Tag Archive for: public sector pensions

Pension Costs Are Still Eating Government Budgets

About 20 years ago, I read an ad in a local Sacramento newspaper that said “Get a government job and become an instant millionaire.” The ad went on to describe how public bureaucrats in California enjoyed benefits private sector employees can only dream of, including a guaranteed retirement pension worth the equivalent of millions of dollars in a private 401K plan. I’d had no idea. Most people still don’t.

Pension finance, and how pension obligations affect government budgets, remains one of the most consequential elements of public policy that nobody has ever heard of. Until someone is elected to a city council, or a county board of supervisors, and sees first-hand how pension payments crowd out other budget items, the typical response to pension policy debates is one of befuddlement or indifference.

But as they say, even if you are indifferent to pensions, pensions are not indifferent to you. Also about 20 years ago, a series of pension benefit enhancements enacted by gullible elected officials, egged on by aggressive pension system managers and public employee unions, led to pension payments moving from a negligible portion of civic budgets to ravenous monsters that threatened to drive into insolvency every government agency in the state. The result has been higher taxes and fewer services, and everyone feels that.

To begin to cope with out of control pension costs, in 2013 the California State Legislature enacted PEPRA, the Public Employee Pension Reform Act, which reduced the pension benefit formulas for new government hires, and phased in a cost sharing whereby all active employees would contribute more to their pension systems via payroll withholding.

The PEPRA reform, while incremental, has helped to financially stabilize California’s public sector pension systems. But because the PEPRA reforms were primarily restricted to new hires, the savings generates will happen slowly and will take decades to be fully realized. Meanwhile, the cost to California’s cities and counties to pay their pensions has reached record highs.

To more thoroughly illustrate what California’s government agencies are up against, the following chart depicts the financial status of three representative entities, each of them a rough order of magnitude apart in size. All three are clients of CalPERS, the largest of California’s state and local pension systems, with nearly 1,700 active clients and assets that have exceeded $500 billion.

The statistics depicted below, although mind numbingly opaque to the uninitiated, nonetheless distill the financial obligation represented by pensions to a few key variables. With the exception of “Total Civic Budget” the context providing denominator offered in the final block of numbers on the chart, all of these figures come directly from CalPERS itself. For each of their clients, CalPERS provides a “Public Agency Actuarial Valuation Report.” They are highly reliable since they disclose exactly how much CalPERS intends to charge each of its clients. The data shown on the chart pertains to the 2023-2024 fiscal year, which begins in July 2023.

The first three rows of data on the above chart report (1) how much CalPERS has invested on behalf of each client, (2) the present value of how much CalPERS expects at this point in time to eventually pay out in pensions to each client’s retirees, and (3) the difference between these two values, which is the unfunded pension liability.

As can be seen (4), Santa Clara County and the City of Sacramento have only 77 percent funded pension accounts, and the City of Costa Mesa’s pension account is only 70 percent funded. Because of this, in addition to their regular ongoing payments to the pensions system to fund pension benefits as they are earned, these employers have to make catch-up payments to reduce their unfunded pension liability.

The next section of the chart depicts and quantifies these two types of contributions that agencies must make to their pension system. The so-called “Normal Contribution” (5) is how much money has to be paid to the pension system and invested each year to yield sufficient funds to eventually pay the additional pension benefits earned by active employees in that year. As can be seen (7), the employers – i.e., the taxpayers – pay about two thirds of the normal contribution. The PEPRA reform requires employees to pay half of the pension cost through payroll withholding, but, again, PEPRA only affects those hired after 2013. This means that in a few decades the taxpayer share of the normal contribution will come down to 50 percent.

The “unfunded contribution,” next on the chart (8), is what cities and counties have to pay to reduce their unfunded liability. For that amount, no employee contribution is required. The employer has to pay 100 percent of it. As can be seen, in all cases the unfunded contribution is far more than the normal contribution (row 8 compared to row 6). This means the employer share of the total contribution to CalPERS (normal and unfunded payments combined) is 79 percent of Santa Clara County’s total pension payment obligation, 82 percent of Sacramento’s, and 88 percent of Costa Mesa’s (row 10).

