What Percent of Payroll Will Keep Pensions Solvent?

In a previous post “Why Pensions Are Grossly Underfunded,” the point is made that for every percentage point that an investment fund lowers their projected rate of return, the required annual pension fund contribution as a percent of salary goes up by over 10%. The assumptions underlying that analysis were 30 years working, 30 years retired, a pension equivalent to 90% of final salary, with the salary doubling (in inflation adjusted dollars) between the first year of employment and the final year of employment. Using the same assumptions, but for a pension equivalent to 60% of final annual salary, for every percentage point that an investment fund lowers their projected rate of return, the required annual pension fund contribution as a percent of salary goes up by a bit less than 10%. The implications of these facts should be clear to anyone involved in the issue of public employee pension benefits.

This post is in response to a commenter who, after reading the previous post, asked what the impact might be on required annual contributions to pensions if the assumptions are changed so that the years retired are shortened. The implication was that a 30 year working, 30 year retired scenario is an unlikely average, since on average, employees who log 30 years of government service do not survive an additional 30 years in retirement. But when analyzing the variability of required pension fund contributions based on 20 year and 25 year retirements, while assuming 30 years of work, the results are still noteworthy. Here they are:


In the above table, the first set of four rows show various scenarios based on a pension equivalent to 90% of final salary, the second set of four rows show various scenarios based on a pension equivalent to 60% of final salary. One might suggest the first set of rows depicts public safety workers, representing approximately 15% of California’s 1.85 million state and local government workers, and the second set of rows depicts everyone else working for state and local government agencies in California.

For each pension example, the fund return is calculated at a best case of 4.75% per year, which is the official rate used by CalPERS currently, and is the rate used by most public employee pension funds across the U.S. That return is then dropped by 1.0% in each of the next three rows. It is important to note that these are “real” returns, after inflation, which is typically projected at 3.0% per year. In nominal terms, CalPERS official long-term projected rate of return is 7.75% per year. So in nominal (before adjusting for inflation) terms, the four returns evaluated on this table are 7.75%, 6.75%, 5.75%, and 4.75%. To keep this in perspective, the “risk-free,” nominal rate of return on the 10 year Treasury Bill is 3.0% per year, nearly two percent lower than our worst case scenario in this analysis.

As can be seen by reviewing the first column in the boxed set of data on the table, when someone works 30 years and is retired 30 years, and has a pension equivalent to 90% of their final salary, if you drop just one-percent from CalPERS official long-term projection, you have to increase the annual pension fund contribution by 10.1% of salary – from 30.3% per year to 40.4% per year. But if you want to be more realistic (notwithstanding pension spiking, staggering losses to the funds over the past 10 years, or retroactive pension benefit increases, which this analysis does not take into account, and which make the required contributions much higher), you may consider the next two columns in the boxed area on the table.

If someone works 30 years and retires for 25 years, with a pension equivalent to 90% of their final salary, if you drop just one-percent from CalPERS official long-term projection, you have to increase the annual pension fund contribution by 8.6% of salary, from 27.7% per year to 36.3% per year. If someone works 30 years and retires for 20 years, with a pension equivalent to 90% of their final salary, if you drop just one-percent from CalPERS official long-term projection, you have to increase the annual pension fund contribution by 7.1% of salary, from 24.4% per year to 31.5% per year. Clearly increasing the proportion of years working to years retired reduces the impact of lowered rate of return assumptions, but the impact of a mere 1.0% drop in the projected long-term rate of pension fund returns on the required contribution is still quite dramatic.

Anyone who wishes to explore this further is invited to review two example charts below this post, one that shows the derivation of the required pension fund contribution based on a 90% pension, a 4.75% real rate of return, and 30 years working, 20 years retired, and the other using the same assumptions except for the real rate of return, which is lowered to 3.75%.

The hyper-sensitivity of required pension fund contributions to a lower projected rate of return for the fund is something that terrifies actuaries who are under pressure to release sanguine assessments of pension fund viability. It is further evidence as to why pension fund managers continue to claim that 7.75% returns are achievable despite the fact that we live in an era when the cost of money in real terms is literally negative. In our debt saturated global economy, bubble assets and zero real interest is the only way to stave off deflation. As the major currencies of the world – all representing economies that carry debt up to their eyeballs – compete to out-devalue each other, the debt eating panacea of inflation shall remain elusive. Yet the masters of the universe on Wall Street, and in their public employee pension fund bridgeheads throughout America, claim they can still earn the returns they earned when the credit binge was in full bloom.

