through to American consumers in the form of higher prices.  Not only is this type of government intervention very expensive, it amounts to a politically-driven national industrial policy that will inevitably be less efficient than an economy guided by the operation of the free market.  As a result, productivity and growth will suffer.  The government should not pick winners and losers in the economy.

Government Relief Programs Creating Disincentives to Work

The pandemic has led to government-mandated shutdowns of non-essential businesses, causing massive job losses unprecedented in their speed and severity.  Understandably, the government has responded with various initiatives to support individuals and help them make it through this difficult time.   However, it is counterproductive to implement programs with built-in disincentives for laid-off individuals to go back to work.  

This dynamic can be seen in the design of emergency unemployment insurance.  The CARES Act passed by Congress in March increased the normal unemployment payment levels across the board by $600 per week.  This once-size-fits-all program has damaging unintended consequences in large part because prevailing wages vary considerably by region and by type of job.  One analysis from the American Action Forum found that 63% of all workers would receive more from this unemployment program than they would earn by returning to their jobs.  

Restarting businesses after the disruption of pandemic-driven closures will be hard enough, but it will be made much more difficult if workers are financially penalized for going back to work.  Policymakers should explore more effective alternatives.  For example, Georgia implemented a temporary program to allow people to return to work and continue to receive the enhanced unemployment insurance payments, with dollar-for-dollar reductions in their unemployment insurance kicking in only to the extent they earn over $300 per week. 

Temporary Mandates on Business are Burdensome and Prone to Mission Creep 

Recent legislation passed by Congress mandates that certain businesses provide paid time off for coronavirus-related absences, including sick leave and family leave to care for a child if schools or child-care providers close due to the pandemic.   Businesses with less than 50 employees may apply for an exemption if these requirements would jeopardize the viability of their business.

While businesses are eligible to recoup the costs related to this mandate through a payroll tax credit, companies will face the additional administrative burden of tracking and reporting these costs and will be out-of-pocket during the time it takes to receive the tax credits. 

These mandates are scheduled to expire at the end of 2020.  However, many government mandates originally implemented as temporary measures have been extended, expanded, or made permanent.  Indeed, the HEROES Act proposed by the House would extend these mandates for paid time off through 2021 and remove the potential for businesses with less than 50 employees to obtain exemptions.  

Imposing additional government mandates on businesses will increase the cost and complexity of doing business, reducing growth potential.  As a result, these types of mandates should be avoided or at least severely limited, and in no case should they be made permanent.

One-Size-Fits-All National Mandates:  Increased Federal Minimum Wage

One of the most prominent examples of a damaging government mandate is the proposal from some politicians for an increase in the national minimum wage.  Higher minimum wages are a bad idea in general, but it is particularly damaging to impose a mandate that will increase labor costs and discourage job creation during a severe economic downturn.  Businesses are already struggling to survive and the imposition of above-market labor costs will create additional strains, causing some businesses to go out of business for good.  

Labor costs and living expenses vary greatly across the country.  It is very counterproductive and overly prescriptive to institute a national standard across a country with such significant differences in local cost structures.  A wage level that makes sense in New York City might be ruinously expensive in Birmingham, Alabama.  To allow for a return to growth, we need to keep burdens on businesses low and maintain operating flexibility across geographies.

Attacks on the Franchise Business Model

The ability to own and operate a franchised business is one of the most effective ways for small business people in our country to drive their own success.   Many middle-class and working-class individuals have built their livelihoods in this way.  Minorities and immigrants, in particular, have benefited from the ability to own and operate franchises.  

Some on the left have been waging war on this business model.  The primary angle of attack is a standard known as the joint employer rule, which is used to determine when one business is jointly responsible for the employees of another business.  The issue arises when a business utilizes the services of another business as part of its operation.   A franchise is one example of this type of arrangement.  For decades, a business contracting for services from another entity has been classified as a joint employer only if it exercised “direct and immediate” control over the other.  Some are attempting to change the joint employer standard to “indirect control” or even “potential control,” making it so expansive that many typical business arrangements, such as franchising, would be captured.  