The impact of this burden can be put in context when considering how much these costs add to an agency payroll. The total employer payment for their pensions adds 29 percent to payroll costs in Santa Clara County, 38 percent in Sacramento, and a whopping 67 percent in Costa Mesa (11).

The Opportunity Cost

Another useful perspective from which to evaluate just how much pensions are costing taxpayers would be to consider the impact of transitioning every public employee to Social Security. At a cost to the employer of 6.2 percent of payroll, Santa Clara County would save 543 million per year, Sacramento would save $128 million, and the City of Costa Mesa would save $32 million. Why is this a far fetched scenario? Isn’t Social Security what private sector taxpayers must rely upon for their retirement security?

To take this one step further, even if along with the Social Security payment, you added an additional 6.2 percent of salary to be the employer’s contribution to each employee’s 401K – a level of generosity rarely found in the private sector – taxpayers would still save, per year, $399 million in Santa Clara County, $103 million in Sacramento, and $29 million in Costa Mesa.

It is fair to wonder how far $399 million would go towards repairing the roads in Santa Clara County, which are ranked, using data from the Federal Highway Administration, among the roughest in the nation. One might also consider how that money could be invested in more law enforcement, when violent crime has increased for the past two years in a row in Santa Clara County.

In the City of Sacramento, investing another $103 million in basic law enforcement would go a long way towards curbing violent crime in that city, where homicides were up over 30 percent in 2021 compared to 2021, and are on track in 2022 to exceed that. How many shelter beds could $103 million buy, as the homeless count in Sacramento County – most of them concentrated in the City of Sacramento – nearly doubled between 2019 and 2022? As it is, Sacramento’s projected $153 million outlay for pension contributions to CalPERS is more than they will spend on all of their capital improvement programs this year.

Costa Mesa might only save $29 million by replacing defined benefit pensions with a combination of Social Security and an exceedingly generous 401K plan, but with only 110,000 residents, Costa Mesa isn’t a very big city. The city’s general fund budget for 2022-23 is only $163 million. Saving $29 million would add 17 percent back to the city’s budget to tackle other challenges.

It is easy enough to criticize how California’s public agencies would spend the money they could save by adopting more equitable and financially sustainable retirement benefits. Current homeless policies tend to make the problem worse when more money is spent. More spending on law enforcement is wasted if criminals aren’t held accountable. Scandalous waste of public funds on road improvement projects is a perennial problem. But these examples of waste don’t obviate the fact that pension commitments have swamped civic budgets. While we’re fighting waste at city hall, we can give the savings on pensions back to the taxpayers.

Pension systems in California’s state and local government agencies today have achieved a precarious stability, thanks in part to PEPRA, and for the most part thanks to dramatically higher contributions demanded, and gotten, from taxpayers. But this stability has come at a terrific price in the form of lost opportunities for these agencies to better serve the public.

An edited version of this article was published by the Pacific Research Institute.

California Supreme Court Finally Rules on Case Affecting Pensions

On Thursday the California Supreme Court issued its ruling in the case Alameda County Deputy Sheriff’s Association vs Alameda County Employees’ Retirement Association. In plain English, this was a case where attorneys representing government unions were challenging pension reforms enacted by California’s state legislature in 2013. The ruling, which had the potential to empower dramatic changes to pension benefit formulas, was measured. But it is generally considered a victory for the plaintiffs.

Pete Constant, CEO of the Retirement Security Initiative, which advocates “fair and sustainable public sector retirement plans,” found the ruling encouraging, stating “the court has confirmed that the public interest is of utmost concern when determining whether public pensions need reform.”

What advocates for financially sustainable pensions are up against is the so-called “California Rule,” an interpretation of California contract law that dramatically limits the ways in which elected officials, or voters in a ballot measure, can modify pension benefits for public employees. The prevailing interpretation of the California Rule is that it prohibits changes to pension benefit formulas for active public employees, even for work they have not yet been performed.

In practical terms, obeying the California Rule means that whatever pension benefit package was in place on the date a public employee was hired must be maintained throughout their career. If it is changed, the employee must be given a compensatory new benefit of equal value.

