Hyperbolic discounting and Nashville's growing pension problem

The city of Nashville uses discounting to decide how much to save for its future pension obligations. For a pension that pays out $100,000 in 20 years, Nashville must save $20,485=$100,000/(1.0825)^20 today, using an 8.25% discount rate.   If the city invests the $20,485, and earns 8.25%, the savings will compound and be worth $100,000 in twenty years.  If however, the investments return less than 8.25% (in fact they have done much worse),then the city will not have saved enough when the future finally gets here.  Of course, a more realistic discount rate, say 6.5%, would mean much higher current savings, 28,380=$100,000/(1.065)^20 to fund the same future pension.  But higher savings means less current spending, and spending is politically popular.

If voters were perfectly rational, they would recognize that their cities are not saving enough to fund their future pension obligations. 

That they don’t seem to care has long been recognized by psychologists, and even has a name, “hyperbolic discounting.”  It means that most people make decisions using discount rates that are too big.  In other words, they place too much weight on the present, and not enough weight on the future.  Businesses, like politicians, take advantage of this irrationality by, for example, offering a low “teaser” price which goes up in the future, or by offering a low price on a consumer durable, like a pod-coffee maker, and then charging a high price on the consumables,like the pod.  When deciding whether to purchase the pod-coffee “system,” consumers place too much weight on the “current” low price of the machine, and discount too heavily the “future” high price of the pods.  By shifting most of the system costs to the future, the coffee company makes the system appear cheaper, which increases demand.

What's the difference between Keurig Coffee and Nashville city government?

In order to persuade coffee drinkers to switch from normal drip coffee makers to Keurig's unique K-cup coffee system, Keurig has to keep the initial system price low by essentially giving away their coffee makers. Whatever Keurig loses on the machines, it more than gains on future sales of K-cups.

Similarly, Nashville discounts its future pension liabilities at the unreasonably high rate of 8.25%. This allows the city government to save less--and spend more--than they should.

Both Keurig and Nashville are taking advantage of people's irrational over-weighting of the present relative to the future, which is so common that economists have given it a name, hyperbolic discounting.

The difference is that Keurig will make up for the initial loss with profit from future sales whereas Nashville has no such plan. In the meantime, the size of our unfunded debt keeps growing. Someone else--presumably our kids--will wind up with the bill.

As strange as it may sound, we could learn something from California. Just yesterday, Calpers took the unusual step of lowering its discount rate to 7.5% (the actuary had recommended 7.25%). It is unusual because the the policy alleviates future problems, but causes pain today, exactly the opposite of what hyperbolic discounting tells them they should do.

By lowering the so-called discount rate, Calpers could ask the state to eventually contribute an additional $300 million annually. The pension board asked the staff to come up with a plan to phase in the increased contributions from state and other government agencies over the next two years to help soften the financial blow.

That such a small change in the discount rate (0.25%) can have such big effects illustrates the power of discounting. Imagine what would happen if they had to lower their discount rate to a much more realistic number, say 6.5%? (Derivation here).

See also Stossel on city pensions; and how the Swedes solved their pension mess.

And as if this weren't scary enough, the pension problems are dwarfed by the unfunded medical benefits:

while most public pension plans are 75 percent funded, the figure for health-care plans is only 4 percent nationwide. So unlike pensions, governments are setting aside little money in advance to pay for their future obligations.

HT: Instapundit

Trust only 1/3 of the results from Pscyhology, but 2/3 of the results from behavioral economics

Dan Ariely (psychologist and behavioral economist) was forced to retract a well-cited paper based on fraudulent data. Ariely, a frequent TED Talk speaker and a Wall Street Journal advice columnist, cited the study in lectures and in his New York Times bestseller The (Honest) Truth About Dishonesty: How We Lie to Everyone — Especially Ourselves. We have blogged about Ariely's work and want to warn readers that we may have retract the blog posts, pending the outcome of an internal investigation.  

Professor Ariely's problems are part of a larger "replication crisis." It began when the journal Science found that only 1/3 of the psychology experiments underlying the most cited papers in the field of psychology  could be replicated.  A bigger and more recent study finds much the same thing.  [Behavioral Economics does better than psychology, as 2/3 of the results can be replicated.]

Contributing to the crisis is what is called HARK, Hypothesis After Results Known.  Due to the pressure to publish statistically significant results, researchers do science backward.  They begin by looking for a statistically significant result (p hacking).  Then, they specify an hypothesis to explain it.  Now, good practice requires that researchers register hypotheses before testing them.  Note that a similar problem plagues non-experimental data as well (regression fishing).

We regularly blog about deviations from the rational actor paradigm, and include some of the more useful results in our textbook, notably loss aversion (losses hurt more than gains help), and hyperbolic discounting (overweighting the present).  To the extent that these findings cannot be replicated, we could be wrong.

For the sixth edition, we will do our best to determine whether these Behavioral Economics results can be trusted.  For now, place a 2/3 weight on them being right.