This is important because once a business is classified as a joint employer of another entity, it is jointly responsible for the labor practices of that other entity.  If franchisors are legally liable for franchisee employment practices, they will have a strong incentive to take control of the franchised operations.  This could make the franchise model largely obsolete.  

Why would anyone want to attack such a beneficial engine of economic growth and opportunity?  There are several motivations.  One key objective is to make it easier to unionize businesses by pushing the independent franchisees under the umbrella of the larger franchisors.  In addition, making the bigger franchisor entities responsible for the employment practices of the smaller franchisee businesses would create more sizeable litigation targets with deeper pockets.  

But it gets worse.  The proposed expansion of the joint employer rule could also impede other standard business practices such as contractor arrangements, temporary staffing, and outsourcing.  Inhibiting the flexibility of our economy in this way would be very damaging to our country’s growth potential.  The franchise model, in particular, is a powerful tool for individuals to build their own prosperity and it should be vigorously defended.

Inhibiting New Forms of Working Arrangements:  The Gig Economy

A similar challenge to flexible employment relationships can be seen in recent attacks on emerging working arrangements, such as the gig economy.  Increasingly, technology is being used to match independent workers with customers.  A very successful example of this type of innovation can be seen in the ride-sharing platform pioneered by Uber.  Customers love the benefits this service provides.  Many people are now able to go about their lives much more efficiently without needing to own a car.  Drivers are able to set their own work schedules.  

A fundamental pillar of this business model is that drivers operate as contractors rather than direct employees.  Many progressives have been agitating to prohibit this flexibility and mandate that gig workers such as ride-sharing drivers must be treated as employees of the company they have contracted with.  This change would result in a host of costly and burdensome regulations including minimum working hours, minimum wages, the loss of scheduling flexibility, and requirements that gig workers receive paid time off, family leave, and health insurance.  

For example, California has recently passed a law to limit the ability of its residents to choose to work as independent contractors such as ride-share drivers.  The ride-sharing companies object that these requirements would significantly increase the costs of their services, making them much less attractive to consumers.  If widely implemented, these restrictions would result in higher expenses and decreased flexibility so severe as to make some gig economy business models unworkable.  

Predictably, California’s new law has resulted in unintended negative consequences, with a wide range of professions caught up in the restrictions.  For example, freelance journalists have found that this law limits the number of assignments they can accept from any particular out-of-state publication.

Similar constraints on flexible work arrangements have been proposed in several other states and by members of Congress who see the pandemic as an opening to implement restrictions on the gig economy.  There is never a good time for opportunity-killing regulations like these.  But given the daunting levels of unemployment we currently face, this is an especially bad time to limit employment options.

Jobs in the gig economy are not appealing to everyone.  But for people who seek flexibility and autonomy, these jobs can be very attractive.  Frequently, these types of opportunities function as a lifeline for individuals in transition between jobs.  Regulations that restrict these opportunities do a disservice to the people who want these types of jobs, not to mention the customers who could lose a valuable service.  The government is not in a position to predict what type of employment systems will work for its citizens.  This should be left to the operation of the free market which is much more able to determine which working arrangements are better suited to workers, employers and consumers.

Undermining the Sanctity of Contracts

The reliability of contractual arrangements is an important pillar of our modern economy.  When two parties enter into a contract, they need to have confidence that they can rely on it.  From time to time, politicians seek to subvert contractual arrangements to illegally extract value for special interests at the expense of innocent parties.  During the pandemic, some have seized on the current economic dislocation as an excuse to do just that.

One example is business interruption insurance.  Many non-essential businesses have been required to close due the coronavirus.  Some of these businesses want providers of business interruption insurance policies to make payments to compensate them for costs incurred during the crisis, even though the policies were never designed to cover losses related to a pandemic.