Related posts:

Why Pensions Are Grossly Underfunded -  June 27, 2011

Preserving America’s Retirement Security -  June 4, 2011

Government Worker Understates Average Pension -  May 31, 2011

Why Real Rates of Return Must Fall -  May 5, 2011

How Rates of Return Affect Pension Contribution Rates -  April 27, 2011

Require CalPERS to Invest 100% in California? -  April 14, 2011

How Rates of Return Affect Required Pension Assets -  April 7, 2011

The Cost of Government Pensions -  March 11, 2011

When is Debt Unsustainable?
-  February 4, 2011

China’s Economic Challenges -  December 28, 2010

The Cost of Retirement Security in America -  December 23, 2010

National Debt and Rates of Return -  December 18, 2010

Teacher Pension Solvency -  December 12, 2010

Entrepreneurial vs. Casino Capitalism -  November 11, 2010

Pension Reform Options -  November 1, 2010

Pensions: Giant 401K Plans -  September 14, 2010

Sustainable Retirement Finance -  September 11, 2010

Avoiding Global Deflation -  July 18, 2010

The Axis of Wall Street & Unions -  July 8, 2010

The China Bubble
-  June 8, 2010

Funding Social Security vs. Public Pensions -  May 22, 2010

Social Security Benefits vs. Public Pensions -  May 8, 2010

The Razor’s Edge – Inflation vs. Deflation -  March 15, 2010

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17 comments to What Percent of Payroll Will Keep Pensions Solvent?

  • Tough Love

    Ed, Nice writeup and commentary, as usual. I duplicated your 2 examples (via an EXCEL spreadsheet) to make certain I understood what you are doing. Here are two comments and observations:

    (1) The top section of your table with the 90% of salary pensions is applicable to police who retire much earlier than miscellaneous workers. A reasonable number of police retire at 55 (or earlier), and a reasonable % of these will live to age 90 (and even 95), especially when factoring in expected future mortality improvements over the next few decades. As such, adding table columns for 35 and 40 years in retirement would be informative.

    I calculated the required level %s of pay for the top row of your chart. For 35 years in retirement it’s 32.3% of wages, and for 40 years in retirement it’s 34.0%.

    (2) Most economists believe a reasonable range for the “real” (after-inflation) rate of return on a balance portfolio is 3.0-3.5%. The 4.75% CalPERS is currently using (per your subtraction of 3% inflation from CalPERS gross return assumption of 7.75%) is way over the top. Just as a FYI, I recall that inflation over the past 25 years has averaged 3.25% (not 3%). If true, using this, CalPERS 7.75% translates to a 4.50% real rate of return …. a bit lower than the 4.75, but still “over the top”.

  • Editor

    Tough Love – thank you for your comments and calculations. I have revisited the spreadsheet and the analysis in response to them – it is very encouraging to know that someone is verifying the numbers.

    You’re right that life-expectancies are also something that the actuaries at public sector pension funds are probably underestimating. According to the social security administration, the current life expectancy for a 55 year old man is 80, and for a 55 year old woman is 83. So using 80, representing a 25 year retirement, is probably conservative – especially in the case of public safety workers who, on average, retire before the age of 55.

    http://www.ssa.gov/oact/STATS/table4c6.html

    By the way, the official inflation projection used by CalPERS is 3.0%. I think they use a longer period than 25 years to develop that figure. So they really are going for that 4.75% real rate of return.

  • Tough Love

    Ed, I used my duplicate of your spreadsheet to test the impact of unjustified end-of-career pay enhancements. Your assumption that salary would double over 30 years implies a level annual (compound) rate of salary increase of 2.34% (as noted in your detailed examples).

    For this test, I assumed the the 2.34% stays the same, applying for wage years 1-27, with three times the 2.34% (or 7.02%) in years 28-30. Note that the final salary is now more than double the initial salary.

    I did this only for one cell in your summary table, the cell in your 2-nd row with the 40.4%.

    Tripling the wage increase rate from 2.34% to 7.02% in years 28-30 changes the 40.4% to 45.8%. This is quite telling, an ADDITIONAL 5% of salary contribution being required EVERY year as a consequence of such abuse.

  • Tough Love

    Ed, Follow-up to my last comment:

    In my last comment, I calculated that if pay in years 28-30 of a 30 year career is enhanced (through spiking, end-of-career promotions, pensionable sickday payout, etc.) to an annual increase of 7.02% (3 times the 2.34% assumed in working years 1-27), the CELL (in your table) with the required level annual 40.4% of pay contribution would increase by over 5% of pay to 45.8%.

    That 5% increase is “conceptual”, because the cost-impact of end-of-career pay-spiking is never pre-funded via an extra annual 5% of pay over one’s career. In all likelihood the cost of that pay spiking is not recognized until retirement.

    So how do we quantify that “cost” ? It’s simple. We compare the age 55 “fund ending balance” with an without the enhanced pay. Without it (for the cell with the 40.4%) it is $1,608,543 and with the pay spiking it is $1,839,206, an increase of $230,658. Not a bad deal for favored workers from cooperating managers ……. but quite a lousy deal for taxpayers.

