A History of Public Sector Pensions in the United States

Published by EH.NET (October 2003)

Robert L. Clark, Lee A. Craig, and Jack W. Wilson, A History of Public Sector Pensions in the United States. Philadelphia: University of Pennsylvania Press, 2003. ix + 259 pp. $49.95 (cloth), ISBN: 0-8122-3714-5.

Reviewed for EH.NET by Price Fishback, Department of Economics, University of Arizona.

Professors Clark, Craig, and Wilson (CCW) have written an extremely useful history of public sector pensions in the U.S. from Revolutionary times through the 1920s. After laying out the basic economics of pension plans, they set the stage for a discussion of the U.S. experience with military pensions by tracing the history of military pensions from Roman times through the various European plans in the late eighteenth century. Almost half of the book is devoted to an extensive case study of the development of the U.S. Navy pension fund. Once the naval experience has been established, they compare and contrast it with the development of pension plans for the Army, federal nonmilitary employees, and state and local workers.

One of my favorite chapters is the second chapter on “Pension Economics.” It is a marvelous introduction to the economic issues related to the provision of retirement pensions. It is clearly written with simple illustrations that make the fundamental points well. I plan to use it as a reading for MBA students to give them a better appreciation of pension schemes and how they influence labor market decisions. It would be useful as an extra reading for undergraduate labor economics or any other course where pensions are an issue.

The bulk of the book deals with the development of the U.S. Naval pension fund, which is fascinating in part because it seems so unusual to the modern student of pensions. The Continental Congress had offered disability payments to veterans of the Revolution but had never really established a fund. As the navy was established under the Early Republic, a specific disability fund was established and it relied primarily on the sales of prizes captured in naval conflicts. It seems unusual to fund long standing and relatively stable obligations with assets that are highly variable in nature. However, CCW show that the use of prizes to fund disability pensions and to provide direct compensation to naval forces was a long standing practice in many societies. They argue that it was difficult to monitor the actions of naval officers and that the provision of prizes helped provide the proper incentives in naval engagements. (For more extended discussions of this issue, see the recent debate between Douglas Allen and Daniel Benjamin and Christopher Thornberg in the April 2003 issue of Explorations in Economic History.)

Through the early 1830s, assets in the naval funds accumulated at a faster rate than payments for disability. Given this surplus of assets, it was easy politically for Congress to expand the definition of disability on several occasions. Eventually old age and service in the Navy qualified the ex-sailor for funds. The generosity to the family of veterans who died also expanded greatly. Problems arose with the pension fund eventually because the benefits kept expanding but the capture of prizes was highly variable, so that Congress had to bail out of the funds.

CCW’s description of the management of the naval pension fund will make pension experts cringe. Monies from the sale of the prizes were originally invested in relatively safe U.S. Treasury bonds, although the fund appeared to be paying a premium on the purchase of the assets. This avenue for investment eventually dried up as the U.S. retired its war debt and the fund was then invested in a range of state bonds and bank stocks. In analyzing the choices made by the pension fund manager, CCW provide a nice summary of the recent research on investment opportunities in the early 1800s. In their view the fund managers made a series of odd choices, particularly the choice to invest in some Washington, D.C. area banks. These investments were substantially riskier than the First Bank of the United States and many of the New York banks. Further, the failures of the Washington banks created some temporary problems for the disability fund. The odd choices came about partially because of political pressures that left the stock in the Bank of the United States and British government bonds out of bounds. In other cases, the choices appear to have been fraudulent. My sense is that CCW may have relied too much on hindsight in describing the problems with the investment choices. Here we have a brand new method for insuring the payment of disability and no one who had any prior experience in operating such a fund. The options for asset investments were very limited because there were few banks and British government bonds were not an option. The choice of Washington area investments may well have been driven by monitoring issues, as the fund manager trusted investing in assets that he could see close to home with people he knew as opposed to assets in New York (or in Britain for that matter) at a time when the post took a couple of weeks to arrive. Certainly, the discounts on distant bank currencies prior to the Civil War and the regional differences in interest rates through the nineteenth century are consistent with people treating distance as a significant source of monitoring costs.