Another example is government-mandated payment holidays for mortgages and rent.  The CARES Act grants borrowers with federally-backed mortgages the right to payment forbearance for up to a year.   About 70% of single-family mortgages fall into this category so this provision has a wide-ranging impact.  While this is a unilateral modification of a contract, at least the federal government is bearing the bulk of the cost.  The HEROES Act proposed by the House goes further, calling for forbearance and eviction protections for up to a year for all mortgage borrowers and renters, even those not in federally-backed housing.  

These proposals would certainly be helpful to borrowers and renters in the near term, but these provisions were not contemplated by lenders when they extended the mortgages or by landlords when they signed rental leases.  Other provisions of the HEROES Act propose an additional moratorium on debt collections for certain small businesses and non-profits, along with programs including forbearance options after the moratorium ends (proposed to be in effect until 120 days after the end of the crisis).

When governments retroactively change contracts, one party inevitably benefits at the expense of another party.  Not only is this unfair, this type of behavior undermines the ability of market participants to rely on contractual arrangements, making the process of doing business more difficult and inefficient.  Ultimately, additional costs will flow through the economic system.  In the case of mortgages, imposing payment holidays and foreclosure limitations can be expected to reduce the availability of mortgages and increase borrowing costs as lenders raise rates to compensate for added risk.

Anti-Growth Tax Policies

Given all the recent proposals for increased government expenditures, it is not surprising that politicians with a “tax and spend” approach to fiscal matters are putting forward a range of suggested tax increases.  After all, they say we need to pay for all this government spending.  Unfortunately, many of these proposed tax changes would suppress the growth potential of our economy. 

In general, lower tax levels are more conducive to promoting a healthy economy.  As a country, we may decide to increase the overall level of taxation as a percentage of GDP to reduce our debt levels.  If this decision is taken, it is important to design the tax code to raise revenue as efficiently and fairly as possible while preserving a pro-growth economic environment. 

As we evaluate alternative tax strategies, we should avoid increasing corporate tax rates because this will discourage investment and job creation and put American businesses at a competitive disadvantage to companies operating outside our country’s tax regime.  In comparison to other types of taxes, corporate taxation can be a relatively inefficient and regressive way to raise revenues because of the cost is passed on to consumers and employees.

Government Interference in the Allocation of Capital

A healthy economy relies upon the efficient allocation of capital among various investment opportunities.  An important part of this process is when companies use dividends and stock buybacks to redeploy capital to more productive uses.  The current crisis has encouraged critics of stock buybacks and dividends to advocate for government control of these practices.  

This tendency is evident in the HEROES Act proposed by the House.  This legislation would prohibit corporations from utilizing tax loss carrybacks if their distributions to shareholders after 2017 exceed 5% of the company’s equity market value.   This is an unreasonable and inefficient precondition for access to tax relief.   Our system is designed to tax companies over economic cycles, so profits from good years can be grouped with losses from bad years.  This allows companies to plan and operate within a long-term context, increasing the overall efficiency of the economy.  Bureaucrats should not weaken this important principal, particularly as part of a political effort to meddle in capital allocation decisions driven by free market forces.

In another example, the Federal Reserve’s emergency lending program prohibits certain shareholder distributions by loan recipients for one year after they have repaid their borrowings.  A limitation on dividends and stock buybacks is justified while a company owes the government money, but not after repayment.  This type of government interference in the capital allocation decisions made by the private market is damaging because it prevents the optimal deployment of capital and reduces the growth potential of the economy.

Federal Bailouts for States and Localities Without Requiring Budget Reforms

As part of its initial emergency response, Congress passed the CARES Act which included $150 billion for healthcare-related aid to state and local governments to assist with the costs arising from the pandemic.  As the crisis continues, there are calls for much more in federal aid to state and local governments. 

To be sure, the pandemic has hit state and local governments hard with increased health care costs and contractions in the economy causing severe reductions in tax revenues.  But this crisis should not be used as an excuse to funnel bailouts to states that have engaged in irresponsible fiscal practices for many years.  Doing so would be a drag on the economy by enabling continued bad fiscal behavior and would be unfair to states that have made difficult budgeting decisions.  No further federal aid should be provided to states unless they commit to common sense fiscal reforms that will put their budgets on a more sustainable path.  

