Why Pensions Are Grossly Underfunded

The San Diego Union Tribune ran a report on June 17th entitled “Escondido firefighters do contribute to pensions.” Apparently this report was to correct an error from a previous article in which the Tribune stated that Escondido’s firefighters did not make any contribution to their pension. In reality the firefighters contribute to their pension fund an amount, in the form of payroll withholding, equivalent to 9% of their salary.

While it is commendable that Escondido’s firefighters do pay something towards their pensions, considering how many safety employees in California still pay nothing, it is important to place this 9% contribution within the perspective of how much it really costs to fund a “3 at 50″ pension.

The following table depicts how much, in terms of percent of salary, an employee will need to have contributed into their pension fund in order to maintain solvency based on various rates of return for the fund.

This table uses after inflation numbers, which makes the returns appear small. In reality, CalPERS, CalSTRS, and most other pension funds, project a long-term rate of inflation of 3.0%. This means that the nearly best case scenarios here, 7.5% before inflation (showing as 4.5% after inflation on the table), are representative of the current official long-term projections used by most pension funds. Based on the official rates of projected returns for pension fund investments, a 30 year veteran, retiring on a “3.0% at 50″ pension, will collect 90% of their salary in retirement, and they will need to contribute 32.5% of their pay into their pension fund every year they work. On that basis, 9% is less than one-third what will be necessary to fund their retirement pension. But what if the pension funds return less than 4.5% (7.5% before inflation) per year?

As can be seen, for every 1.0% the real rate of return drops, the required contribution increases by over 10%. That is, if CalPERS can only deliver a 6.5% return (3.5% after inflation), the contribution goes up from 32.5% of salary to 43.4% of salary. If CalPERS rate of return goes down to a 5.5% return (2.5% after inflation), the contribution goes up from 32.5% of salary to 57.9% of salary.

Nobody seriously questions the fact that police and firefighters deserve to be paid a premium for the work they do. But how much of a premium is appropriate? A self-employed independent contractor has to pay the employer and employee share of social security. That means they have to pay 12.5% of every dime they make into the social security fund. And if they are fortunate enough to earn, at the end of their careers, what the average veteran police officer or firefighter makes – let’s lowball that at $100K – they will get a social security benefit, at most, of $30K per year at age 68. This equates to a pension formula of roughly “0.75% at 68″ vs. “3.0% at 50.”

Public sector workers, all of them, should consider these apples-to-apples comparisons to the taxpayers in the private sector who support them, when they suggest that 9% is an appropriate or commendable amount for them to be contributing to their pension funds. They should be prepared to explain why they aren’t contributing at least 50% of the cost for their pensions, with that contribution going up whenever projected rates of return for their pension funds go down.

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7 comments to Why Pensions Are Grossly Underfunded

  • Nick Croom

    It’s irrelevant what share of the cost the employees meet – they’re meeting it out of their wages after all, so if they meet 50%, you’ll have to pay them more.
    And linking pay (because an increase in contributions is a cut in pay) to future expected returns which are borderline fiction? It’s a complicated concept to explain…..

  • Editor

    Nick – you’re right that we’re dealing with a complicated concept. But we can’t hide behind the complexity, either. As this post attempts to convey in as plainwrapped terms as possible, when you lower the projected rate of fund return by just 1%, you have to raise the annual pension fund contribution by an additional 10% of salary. That is pretty much a given. There are many solutions to this, and some are easier to understand, or implement, than others. None of them will be easy, but the price of inaction is worse.

  • Terry

    Does this chart adjust for the fact that people tend to earn less earlier in their career?

    Does this chart in any way compensate for last year extra overtime, which inflates the highest year earnings?

  • Editor

    Terry – thank you for your questions. The chart is derived from an analysis that assumes the real annual salary of the employee doubles over the course of a 30 year career. As you probably know, if you do the analysis while assuming a level salary, you will improve the investment returns since more money will have been invested earlier and earn returns for a longer period of time. But it is more realistic to assume a doubling of the annual salary of the average pension recipient during their career, in real dollars, between when they entered the workforce and when they retired as a senior employee. To answer your second question, the analysis underlying this chart does not take into account end of career pension “spiking” (via overtime, cashed in sick-time, or inappropriate final year salary boosts, to name a few), which means the conclusions implicit in this chart are understating the scale of the problem we face.

