We got it all wrong

Wages are stable, DC pensions are great, and free college is very expensive

Photo by dylan nolte on Unsplash

Hello,

Welcome to Known Unknowns, a newsletter where what you think is free is expensive, and what you think is risk-free is very risky.

We got wage risk totally wrong

I am a bit of a big data skeptic. I just don’t think it’s that new or interesting; it’s just a bigger version of what we already had. But sometimes the ability to manage very large data sets allows us to do a new analysis that totally overturns what we thought was true. You probably never heard about it, but that’s what happened in economics several years ago.

For years, economists, the media, and politicians all believed that work had gotten riskier. The latter two still believe it. As the narrative goes, people can’t count on stable wages anymore because income has become less predictable. This argument was central to my PhD dissertation. I even proved it using survey data.

Then, a few years later, a group of economists got their hands on Social Security records. This was an enormous data set (and a huge improvement on the surveys everyone else used) that could track what happened to the wages of many individuals over their lifetime and how they changed. This was important because when we talk about income stagnation, usually we look at median wages of the whole population at a single point in time. That does not actually tell you much about what’s happening to individuals. Older people get smaller raises, so stagnant wages may just mean an aging population. When people say, “Americans have not gotten a raise,” they could just be referring to demographic changes, not the experience of individual households. The idea that we have stagnant wages and more risk drove our policies and our conversation about work.

One of the economists who worked on the Social Security data project is Fatih Guvenen, and he joined me on my podcast last week about what he found. As it turns out, once we could examine what happened to individuals’ wages over their lifetime, many of our narratives were totally wrong. This should have been on the cover of the New York Times.

Not only are wages still growing, but they are also more stable than ever. Men’s wages still grow (but at a slower rate) and start lower when they are young. This all means men earn less over their lifetime, but they experience less risk—so it’s hard to make a welfare judgement. Other shocking findings are that high-paid CEOs are not to blame for runaway inequality, and most of the 1% are only in the 1% for a few years of their life.

One thing I love about Fatih’s work is that he approaches macro with a finance sensibility. Wages are an asset like any other, so understanding their risk characteristics takes an understanding of finance. And it turns out that while wage variability has declined, tail risk during the business cycle has increased. We know from finance that when we become too focused on volatility and ignore tail risk, we don’t insure or hedge properly. But that sums up our approach to policy lately.

I hope you will either listen or read the transcript; it will change how you see everything.

Free college is the next big bad idea

Last time I was kind of mad about student loan bailouts, but now I am trying to look forward to what the next bad policy will be. And the debate will probably move to free college. Many of the bailout fans think college should be free, which is consistent with the idea that loans should be forgiven. I wrote in Bloomberg why this is also a bad idea because it is regressive, worsens inequality, and can mean students end up with even more debt.

Free college, like free health care, is something that happens in Europe that Americans tend to idealize. But nothing is ever really free, and if you want better services—provided to more people—“free” rarely achieves that goal.

The American system has many problems. It is wasteful and too expensive, and our loan system needs reforms. But on balance, it works pretty well. A high percentage of Americans have degrees and earn a great rate of return on them.

One for the Pension Geeks

I am a tried-and-true Pension Geek. After all, my (now disproved) dissertation compared DB/DC pension risk. I tend to focus on other things these days, but I did write a column for Bloomberg defending DC pensions, like the 401(k). In times like this, we tend to romanticize DB pensions where someone saved, invested on your behalf, and bore all our market and longevity risk. But DB pensions are not that great. Retirement finance is still really expensive, DB plans just make it easier to obfuscate that fact. And it is really hard to align incentives to get that person, or government, to fund DB pensions properly and invest them responsibly.

DC plans have their problems, but they are at least transparent and have better-aligned incentives. A friend pointed out that there are also incentive and transparency problems with 401(k)s. Layers of regulations mean plan consultants often suggest subpar investment options and higher-than-necessary fees. Consultants also make it hard to innovate, which is needed since there is scope to help individuals better manage asset and longevity risk. And, as we saw in Chile, it’s tempting to not save enough, and then people because get angry when they look at their account balances. People don’t save enough with DB plans either, but no one ever notices until it’s too late. But these problems are easier to solve than the issues with DB plans.

Personally, I think a well-run DB plan is a great thing, even better sometimes than a well-run DC plan (if you never change jobs). The problem is, it is very, very hard to find a well-run DB plan and get the incentives right, so I’ll take transparency.

As Social Security burns through its trust fund and Chile revisits its pension system, we’ll hear more demand for expanding DB pensions. But the future is DC.

ESG’s murky future

A tumultuous market tends to expose investment trends that never really made sense. In this case, ESG and crypto. I fully support individuals who want to invest in companies that reflect their values. But I never understood why so many people expected BlackRock to shape and share their values. Because what is an ethical company? That’s a hard question. Even an environmentally sound company is hard to define—since many big polluters are also in renewables. Ethical investing is lots of work and requires taking strong moral and often hypocritical stands.

And that’s fine. People chose investments for all sorts of reasons. But one thing that bothered me about ESG is the same thing that bothers me about the entire environmental movement, it promised a free lunch: high returns and investments people could feel good about. But there is no free lunch here. A constrained portfolio will return less than an unconstrained one. These choices cost money, and if you want to pay that price, I admire that.

If you are managing public pension money, this all gets a little more dicey. The so-called woke investment backlash was inevitable. When you take taxpayer money (which they have to guarantee) and invest it in your favored causes, you should be subject to more scrutiny.

Until next time, Pension Geeks!

Allison