The most prominent issue that should be addressed at the state and local level is unfunded public pensions.   This problem varies significantly by state.  According to a recent report from the Hoover Institution, South Dakota reported that its public pensions are 100% funded while Illinois calculated its public pensions are less than 50% funded.  Significant unfunded public pension liabilities are evidence that states are not capable of responsibly managing their defined benefit pension plans.  As a precondition for any further federal aid, states should be required to reform their public pension plans to put them on sounder footing.  For example, in exchange for additional federal bailouts states should be required to transition public pensions from defined benefit plans to defined contribution plans.

Restructuring Global Supply Chains and Requirements for Domestic Production

As the pandemic spread and countries around the whole shut down their economies, governments and businesses scrambled to obtain medical supplies and other critical industrial inputs.  Global trade was disrupted and it became apparent that the U.S. and many economies were overly dependent on other countries for a variety of vital medical supplies and key industrial components.  In response, some voices in this country are advocating for requirements that “strategically critical” items should be manufactured domestically.   

Certain inputs may be genuinely “strategically critical.”  In these cases, it is prudent for our government to maintain emergency inventories and to develop a reliable plan for sourcing these items in a crisis.  The danger is that politicians will adopt an overbroad definition of what is “strategically critical” in designing the requirements for domestic production.   Over time, global supply chains have developed to maximize efficiency.  Unravelling these arrangements will inevitably reduce productivity.  Ultimately, higher costs will be passed on to consumers and taxpayers. 

Our leaders may conclude this is a price worth paying to prepare for future health crises, but we should require rigorous analysis before imposing domestic sourcing requirements and limit the scope of such mandates to what is absolutely necessary.  We should also consider other approaches that could improve the resilience of our supply chains without increasing costs unnecessarily, such as geographically diversifying the sources of our global supply chains to make them less susceptible to problems arising in particular areas.

Suppressing Accurate Credit Information

For credit markets to function efficiently, it is important that accurate information on counterparties is available.  Lenders need to understand the creditworthiness of borrowers to provide the best possible loan pricing and terms.  In difficult economic times, some politicians are tempted to suppress credit information in an attempt to help borrowers.  The HEROES Act proposed by the House includes a provision to suspend negative credit reporting during the pandemic and to prohibit the introduction of new credit models that would result in lower credit scores for as long as the emergency continues.  In addition, the HEROES act would permanently ban the reporting of medical debt arising from Covid-19 illnesses.  These proposals are very ill-advised because suppressing information on potential borrowers will result in reduced credit availability and higher prices as lenders respond to a lack of reliable data by erring on the side of caution.

Conclusion

The federal response to the current crisis will leave our country with daunting levels of government debt.  But perhaps a more dangerous risk is that politicians use this emergency as an opportunity to implement changes that will damage the structure of our economy.  This can be particularly problematic for two reasons.  First, once imposed these types are changes are very hard to reverse as they become imbedded in the political system and create constituencies that benefit from their continuation.  Second, structural changes that are harmful to the economy result in costs that are difficult to quantify and burdens that are opaquely dispersed throughout the economy in ways that are challenging to track.  As a result, taxpayers don’t personally experience the adverse impact the way they would feel an increase in their own taxes.  This lack of transparency is one of the main reasons politicians use these types of indirect and veiled strategies to dispense political favors and advance partisan agendas. 

In responding to the current crisis, it is imperative that our policymakers do not create new laws and regulations that will hinder the economy’s ability to flourish in the future.  There is no one solution to building a robust economy.  Rather, economic growth and jobs are created by the free market in thousands of different places in millions of different ways.  We need to recognize and respect this complex reality and guard against every assault on the dynamism of our economy.  More than ever, nurturing the flexibility of our economy is critical to developing a pathway back to an environment that provides opportunities for Americans.