Pension benefit formulas for California’s state and local public employees are typically calculated based on three variables – how many years the employee worked, how much the public employee earned in their final year of employment, and a “multiplier” that is applied to the product of these two values. For example, a public employee who has worked for 30 years, making $100,000 in their final year of work, whose pension “multiplier” was 3 percent, would get a pension equal to 30 x $100K x 3%, or $90,000.

During Jerry Brown’s second eight year stint as Governor of California, he consistently advocated for pension reform, claiming the unforeseen and escalating costs to fund public employee pensions were putting an unsustainable burden on civic budgets and taxpayers. The reform he pushed through the California State Legislature, the Public Employee Pension Reform Act of 2013 (PEPRA), was an attempt to curb what were seen as abuses in public pension systems. Passage of PEPRA immediately generated litigation by attorneys representing public sector unions.

In an earlier case decided in 2019, Cal Fire Local 2881 v. California Public Employees’ Retirement System, the court upheld PEPRA’s prohibition of the purchase of so-called “airtime,” which manipulated a pension calculation variable by increasing the number of years an employee worked.

In this case, the court upheld PEPRA’s amended definition of another pension calculation variable, how much they earned in their final year of employment. This PEPRA provision was designed to “exclude or limit the inclusion of additional types of compensation in an effort to prevent perceived abuses of the pension system.”

The various ways in which PEPRA attempted to end these practices that critics refer to as “pension spiking” have been repeatedly challenged by public employee unions in court. Relying on the California Rule, the union argument might reduce to this: “if pension spiking was a common and accepted practice at the time we were hired, then we relied on the ability to eventually spike our pensions back when we made the decision to enter public service. It is a vested right which cannot be taken away.”

The court did not agree. Buried in its nearly 100 page opinion was the following: “They [the provisions of PEPRA] were enacted for the constitutionally permissible purpose of closing loopholes and preventing abuse of the pension system… Further, it would defeat this proper objective to interpret the California Rule to require county pension plans either to maintain these loopholes for existing employees or to provide comparable new pension benefits that would perpetuate the unwarranted advantages provided by these loopholes.”

The implications for future reform are mixed. Jon Holtzman, a partner with the Renne Public Law Group and an expert on the laws governing public sector pensions, was encouraged, saying, “This is a very positive ruling. The court concluded there was not a contractual right to spiking. A more notable aspect of the decision is they once and for all dispelled the notion that if you take away a benefit that you must give a comparable benefit.”

There are two ways this ruling chips away at this core element of the California Rule. First, as noted, the court does not recognize the obligation to “perpetuate the unwarranted advantages provided by these loopholes” by providing a comparable benefit when the loophole is closed. The second way this ruling undermines the California Rule is more ambiguous.

The concurring opinion summarizes this ambiguity. Justice J. Cuellar writes “The test the court applies here is merely a specific application, fit for this situation, of a more general inquiry: whether a reduction in pension rights without any comparable new advantages is ‘reasonable’ and ‘necessary’ to further ‘an important state interest…'”

There’s a lot to unpack here. First, the ruling does not invalidate the prevailing interpretation of the California Rule, it makes clear the court is looking at a specific application – namely, what constitutes pension eligible pay when calculating a retirement pension. Secondly, it is implying that if the plaintiff can demonstrate that a provision of PEPRA, or any other pension reform that might come along, requires unnecessary or unreasonable reductions to pension benefits in pursuit of “an important state interest,” then the California Rule may still be applicable, preventing those reforms. Finally, though, what constitutes an “important state interest?”

This question awaits another court case for further clarification, and it could be the answers continue to arrive only in the context of specific applications of the question. Yet on this question hinges the ability of pension reformers to enact more meaningful modifications to public sector pension formulas. At what point does modifying public sector pensions become an “important state interest?” When they’ve become too expensive? They’re already too expensive. Or when the burden of paying them propels an agency into bankruptcy? And what if instead of bankruptcy, agencies – cities and counties and special districts – simply cut services and staff in order to cover operating deficits, and leave the pensions intact?

