Tag Archive for: public employee pensions

Social Security Benefits vs. Public Pensions

When discussing the issue of public employee pensions, it is easy to suggest that these pensions are necessary because public employees usually don’t earn a social security benefit. While this is true, it ignores the startling disparity between the value of a social security benefit and the value of the typical public employee pension. And it isn’t hard to make the comparison.

If you go to the Social Security online “Estimated Social Security Retirement Benefit” table, you will see what you may expect to receive from social security when you retire, based on how much you earned in your last year working. A person making $65K per year, retiring on their 66th birthday, will begin to collect a monthly social security benefit of $1,609, or $19,308 per year.

In California, public employee pensions typically are calculated based on how many years the employee works, times a set percentage that usually ranges between 2.0% and 3.0%. As an example of how this would work, here are some apples to apples comparisons with social security, i.e., a public employee who enters the workforce at age 22, works for 44 years, makes $65K per year, and retires on their 66th birthday. At a 2.0% per year pension factor – which is the low end of the scale for public employees – this person will qualify for a pension equivalent to 88% of their final salary, based on 2.0% per year times 44 years worked. This equates to a monthly benefit of $4,766, or $57,200 per year.

Using the same assumptions – the same number of years working, and the same earnings during their years working – the 2.0% per year benefit will provide a public employee with a retirement income that is nearly three times better than what a private sector social security recipient will receive.

The high end of the pension benefit scale for public employees is reserved for those engaged in high-risk occupations such as police officers, correctional officers, and firefighters. While according to CalPERS own actuarial data, these individuals actually, on average, have lifespans slightly longer than the average worker – the theory is they live somewhat longer because they retire earlier and endure less financial stress – there are nonetheless compelling reasons why people who are first responders and take risks to safeguard the rest of us should earn a premium for this. The question is how much of a premium is appropriate.

A public safety employee who enters the workforce at age 22, works for 44 years, makes $65K per year, and retires on their 66th birthday – earning a 3.0% per year pension factor – will qualify for a pension equivalent to 132% of their final salary, based on 3.0% per year times 44 years worked. This equates to a monthly benefit of $7,150, or $85,800 per year, a retirement income 4.5 times better than what a social security recipient would earn after working the same number of years and earning the same amount of money.

There are countless nuances to this – public employees generally retire earlier than age 66, for example, which means they don’t qualify for as high a benefit as the comparisons made here would indicate. But early retirement also means fewer working years to set aside funds for the retirement benefit, and who doesn’t want to retire early? Many retired public employees who are still in their early 50’s collect pension incomes well in excess of social security, and are young enough to embark upon lengthy second careers.

Defenders of the public employee pension benefit – which is between 3.0x and 4.5x better than the social security benefit – claim there is little cost to the public for this disparity because most of the funds necessary to pay for this benefit are proceeds from investments by public employee pension funds, and not the burden of the taxpayer. There are several serious problems with this argument.

As argued in-depth with earlier posts, including Pension Funding and Rates of Return, The Razor’s Edge – Inflation vs. Deflation, Pension Rhetoric vs. Pension Reality, Sustainable Pension Fund Returns, California’s Personnel Costs, Maintaining Pension Solvency, and Real Rates of Return, the public employee pension funds have been overestimating how much they can earn on their funds. CalPERS still has an official projected rate of return of 4.75% after inflation. In the long term, it is unlikely CalPERS, or any other pension fund with hundreds of billions of invested assets, can earn an inflation-adjusted annual return of more than about half that. And if your fund earns half as much per year, without splitting hairs, it is roughly accurate to say your annual contribution rate to that fund has to double, in order for these defined retirement benefit promises to be met. This painful readjustment is happening now, and is one of the primary reasons our cities and counties are sliding into bankruptcy.

Another problem with this argument is the implication that investments of taxpayer sourced funds should yield returns to public employees, but not to taxpayers. Why are public employee pension funds pouring money into speculative investments, and showering the benefits of those investments onto the public sector workforce when the returns are good, then holding the taxpayer accountable to make up the difference when the returns are bad?