By J.C. Pate

Introduction 

There are hundreds of public pension plans across this country run by states and various local government entities covering a range of public employees.  Many of these pension plans are in terrible shape.  These problems have been brewing for a long time and the challenge is daunting.  By one estimate, the unfunded liabilities related to these pension plans is over $12,000 for every man, woman, and child in the U.S.  A multitude of factors are driving the current crisis in public pensions, but the core of the problem boils down to overly optimistic assumptions about future costs combined with a failure to adequately fund those pension obligations.  

These issues are compounded by a lack of transparency and conflicts of interest in the political system.  It is only a matter of time before these problems come home to roost, leading to a combination of massive tax increases, significant cuts in public services, or reductions in benefits.  This challenge has been years in the making, so the solutions must include fundamental reforms. 

Overly Optimistic Assumptions and Funding Shortfalls are the Main Problems

Pensions are by their nature very long-term programs, spanning the careers and retirements of their members.  To quantify the cost of these long-term promises, the plans make a variety of assumptions ranging from the life expectancy of pensioners to cost of living adjustments.  But the most important assumption is estimating the value of future payouts in today’s dollars and how those amounts relate to estimated investment returns on pension assets.   In making these estimates, public pension plans are using assumptions that are far too aggressive.  

This seriousness of this error is demonstrated by comparing these assumptions to those used by more highly-regulated private pension plans.  State and local pension plans tend to make overly optimistic assumptions about their ability to earn investment returns on their invested assets, typically assuming around 7% per year in earnings, and also use these relatively high rates to discount the future value of pension payouts back to today’s dollars.  The higher the discount rate used in the calculation, the lower the net present value of the liability.  Because pensions are paid over such long periods of time, the selection of a discount rate can make a big difference in correctly calculating the amount of the future liability in current dollars.   

Private pension plans tend to use much lower discount rates than public pensions.  What is the right rate?  Financial theory says future cash flow obligations should be discounted at a rate reflecting the creditworthiness of the entity making the payments.  In the case of public pensions, the relevant government entity is obligated to pay the pension expenses.  This indicates that a rate closer to the risk-free debt rate of 2-3% would be appropriate.  

Over long periods of time, the difference between a 7% rate and a rate of 2.5% has a huge impact.  The Hoover Institution recently analyzed 619 state and local pension plans and found that they reported unfunded liabilities of $1.7 trillion using a rate of about 7%.  Using a more appropriate “market-based” discount rate of about 2.5% results in total unfunded liabilities of $4.1 trillion.  

Exacerbating the problem of overly rosy assumptions is a failure to set aside enough funds to cover pension promises.  The Hoover Institution looked at pension plans across the nation and found that these plans had set aside only about 48% of the current value of pension liabilities calculated using the appropriate “market rate” of about 2.5%.  Even based on the more optimistic rate of about 7% used by public pension plans, pension assets were only 74% of the net present value of nationwide public pension liabilities.

The problem varies widely by state and locality.  Illinois is the poster child for poor pension management.  According to a recent calculation by The Hoover Institution using the more aggressive discount rate of about 7%, Illinois had set aside assets covering about 46% of the current value of its public pension liabilities.  Using the “market rate” of around 2.5%, Illinois’ pension assets amounted to only 33% of the net present value of pension liabilities.   

There are plenty of other states with pension plans in trouble.  According to a recent analysis of public pensions from the American Legislative Exchange Council, 32 states have liability funding levels that fall below the 80% threshold that private plans must meet to avoid being considered “at risk” of defaulting on their pension obligations.  And these calculations are based on the more aggressive discount rate assumptions of about 7% used by public plans.  

Structural Issues Also Contribute to Pension Challenges

Structural factors, including a lack of transparency and conflicts of interest in the political system, are also important drivers of the current public pension crisis. 

Politicians interested in getting re-elected have an incentive to defer tough decisions and funding requirements into the future.  The complexity of pension accounting combined with the long-term nature of pension liabilities means it is relatively easy for politicians to obscure the real cost of future pension obligations.  Because the assumptions play out over such a long period of time, even small adjustments to assumptions can make a huge difference in the calculation of the current value of future obligations.