Pete Constant, commenting on the limited scope of today’s ruling, said “with the uncertainty we’re seeing today, this would have been a good time for the California Supreme Court to issue a broad decision.”

Carl DeMaio, the former San Diego City Councilman who has spent decades pushing for pension reform, was less subtle. In a blistering press release, he said “By crafting a narrow ruling that sidesteps the fundamental flaws with the notorious California Rule, the California Supreme Court seems hell bent on forcing California taxpayers to bear the excessive costs of unsustainable pension payouts for state and local government employees.”

They’re both right. The economic uncertainty ahead for California’s public agencies, as Constant warns, will demand further action to reduce pensions. Pension payouts, as DeMaio says, are excessive and unsustainable.

Future reforms, either initiated by the legislature, citizen initiatives, or bankruptcy courts, may have to take aim at more substantial elements of pension benefit formulas. To list just a few: reducing the multiplier for future work, reducing the cost-of-living adjustment for retirees, requiring active public employees to personally contribute more to the pension system via payroll withholding.

The ruling this week did not go far enough. But it reinforced earlier precedents that make clear the California Rule will not apply in all cases, and it left open the door to define an “important state interest” in a manner that is broad enough to empower more substantial reforms in the future.

This article originally appeared on the website California Globe.

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Government Pensions Are Dividing Americans and Damaging the Economy

Now that financial markets around the world are experiencing a long-overdue correction, the best we can hope for is that we hit bottom before a deflationary cascade causes a worldwide depression. Those economists who believe in the long-term debt cycle may claim that this time the end has arrived, and they may be right. COVID-19, oil price wars, traders and investors hating Trump—these are just pinpricks. This bubble has been inflating for decades.

There have been plenty of warnings. Interest rates at near zero in the United States and actually negative in European nations. Record borrowing by the federal government, and, possibly worse, record levels of consumer debt. Corporate borrowing to buy back stock instead of invest in R&D and plant modernization.

In January 2000, at the peak of the internet bubble, total credit market debt in the U.S. was $27.8 trillion. By October 2007, at the peak of the housing bubble, total debt had climbed to $51.4 trillion. As of October 31, 2019, the most recent period for which data is available, total debt had climbed to $73.4 trillion.

Debt accumulation is not a sustainable way to stimulate growth. At some point, there is not a mere “correction,” such as what was seen in 2000 and 2008, but a fundamental restructuring of the financial economy of nations, such as happened in the 1930s. Has that reckoning arrived?

Either way, as of close on March 12, the Dow Jones had given up nearly three years of gains, with no real end in sight.

Wall Street’s Biggest Player: Public Employee Pension Funds

Which brings us to public sector pensions, which are among the most socially divisive, economically damaging scams that nobody has ever heard of.

To get an idea of the financial scale of public pensions, note that the U.S. Census Bureau estimates the total invested assets of pension funds managed on behalf of local, state and federal government employees is $4.3 trillion. Roughly 17 percent of Americans either work for or are retired from a local, state, or federal government agency.

By contrast, the Social Security Trust Fund, serving all 327 million Americans, and in which many government employees also participate along with receiving their pensions, has a total asset value of $2.9 trillion.

This is an incredible fact. Taxpayers—who it should go without saying, are paying for both systems—have contributed to a public employee pension system that is 50 percent larger than the Social Security Trust Fund, even though Social Security serves six times as many Americans.

By now most Americans, most definitely including voters, will have stopped reading. Pension finance is a boring topic. But public sector pensions pose a far bigger threat to America’s government budgets than Social Security ever will.

For starters, Social Security is adaptable. Lower the benefits, establish means-testing for benefits, raise the contribution percent, raise the contribution ceiling, raise the retirement age; all of these options are but one congressional vote and presidential signature away from implementation. Not so with public pensions, where financially responsible modifications to the pension systems are thwarted by collective bargaining contracts and union power. How bad is the problem?

Determining just how in the red public pensions are today depends on who you ask. And thanks to lax reporting requirements, good data is typically about two years behind. A Pew Research study released in June 2019 estimated the pension funding gap, “the difference between a retirement system’s assets and its liabilities,” for all 50 states, to be just over $1 trillion. But that’s only the officially reported number.

