Federal Reserve Bank of San Francisco

Community Development

Beyond the Hype: The Promise and Pitfalls of Pay for Success

August 12, 2013

By Ian Galloway, Federal Reserve Bank of San Francisco

Interest in Pay for Success (PFS) financing tools, like the social impact bond, has been growing steadily since 2010. Many governments are exploring PFS solutions, including the State of California, which recently convened an informational legislative hearing to discuss the idea. My testimony to the Select Committee on Procurement and the Business, Professions & Economic Development Committee was based on the most recent issue of the Community Development Investment Review, which explored PFS in depth. I used my remarks to highlight four potential benefits and pitfalls. First, the benefits:

PFS busts funding silos. We know neighborhoods need comprehensive solutions but government funding streams remain circumscribed. Likewise, we know stable housing reduces emergency room use but savings that accrue to one agency (HHS, for example) can’t be used to reimburse the agency that paid for the housing (HUD).  PFS creates a framework for multi-party contracting that eliminates these challenges.

PFS promotes evidence-based policy. In his “Fixes” blog, David Bornstein observed that “People with good intentions have long worked on social problems in the dark; increasingly they are being asked to prove that they are getting somewhere. This is a departure from the past. And like the scientific revolution, if the movement grows, it should foster considerable innovation.” That sentiment—evidence-based policy fosters innovation—lies at the root of PFS. When data drives policy, policy drives investment, and investment drives innovation, the result is an ecosystem of social service providers vying for solutions that work. PFS contracts can be the foundation of a competitive marketplace for data-driven innovation in the social sector.

PFS builds on the success of the public-private investment model. PFS isn’t entirely new. The Low Income Housing Tax Credit (LIHTC), for example, raises private capital to accomplish a public sector goal: multifamily affordable housing development. Investors underwrite projects and provide upfront funding in exchange for a future reduction in tax liability. The catch: the project needs to stay affordable for fifteen years, or the tax liability is reassessed. PFS simply expands this public-private real estate investment model to include social programs.

PFS supports holistic community development. Neighborhoods are dynamic environments. As a result, it’s often difficult to identify what’s working and what isn’t. (Did the after-school program reduce gang-related crime, or was it the new community policing initiative?) In many ways, neighborhoods are black boxes—inputs go in, outputs come out, but it’s hard to draw a line from one to the other.  PFS contracts get around this problem by paying for the outcome (improved 3rd grade reading scores) and not the individual programs that may, or may not, have contributed to it.

While there are many reasons to be excited about PFS, there are reasons for caution as well. Here are my top four:

PFS depends on the integrity of community data. Evidence-based policy is a powerful idea but, in practice, it will be limited by our ability to collect and analyze consistently reliable community data. All parties in PFS contracts stand to gain or lose based on “what the data show.” Community impact may be difficult to accurately measure, however, undermining the legitimacy of the contract and inviting potential litigation. The community data house must be in order before PFS contracts can be adopted widely.

PFS isn’t just about saving money.  One of the more attractive elements of PFS is the prospect of saving scarce public resources. When governments pay for “success” they do so using projected downstream savings (reductions in incarceration and public assistance costs, for example). As a result, PFS is often hailed as a commonsense win-win—good for the service recipients and good for government. This obscures the reality, however, which is that future savings are almost impossible to extract from public budgets.  A successful recidivism-reduction PFS contract may, in fact, reduce the prison population but until prison salaries, pension obligations, and facilities are defunded, savings will only accrue in the form of efficiency gains, not lower taxes. This isn’t to say that PFS contracts shouldn’t be pursued by government; to the contrary, there’s a lot to be said about efficiency as a public sector goal. But decoupling savings from payouts will be the key to scaling PFS contracts beyond one-off pilots.

PFS is not government business as usual. PFS upends the existing social service procurement process. Government officials need to be ready to manage PFS contracts and prepared to meet their obligations when their terms are met. Agencies, staff, and budget processes will all need to change to accommodate them. This is crucial. PFS investors are already tasked with underwriting service providers; underwriting government capacity and appropriations risk will all but eliminate investor demand and stop PFS in its tracks.

PFS should express society’s values. As PFS becomes more commonplace, there will be significant pressure to prioritize contracts that produce the most savings. That will be a mistake. Reducing the chronically homeless’ use of emergency care services saves a great deal of money but we should choose to fund supportive housing because it’s the humane thing to do, regardless of the savings. Equally important, we must define within a PFS contract what is appropriate in the pursuit of achieving the contract’s goals. If the goal is to reduce childhood asthma emergencies, for example, it would clearly be wrong for a service provider to reduce access to emergency facilities as a means of achieving it. As a general rule, if providers are delivering services through government fiat their behavior should be subject to a higher level of scrutiny. These considerations should play an active part in PFS contracting going forward.

Ian Galloway is a senior research associate at the Federal Reserve Bank of San Francisco and the issue editor of a recently-published Federal Reserve journal on Pay for Success financing. His views are his own and do not necessarily reflect those of the Federal Reserve Bank of San Francisco or the Federal Reserve System.


The views expressed are not necessarily those of the Federal Reserve Bank of San Francisco or of the Federal Reserve System.