There’s more: Why are these quasi-government entities, using taxpayer’s money, being permitted to own shares in private sector corporations in the first place? Why aren’t more restrictions placed on the influence public employee controlled pension funds have on our corporations through becoming major shareholders? Isn’t this just another subtle but significant government encroachment on private property?

It’s important to note that the disparity between public sector pensions and social security is only one glaring example of the disparity in overall compensation between the public sector workforce and the private sector taxpayers. In most cases, public sector employees now make more in base pay than their counterparts in the private sector who have similar skills. They also receive more vacation time, sick leave, personal days, “comp” time, job security, annual cost-of-living increases, medical benefits, retirement medical benefits, auto allowances, low-interest loans, and more. The pension examples cited here, by the way, are conservative – they don’t take into account pension “spiking,” or the commonplace practice of fraudulently claiming additional disability benefits in retirement. There is a staggering cost for all this. The idea that we can continue to increase benefits to government employees, and finance this through increased indebtedness and higher taxes, is utterly unsustainable and morally bereft.

Ultimately the problem with public sector pensions goes beyond issues of financial sustainability, and like the entire compensation package public sector employees enjoy, becomes a question of fairness. For economic reasons, but also to be fair, the solution to government deficits is to lower the base pay and benefits to all public employees across the board.

* * *

* * *

Maintaining Pension Solvency

One of the biggest challenges facing governments is determining how to adequately fund present and future pension benefits for their employees. While public employees are working, if a sufficient amount of money is set aside for them each year and invested competently, then by the time the employee retires, their fund balance should be adequate to draw down each month to pay their pension, yet not be fully depleted until after they’ve died. As will be seen, however, unless some very optimistic scenarios are used as the basis for projecting future pension solvency, the amounts that are currently being contributed to public employee pension funds are grossly inadequate.

While the calculation of how much money needs to be set aside each month to build up an adequate pension fund is not simple, it is not so complex or arcane as to defy analysis by policymakers, journalists and commentators, voters, employee advocates, or anyone else concerned with this issue.

In the analysis to follow, four cases are presented, each one calculating what percentage of payroll must be allocated to annual pension funding under various assumptions. These cases concern the pension of a single individual, but when assessing the sustainability of public employee pension benefits, these calculations apply in aggregate as well.

In the four examples below, the same assumptions are made for each individual pension fund chronology – the individual enters public employment at age 25, works until they are 55, and dies at age 85. All calculations and assumptions deal in “real” dollars, meaning that there are no cost of living adjustments either during the worker’s career nor during their retirement. During their career, it is assumed that in real dollars, their annual salary doubled between the time when they started working and the time when they retired, presumably based on merit increases. In one case the employee retires with a pension equivalent to 60% of their final pay – representing the now common “2% per year for 30 years” benefit granted to most non-safety public employees, and in the other case the employee retires with a pension equivalent to 90% of their final pay – representing the now common “3% per year for 30 years” benefit granted to most public employees involved in safety-related occupations. What percent of their salary must be invested each year to make certain their pension will remain solvent until they are 85 years old?

With these assumptions thus made, there is only one variable left to consider, which is the projected long-term real rate of return of the pension fund investments. For each example, I’ve used two rates of return, one provided by David Lamoureux from CalPERS, which is currently the rate they use in their projections, and one somewhat lower rate which I believe to be a more realistic rate. Here is what Lamoureux wrote in response to my inquiry regarding their pension projections: “Our assumption is composed of a 3% inflation and a 4.75% real return for a total of 7.75%.

Since this analysis excludes inflation in the pension pay-ins and pay-outs (i.e., no COLAs), the rate of return on the fund we’ll start with is 4.75%. This is what CalPERS currently projects as the rate, after lowering returns for inflation, they believe they can sustain over the next several decades.

Each of the examples summarized here are shown on spreadsheets following the text of this analysis. The reader is encouraged to check these spreadsheets and verify the calculations. Here is the summary of what we found:

(1) At a real rate of return of 4.75% per year, a worker would need to set aside an additional 21% of their salary each year for 30 years, in order to enjoy a pension benefit during a 30 year retirement equivalent to 60% of their paycheck.