A study conducted by the prestigious Stanford Institute for Economic Policy Research put the total at over $5 trillion. This massive disparity in estimates is because how much has to be invested today in order to fund pension payments in the future largely depends on how much pension system fund managers think their investments can earn. Private-sector pensions have to use the bank lending rate as their required earnings estimate, which is why private-sector pensions are, generally speaking, not in financial trouble.

Public-sector pensions, on the other hand, are heavily influenced by government union bosses who want to maximize pension promises with minimum input either from their members through withholding or through direct contributions by government agencies. So they hire actuaries and money managers who claim they can earn, on average, 7 percent (or more) in interest on their investments, every year, year after year.

But what happens when they don’t?

That is where we find ourselves today. Pension funds, over the long term, are considered financially “healthy” if they are 80 percent funded or more. That means, for example, if the official numbers for 2018 are correct, the public sector pension assets nationwide were $4.3 trillion, the total liability was around $5.3 trillion, and the funds in aggregate were around 80 percent funded. There are big problems with this, however.

First of all, nobody believes the collective unfunded liability of America’s public employee pension funds is only $1 trillion. As noted, the Stanford researchers put that number at over $5 trillion. But most ominous is the fact that even if these pension systems were 80 percent funded, that is not where they’re supposed to be at the tail end of an 11-year bull market. Over the past 10 years, the U.S. stock market has tripled. Why are these pension systems, at best, only 80 percent funded?

Dividing Americans, Damaging the Economy

Public employee pension funds are among the biggest players, if not the biggest players, on Wall Street. If you want to know where literally trillions of dollars are being aggressively invested in private equity deals, hedge funds, and countless other speculative investments in debt, real estate, and foreign securities including in fascist China, look no further. These funds are under relentless pressure to deliver rates of return that are historically unsustainable, and the reason they are historically unsustainable is intimately connected to the populist discontent sweeping America today.

Public-sector pension funds, because they involve trillions of dollars, are too big to beat the overall rate of investment returns, and ultimately the rate of investment returns cannot exceed the rate of economic growth. The fact that investment returns have exceeded the rate of economic growth over the past few decades is precisely the reason there has been a widening in the gap between the super-rich and the desperately poor in America. It is the reason for the financialization of the American economy, where asset bubbles create collateral to create debt to create liquidity to create consumption to create profits.

This can’t go on, but the money managers want it to go on so public sector pension systems can buy another quarter of phony solvency. The alternatives are unpleasant to contemplate.

A few years ago the largest public sector pension system in the United States, the California Public Employees Retirement System with over $300 billion in assets, announced it was going to double the required payments from participating agencies over the next five years. That process is well underway and is the primary motivation for the hundreds of local tax and bond proposals on every primary and general election ballot in the state. If there is a recession, much less a depression, it won’t be enough.

Meanwhile, in the rest of America, those private-sector workers who are required to save money in 401k plans to supplement their eventual Social Security benefit, are now watching their retirement security vaporize before their eyes.

How is this fair? How is it that public sector employees can collect guaranteed pensions that pay, on average, two to three times as much as Social Security and, on average, are collected ten years earlier in life.

Defenders of public employee pensions point out that investment returns pay most of the cost for these pensions, not taxpayers. That’s only true, however, as long as those investments continue to deliver excellent returns. Once that assumption goes off the table, taxpayers pay for public-employee pensions. This results in higher taxes and lower services, and still doesn’t solve the problem of poorly regulated pension funds rampaging through the financial sector with trillions of dollars and grossly inadequate risk aversion, since they know taxpayers will pick up the tab whenever their schemes falter.

Public Sector Union Agenda Aligns with Big Finance

Public-sector pensions are yet another reason why the big corporate and financial sector political contributions in America overwhelmingly favor Democrats. These pension systems, and the benefits they provide, establish a common interest between government workers and big finance. Through the political agenda of their public-sector unions, which are overwhelmingly Democrat, the economic interests of public employees and America’s wealthiest elites are kept in perfect alignment.