There has been a lack of adequate disclosure of the true scope of pension liabilities, as well as the underlying assumptions used to value future pension promises.   If taxpayers don’t clearly understand the status and cost of public pensions, it is difficult for them to hold politicians accountable for their management of these plans.

The political process itself creates a conflict of interest in pension negotiations with public sector unions.  Politicians are supposed to represent the taxpayers in these discussions.  However, politicians have very little motivation to take a firm stance over pension costs.  After all, it’s not their money.  At the same time, public sector unions and their lobbyists are large contributors to politicians who then have an incentive to accommodate union requests.   In the resulting negative feedback loop, politicians receive contributions from public sector unions and, in return, work to increase their pension benefits.

The political influence of public sector unions has also contributed to another impediment to healthy public pension reforms:  many of these plans now benefit from protections in state constitutions and other laws that inhibit changes to pension plans.  

Proposals for Pension Reform

For pension reform to be effective, it should address these core issues, from overly aggressive assumptions and funding shortfalls to a lack of transparency and conflicts of interest.  

Improved Assumptions and Funding Requirements

To correctly value long-term liabilities, it is very important to use appropriate assumptions.  Getting this right is one of the most critical elements of pension reform.  Private pensions provide a good model to follow.  Prior to the 1970s, many private pensions were seriously underfunded and ran into significant trouble meeting their obligations.  Starting in 1974, a series of reforms were implemented that significantly improved the health of private pensions.  Public pensions would benefit from adopting some of these reforms.  

For example, private pensions were required to calculate the present value of their pension obligations using discount rates that reflected the underlying credit risk of the companies making the pension promises.  For public plans, adopting this standard would mean using a “market rate” of around 2.5%, reflecting the fact that public pensions plans are backed by governments and supported by broad taxing power.  This would not change the payments due over time, but would increase the reported pension liability amount, providing a more accurate picture of the situation. 

More accurately calculating the actual liability is a helpful step to the next logical reform:  better funding of pension plans.  Private sector pension plans implemented more stringent funding requirements and were able to significantly improve the funding status of their plans as a result.  

Ideally, this reform would mean implementing requirements to set aside funding for the current value of future pension payouts as those benefits are earned, plus enough to pay down existing unfunded liabilities over a reasonable period of time.  The result would be an increase in current taxpayer contributions, but a policy of funding benefits as they are earned is a fairer approach than deferring the cost of today’s promises to future taxpayers.  Funding benefits as they are earned would also help taxpayers and politicians evaluate the real cost of pension compensation in the context of other budget priorities.  

Fairer Risk Sharing Between Pensions and Taxpayers

The vast majority of public sector pension plans are defined benefit (DB) plans rather than defined contribution (DC) plans.  Under DB plans, the state and local entities make promises to pay certain benefits to pensioners and bear the financial risk of finding investments to generate sufficient returns to fund those payments.  This arrangement shifts all the investment risk to the taxpayers.  In contrast, DC plans simply make a certain amount of contributions into their members’ accounts and the pension members bear the investment risk over time.  

Because DB plans are inherently riskier for taxpayers and harder to manage and understand, public pension plans should be transitioned to DC plans to reduce these risks.  Moving from DB plans to DC plans would also eliminate the problems of projecting the amount of future benefits and choosing the appropriate discount rate to calculate the present value of long-term pension liabilities.  Once a contribution is made into a DC plan, the government’s obligation is satisfied. 

Many private pension plans have transitioned to DC plans for these reasons.  In the private sector, only 4% of employees are covered by pure DB plans, while an additional 13% of private sector workers have access to plans that are hybrids of DB and DC plans.  On the other hand, 94% of public sector workers have access to DB plans where taxpayers bear all of the investment risk related to pension benefits.   Transitioning public employees to DC plans would put public employees on a more equal footing with most private employees who must bear the investment risk related to their own retirement plans.  Public sector workers should not get a better deal than the private workers whose taxes fund public pensions.