CCW draw several lessons for modern public pension funds from the naval fund experience with which I agree. First, fund surpluses give politicians incentives to expand the generosity of benefits, particularly because beneficiaries can expect that if the fund goes bust, the taxing power of the state can be relied upon to maintain their benefits. Second, absence of adequate oversight can lead to significant problems with fraud in the administration of the funds, particularly when the funds are invested in private assets. Third, it is likely that political exigencies will get in the way of sound financial management of the fund. We can already point to experiences with Social Security funds that seem to fit these warnings, although I believe that CCW could have done more to describe actual problems experienced with modern pension funds that highlight how the lessons from the past are repeated.

CCW use the chapter on Army pensions to explain the fundamental differences in the financing of the pension disability funds for the Army and the Navy and to illustrate the common labor economics of retirement plans. The Army, unlike the navy, did not rely on prizes for compensation in part because the actions of land-based forces could be monitored more closely than could the navy. Eventually, the reliance of the naval fund on prizes was eliminated as changes in naval technology lowered the costs of monitoring effort at sea and Congress sought to eliminate the costs of operating two separate plans for the army and the navy. Both the Army and Navy pensions eventually shifted from pure disability plans into retirement plans. The retirement plans offered the advantage of providing deferred payment of compensation that would more tightly bind people to military careers. However, the typical patterns of promotion led to too many officers “retiring on the job.” Thus, the army and navy plans used a combination of limits on service and generosity to force and induce officers to retire when their productivity declined.

I have a couple of speculative insights to offer on the development of the army and the navy plans (and for that matter plans for police and firemen, as well). All of these plans started as disability plans to take care of those protecting the public when they were injured. All eventually turned into retirement plans by expanding the definition of disability to include old age. I believe that a combination of compassion for those who served and protected and the costs of monitoring disability claims can help explain this phenomenon of converting disability plans into de facto retirement plans. At young ages it is relatively easy to determine a disability related to service. However, battle wounds, injuries, and diseases often take their toll not just initially but later in life as well. Once veterans reached their sixties, trying to sort out the difference between battle-related and other disabilities became more difficult. As the number of potential pensioners dwindled, the total costs of taking care of those remaining fell, so it became easier to make the case that mere veteran status and current disability were enough to qualify for benefits.

The final two substantive chapters discuss the early origins of nonmilitary pensions for federal employees and for state and local employees. Municipalities led the way in providing pension plans for police officers, fire fighters, and teachers. The funding of these plans was restricted by the basic constitutional relationships between cities and the states; therefore, most city pension plans were invested heavily in their own debt. These plans were relatively generous, replacing nearly 50 percent of lost earnings, as they do today. At the federal level, there had been provisions for pensions for some federal employees but these were typically provided through special ad hoc legislation. The introduction of federal pensions was delayed until the development of a professional civil service that would have long term service. The federal plan provided much better benefits than the existing private pension funds at the time and over the long run put pressure on private employers improve their programs when competing with the government for workers. I found that the two chapters provide some new insights and in particular some valuable quantitative evidence on the character of state and local plans.

CCW could have done more to highlight just how important the military pension funds were in the development of social insurance for the entire population. Theda Skocpol’s Protecting Soldiers and Mothers: The Political Origins of Social Policy in the United States (Harvard University Press, 1992) and Dora Costa’s The Evolution of Retirement (University of Chicago Press, 1998) both show that Civil War pensions were widespread among retirees in the North in the early 1900s. Meanwhile, the pressure from World War I veterans for early payments of the veterans’ bonus was one of many pressures that contributed to the adoption of the Social Security Act.

The book left me sated with information on the navy pension fund, but it left me hungry for more evidence on the state and local and federal pension funds in the early 1900s. In terms of people served, it seems like the nonmilitary funds were more important. However, it is important to note that in terms of published knowledge, we knew much less about the early military pensions than we did about the state and local funds. In the final analysis, this book has admirably filled that gap. It provides a strong foundation for future studies of the development of both public and private pensions in the twentieth century.

Price Fishback is the Frank and Clara Kramer Professor of Economics at the University of Arizona and a Research Associate with the National Bureau of Economic Research. He and Shawn Kantor are the authors of A Prelude to the Welfare State: The Origins of Workers’ Compensation. Price is currently working on a series of studies of the Political Economy of the New Deal.