  • Keen Observer

    Does this chart assume that every employee will have a 30 year retirement?

  • RobL

    By now, I think it has been relayed enough times to not have to come up again and again, CalPERS does not include overtime in pension calculations. Some counties do, but they can change that locally. I can’t speak to teachers, or non-PERS public pensions. Sick-time is not ‘cashed in.’ It can be used as time served, and bring an earlier retirement date, but usually at about 40%, and does not increase the pension (outside of its effect on retirement date). ‘Inappropriate’ final year salary boosts should not be allowed by any employer, public or private. CalPERS investigates and disallows inappropriate boosts, or spiking. And, finally, just to help you with your chart – http://www.calpers.ca.gov/index.jsp?bc=/about/press/pr-2011/july/fy-2010-11-returns.xml
    I wish I was a Fortune 500 CEO. I would have earned 40% more this year than last, standing upon the burning rubble I created.
    http://management.fortune.cnn.com/2011/04/13/how-can-we-address-excessive-ceo-pay/
    And, when I quit or get fired, I can count on at least 3 to 4 times annual salary for severence, plus all my options and share bonuses. Instead, as a public servant, my pay is 18% less this year than two years ago. 18% less, mind you, despite a mutually agreed upon contract. But then, the $35,000 my employer pays towards my retirement (in addition to the 14% of my salary that is deducted) is what has really put us in the poorhouse, so no one should be concerned for broken contracts. I’m sure that the influx of capital from the private industry, especially banking, will drive us back to good times in a few months.

  • Editor

    RobL – thank you for your informed comment. I certainly would never suggest that in many agencies and jurisdictions “spiking” is minimized if not nonexistent. And I’m sure you would agree that in many other cases it is a huge, systemic problem. Remember that while there are nearly 400,000 state workers in California, there are nearly 1.5 million local government workers in California, so suggesting that spiking is not a systemic problem among state workers doesn’t really confirm that it isn’t a problem among local workers, who are about four times as numerous. But in our analyses in this and other posts we never assume there is any spiking at all, just to keep our numbers conservative.

    The fact that CalPERS announced 12 months of good returns does not change the big picture. CalPERS will not earn a real annual rate of return (after inflation which they assume to be 3.0%) of 4.75% over the next decade, which is what they need – at an absolute minimum – to in order to make up for the losses incurred over the past decade plus handle the influx of new retirees who will be starting to receive pension payments. They won’t because there is too much debt in the system globally which forces central banks to loan money at virtually negative rates of interest. You can’t have a real interest rate of zero (or even negative) on federal bank lending and a real return for CalPERS funds of 4.75%. The spread is too big. CalPERS, ultimately, is a lender, and borrowers are not going to offer them this kind of a return. And even if CalPERS and the other pension funds were to achieve this rate of return, which obviously they did last year, to the extent it isn’t just a cyclical bounce-back from the huge losses they’ve incurred in recent years (hence nowhere near a 4.75% rolling five or ten year return), it is because they are taking gigantic risks with their assets, for example, engaging in hedge fund investing. And when hedge funds win, other investors – the rest of us – lose. To the extent they beat the market, CalPERS, along with the other giant pension funds, are engaging in market manipulation at a scale, because they are so big, that kills investment opportunities for the rest of us.

    Finally, your comment about “executive pay” damages your credibility. From the way you write, you don’t come across as an ignoramus. So compare yourself to the hundreds of millions of private sector workers, not to the thousands of corporate CEOs. Your logic is specious on many levels. Not only are there very few corporate CEOs fortunate enough to enjoy the excessive compensation you reference, but the companies they run are so large that even if you paid them nothing, it would not affect the price of goods. For example, if the CEO of a company with $100 billion in revenue were to work for nothing, instead of for $10 million per year, you would be able to drop the price of that company’s products by one-tenth of one percent. And in any case, I don’t have to buy those products, but I have to pay you through my taxes, which as an independent contractor who makes less than $100K per year, are nonetheless 50% on every additional dollar I make (12.5% social security, 2.5% medicare, 10% California state tax, and $25% Federal tax). Compare yourself to other working people in the private sector, Mr. RobL, and go celebrate. Listening to you guys suggest that we should pay 50% taxes (not including our property tax, sales tax, and taxes buried in our utility bills and other goods and services) because you don’t make as much as a handful of CEOs gets really, really old.