No wonder public employee unions don’t fight open border policies. Not only do millions of destitute immigrants require more government administrators at all levels, but corporate profits—to help the pension funds—are boosted by the influx of cheap labor. No wonder public employee unions love draconian environmental regulations. The regulations create artificial scarcity—especially the policies of urban densification—and scarcity creates asset bubbles which help the pension funds.

No wonder public employee unions don’t object to exporting private sector jobs—international corporate profits translate into higher investment gains. No wonder public employee unions always support more bonds and borrowing—the proceeds expand government payrolls at the same time as underwriters and investors reap billions in commissions and interest payments.

And no wonder public employee unions don’t care if the welfare state implodes when the debt bubble pops and government deficits become unmanageable. Public employees don’t depend on the same network of taxpayer-funded social entitlements as the citizens they serve. To put it in terms that are crude but regrettably accurate, American citizenship is economically irrelevant to public employees. They are a separate class of Americans, exempt from the pitfalls of stressed public services, and exempt from the perils of market crashes.

The best thing that could happen to unite Americans would be to eliminate all public sector pensions and transfer the assets into the Social Security Trust Fund. One may endlessly argue the virtues or vices of Social Security, but compared with government pensions, Social Security has not split the nation in two, nor does it pose the same financial threat.

Unlike public employee pension formulas, Social Security benefits are progressive, meaning that high-income Americans have a lower ratio of contributions made to benefits received than low-income Americans. Unlike public employee pensions, there is a cap on Social Security benefits, and there is the ability to fine-tune the system to retain solvency.

Most important, however, if there is going to be a taxpayer-funded retirement security net for all Americans, it should be one system, with one set of formulas and incentives, equally applied for all citizens. If police, firefighters, nurses and teachers are heroes that deserve generous compensation, fine, let that take the form of higher salaries. Then they might invest their monthly surpluses into 401K plans, like the rest of us. And if that’s unacceptable, then they might make common cause with their private citizen counterparts to arrive at ways to improve Social Security. But all Americans would be confronting these problems together.

Patriotic members of the public sector must make some tough choices in the coming years. If lean years come, do they want America to be run by an international plutocracy, where citizenship is meaningless, but their own jobs as government enforcers are secure and lucrative? Or do they want American citizenship to still mean something? Pensions might be a useful litmus test.

This article originally appeared on the website American Greatness.

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How Much Will YOUR City Pay CalPERS in a Down Economy?

When evaluating the financial challenges facing California’s state and local public employee pension funds, a compelling question to consider is just how much more will they demand from their clients in the next economic downturn?

It’s noteworthy that CalPERS still hasn’t issued their actuarial analyses for the period ending 6/30/2018, even though a year ago, the 6/30/2017 analyses were available. Could it be related to the fact that the DJIA index on 10/01/2018 was 26,447 and as of midday 10/01/2019 it sits at 26,599? Between 6/30/2018 and 6/30/2019, did CalPERS have a bad year? And what does that mean?

What is alarming in the case of CalPERS and other public sector pension funds is the relentless and steep rate increases they’re already demanding from their participating employers. Equally alarming is the legal and political power CalPERS wields to force payment of these rate increases even after municipal bankruptcies where other long-term debt obligations are diminished if not completely washed away.

Until California’s local governments have the legal means to reform pension benefits, rising pension contributions represent an immutable, potentially unmanageable financial burden on them.

San Marino’s Payments to CalPERS Will Nearly Double by 2025

The City of San Marino, a small Southern California town with barely 13,000 residents, nonetheless offers a typical case study on the impact growing pension costs have on public services and local taxes. Using CalPERS own records and official projections, the City of San Marino paid $3.0 million (not including employee contributions) to CalPERS in their fiscal year ended 6/30/2017. That was equal to 32% of the base salary payments made in that year. By 2025, the City of San Marino is projected to pay $5.1 million to CalPERS, equal to 46% of base pay.

Can the City of San Marino afford to pay an additional $2.1 million per year to CalPERS, on top of the $3.0 million per year they’re already paying? They probably can, but at the expense of either higher local taxes or reduced public services, or a combination of both. But the story doesn’t end there.