  • Editor

    Tough Love – we must truly be in synch. I prepared a pair of spreadsheets yesterday that show the impact of spiking – I only did it in the final year under the assumption that often it is still only the final year of pay that applies as the base for pension calculations. These will be presented in the next post and should make for interesting comparisons with your analysis. Thank you for your commitment to running through the numbers.

  • Tough Love

    Ed, I did a few quick calcs. spiking ONLY the FINAL year’s salary by 10%, by 20%, and by 30%.

    EACH additional 10% salary spike (in the final ear only) adds (to the cell with the 40.4% discussed in my earlier comments) 3.8% to the 40.4%. And EACH of these additional 3.8%s adds $157,181 to the cost of the pension (the value your example at age 55 in the column “ending fund balance”).

    P.S. By the way, for some reason the ending fund balance at age 80 (when the pensioner is supposed to have died) in your 2 examples is not zero, as it should be. It’s easy the SOLVE for the exact level % of wages such that this ending balance correctly becomes zero. If you do so, your 40.4% becomes 40.314%. You can do this with EXCEL’s “Goal Seek” function under the “tools” drop-down.

  • Editor

    Tough Love – I’ve been iterating to the solutions instead of using the goalseek function. Just call me the workingman’s actuary. If I was a brainiac, I wouldn’t have the common sense to know these hedge funds are skimming the life out of our economy. Isn’t it ironic, that public employee unions tell us to “blame Wall Street” for the economic meltdown, when their pension funds are in bed with Wall Street, employing some of the most aggressive, manipulative, and destructive economic practices possible in that desperate drive to maintain the 7.75% annual return?

  • Tough Love

    Ed, If you’d like a good laugh, re-read your last sentence changing the word “practices” to “parasites”.

  • Captain

    CalPERS conducted a study on this issue in 2010. As explained in this video each .25% reduction in the assumed rate of return increases payroll costs for Misc. employees by 2%, and increases payroll costs for safety plans by 4% of payroll. In other words, a 1% decrease in the assumed rate of return increases costs by 8% of payroll for Misc. employees, and increases safety plan costs by 16% of payroll.

    At 1:02 on the video timer: http://www.youtube.com/watch?v=kgYDVDgIvFg

  • Tough Love

    Captain, I’m guessing CalPERS stated 16% cost increase for a 1% decrease in the assumed rate of return is higher than ED’s 10% because CalPERS 16% is also addressing the funding of the large existing unfunded liability. Ed’s calculation assume no unfunded liability.

  • Pension Actuary

    Illinois finally confronted the spiking problem by charging the local agency for the full actuarial liability caused by pay increases above 6% per year. As Tough Love noted, these are budget busters.
    Currently most public pension schemes (a British term with expanded meaning in the US) will allow that spiking to occur without any extra funding by those who created it. The increased liability would then be charged against the unfunded liability payment over 30 years.

  • Rex The Wonder Dog!!

    Wow, TL brings some serious smack down! As usual!

  • Captain

    TL

    “Captain, I’m guessing CalPERS stated 16% cost increase for a 1% decrease in the assumed rate of return is higher than ED’s 10% because CalPERS 16% is also addressing the funding of the large existing unfunded liability. Ed’s calculation assume no unfunded liability.”

    I understand. I’m sure the unfunded liability assumption and the assumption regarding the rate at which employee wages increase has much to do with the disparity.

    Don’t get me wrong, I love this excellent article and I’ve learned from it. I just wanted to point out the difference between the assumptions that we’re all making out of necessity vs. the actual facts provided by CalPERS. How often do we get facts from CalPERS?

  • Tough Love

    Captain, CalPERS mandate as Plan Administer and Investment fiduciary has morphed into an advocacy roll (for greater benefits) for Plan Participants. This is inappropriate and dangerous to taxpayers.

    The majority employee/labor make-up of their Board is clearly the cause. The Board should be include those with financial/pension expertise with no direct or indirect connection to the Participants. No more than one employee and one labor representative should be included.

  • Rex The Wonder Dog!

    The majority employee/labor make-up of their Board is clearly the cause. The Board should be include those with financial/pension expertise with no direct or indirect connection to the Participants. No more than one employee and one labor representative should be included.
    ==============
    San Jose, one of the independant public pension funds, just disbanded their labor dominated pension board, replacing them with directors who were non partisan and had financial experience, not public union lackeys.

  • Captain

    “Captain, CalPERS mandate as Plan Administer and Investment fiduciary has morphed into an advocacy roll (for greater benefits) for Plan Participants. This is inappropriate and dangerous to taxpayers.

    The majority employee/labor make-up of their Board is clearly the cause. The Board should be include those with financial/pension expertise with no direct or indirect connection to the Participants. No more than one employee and one labor representative should be included.”

    I agree with you, but how do we get there? Rex said that San Jose has just done what you speak of so it can be done, but how?

  • Tough Love

    Captain,

    Query those who pushed through change in San Jose, organize, expose the dirty tricks … and most of all find a few deep pocketed supporters in for the long haul. Money makes the world go round.