(2) At a real rate of return of 4.75% per year, a worker would need to set aside an additional 32% of their salary each year for 30 years, in order to enjoy a pension benefit during a 30 year retirement equivalent to 90% of their paycheck.

(3) At a real rate of return of 3.00% per year, a worker would need to set aside an additional 35% of their salary each year for 30 years, in order to enjoy a pension benefit during a 30 year retirement equivalent to 60% of their paycheck.

(4) At a real rate of return of 3.00% per year, a worker would need to set aside an additional 52% of their salary each year for 30 years, in order to enjoy a pension benefit during a 30 year retirement equivalent to 90% of their paycheck.

Several points bear mention here. First of all, other than the rates of return – we’ll come back to those – these are all very conservative assumptions. The spreadsheet formulas are constructed, for example, to calculate interest on annual contributions for the entire year in which each of them are made, even though contributions occur gradually over the course of the year. Similarly, interest is calculated on the fund’s entire ending balance of each preceding year during the retirement phase, even though that balance is declining steadily throughout each retirement year to pay the monthly pensions. Without dissecting the entire spreadsheet, these examples are meant to emphasize the formulas are constructed to present the best possible case. As for the assumptions themselves, what if the pension recipients live, on average, longer than 85 years? Since a significant number of pensions pay the surviving spouse once the primary beneficiary is deceased, and since medical technology, thankfully, continues to advance, it is likely an average life expectancy of 85 is on the low side. What if workers retire before age 55, something fairly common, which increases the length of their projected retirement? What if they work more than 30 years, increasing their payout calculation? Moreover, no impact of pension “spiking” is considered in this analysis, where a worker’s final year of earnings (upon which the pension benefit is calculated) is sharply increased to a level not representative of their earnings growth over the course of their career.

With all this in mind, policy advocates and public administrators should ask themselves: Are we contributing at least 21% per year of our non-safety employees payroll to their pension fund? Are we contributing at least 32% per year of our safety employees payroll to their pension fund? Because that is the absolute best case in terms of what it will take to keep their pensions solvent. It is important to emphasize that retirement pensions are not the only financial obligations taken on by public employers to their retirees – often lifetime medical benefits are included, and the costs to fund these future benefits during the working years of public employees must be evaluated using the same methodology presented here for pensions. This will add several additional percentage points to what amount of payroll must be set aside each year for future benefits.

Returning to the issue of return on investment is crucial, of course. If CalPERS, for example, could earn a real rate of return of, say, 8.0% per year, the annual payment obligations to fund future retirements would be greatly diminished relative to the numbers here. But 4.75% per year is not a conservative projection, it is probably a very best case, because funds this big cannot expect to outperform the growth of the economies in which they invest. Pension funds that in aggregate manage literally trillions of dollars in assets should not expect to earn real rates of return exceeding the rate of global economic growth.

To put this in a historical perspective, global GDP grew at an annual rate of 1.0% or less until the industrial revolution, which increased growth to around 2.0% per year until about 1950. During the period from 1950 to 2000, the rate of global economic growth increased dramatically, to an average annual rate of nearly 4.0%, as the industrial revolution went global, catalyzed further by information technology. But in recent decades, part of the reason for higher rates of global economic growth was the accumulation of unsustainable levels of debt. It is going to take several years – if not decades – for this to unwind, and until there is light at the end of the tunnel, it is imprudent to project more than a 3.0% inflation-adjusted long-term rate of return for massive pension fund investments.

This begs an even more ominous question our public administrators must ask themselves, heralded not on rhetoric but on transparent calculations and cold reality: Are we contributing at least 35% per year of our non-safety employees payroll to our pension fund? Are we contributing at least 52% per year of our safety employees payroll to their pension fund? Not including what we must also set aside for retirement medical coverages? Because in the world we’re living in, with most public employee pension asset values already well below safe levels, that is what it will probably take to keep their pensions solvent.