Finally, the simplification inherent in DC plans would mitigate the problem of politicians’ conflicts of interest as negotiators of pension benefits because DC plans would focus the negotiations on the amount of the annual contribution, a much easier process for taxpayers to understand.  For pension participants who want more certainty in the amount of their future pension benefits, the plans could include options for pensioners to use their pension funds to buy fixed annuities at a market price.

Many participants in public pensions are protected by laws that restrict changes to their pension benefits.  However, in most cases, changes are allowed for benefits related to new employees and adjustments in future benefits that have yet to be earned by existing employees.  So, while a wholesale transition to DC plans may not be feasible for all plans, most plans would allow a partial transition for new hires and for future benefits that have not yet been earned by existing employees.  Puerto Rico used this approach to reform its troubled pension plans as part of its recent debt restructuring.

Reforms to the Pension Negotiation Process

The process of negotiating public pension benefits is fundamentally flawed, with pernicious conflicts of interest affecting politicians who are charged with representing taxpayers but are often unduly influenced by the significant political contributions from public sector unions.  To reduce these problems, state and local governments could insert independent third parties into the pension negotiations.  

For example, an independent third party such as an insurer could be tasked with deciding the appropriate discount rate to use in valuing future pension obligations.  Based on discussions with the pension plan negotiators, the government entity could provide all the other assumptions necessary to project future pension payouts, producing an “assumed annuity”.  The private insurer would agree to assume a modest (e.g., 2%) pro rata tranche of the “assumed annuity” in exchange for a lump sum payment calculated using the suggested discount rate, plus a profit margin.  This would be a way for the insurer to stand behind the validity of their discount rate assumption.

Similarly, government entities could use other third parties to provide market-based validation of certain pension assumptions, such as assumed inflation or mortality rates, by having the third party take on a small tranche of this risk in exchange for a price.  Some critics may object that this approach would increase costs because the third parties would earn a profit margin on their small tranche of a pension’s plan’s risk.  But the value of improving the accuracy of assumptions would likely more than offset this cost.  The use of market validation would also be helpful in reducing the ability of politicians to manipulate assumptions to appease public sector unions.

Improved Transparency

It is hard to manage what you cannot see.  In the case of public pensions, a lack of transparency has contributed to a misunderstanding of the scope of the problem.  Enhanced disclosure requirements should be adopted to address this issue.  Disclosures should include a clear explanation of all assumptions and projected cash flows used in the calculation of pension liabilities, the annual cost of future promises, and historical and projected investment returns.  In addition, pensions should disclose the value of pension benefits for the average beneficiary and for beneficiaries grouped by quartile.  This information should be publicly available and sent to taxpayers on an annual basis in an easy to understand format.

The federal government should work to move states in the direction of increased pension transparency.  For example, one bill proposed by the House of Representatives in 2018 would have required increased pension disclosures in order for states and localities to qualify for the federal deductibility of interest on the bonds they issue.

Public Pension Reform Needs a Comprehensive Approach

Some factors are more important than others in driving the public pension crisis, but there is no single source of the current pension problems.  Ideally, pension reform should be comprehensive to maximize its effectiveness.  There is a long list of other changes that can be implemented to improve the health of public pensions including raising the retirement age for pension eligibility, capping salary levels that count toward pension benefits, prohibiting “double dipping” among different pension plans, and limiting cost of living adjustments.  

Conclusion

All across our country, many public pension plans are in dire shape, laying the groundwork for a crisis in the future.  Without fundamental reform, shortfalls in pension funds will result in a combination of cuts in essential public services, tax increases, or reductions in benefits.  Eventually, this could lead to taxpayer flight, further weakening the tax base.  Ignoring this problem is not fair to pension participants nor to future taxpayers.  Due to the size and complexity of these problems, there is no quick fix.  The solution requires serious fundament reform, the sooner the better.  When considering this challenge, it is instructive to remember an old Chinese proverb:  “The best time to plant a tree was 20 years ago.  The second best time to plant a tree is now.”  It is time to get started on public pension reform.