The primary reason required payments to CalPERS are nearly doubling over the next few years is because CalPERS was wrong in three critical estimates: how much their pension fund could earn, how much would be paid to retirees, and how much their client agencies had to pay to stay current or catch up. They could still be wrong.

Annual pension contributions are are split into two categories:

(1) How much future pension benefits were earned in the current year, and how much money must be set aside in this same year to earn interest and eventually be used to pay those benefits in the future? This is called the “normal contribution.”

(2) What is the present value of ALL outstanding future pension payments, earned in all prior years by all participants in the plan, active and retired, and by how much does that value, that liability, exceed the amount of money currently invested in the pension fund? That amount is the unfunded pension liability, and the amount set aside each year to eventually reduce that unfunded liability to zero is called the “unfunded contribution,” or, in plain English, the catch-up payment.

Both of these annual pension contributions depend on a key assumption: What rate-of-return will the pension fund earn each year, on average, over the next several decades? And it turns out the amount that has to be paid each year to keep a pension system fully funded is extremely sensitive to this assumption. The reason, for example, that CalPERS is doubling the amount their participating employers have to pay each year is largely because they are gradually lowering their assumed rate of return from 7.5% per year to 7.0% per year. But what if that isn’t enough?

If the Rate-of-Return CalPERS Earns Falls, Payments Could Rise Much Higher

It isn’t unreasonable to worry that going forward, the average rate of return CalPERS earns on their investments could fall below 7.0% per year. For about a decade, nearly every asset class available to investors has enjoyed rates of appreciation in excess of historical averages. Yet despite being at what may be the late stages of a prolonged bull market in equities, bonds, and real estate, the City of San Marino’s pension investments managed by CalPERS were only 74% funded. As of 6/30/2017 (still the most recent data CalPERS currently offers by agency), the City of San Marino faced an unfunded pension liability of $29 million.

As it is, using CalPERS own estimates, by 2025 the City of San Marino is already going to be making an unfunded contribution that is nearly twice their normal contribution. Another reason for this is because CalPERS is now requiring their participating agencies to pay off their unfunded pension liabilities in 20 years of even payments. Previously, in an attempt to minimize those payments, agencies had been using 30 year payoff terms with low payments in the early years.

Nobody knows what the future holds. The following chart shows how that might play out in the City of San Marino. Notice how at a 4% rate-of-return projection, in 2018-19 the City of San Marino would have had to pay CalPERS $10.1 million; at 3%, $11.8 million.

San Marino is a wealthy community. The median household income of $147,960 is more than twice the median for California of $67,739 (ref. City-Data.com, figures for 2016). But with total municipal expenses of $26.2 million in the fiscal year ended 6/30/2017 (ref. San Marino CAFR, page 10), even San Marino’s budget can be stressed by pension expenses. CalPERS has projected the city’s pension contribution will rise to $5.1 million by 2025, which is 19 percent of total expenses.

At what point do these payments become too burdensome? What if investment returns settle down to an average of only 6 percent per year – can San Marino afford to pay CalPERS the resulting estimate of $7.0 million per year? What about at an even lower 5 percent return – can San Marino afford to pay CalPERS an estimated $8.5 million per year? And what about the employees? Will they start to pay more via payroll withholding? In 2017-18, employees only contributed $767,000 out of $3.8 million.

What about the rest of California?

How would a downturn affect all of California’s public employee pension systems, the agencies they serve, and the taxpayers who fund them? In a CPC analysis published in 2018, “How to Assess Impact of a Market Correction on Pension Payments,” the following excerpt provides an estimate:

“If there is a 15% drop in pension fund assets, and the new projected earnings percentage is lowered from 7.0% to 6.0%, the normal contribution will increase by $2.6 billion per year, and the unfunded contribution will increase by $19.9 billion. Total annual pension contributions will increase from the currently estimated $31.0 billion to $68.5 billion.”

That’s a lot of billions. And as already noted, a 15% drop in the value of invested assets and a reduction in the estimated average annual rate-of-return from 7.0% to 6.0% is by no means a worst case scenario.

To-date, meaningful pension reform has been thwarted by powerful special interests, most notably pension systems and public sector unions, but also many financial sector firms who profit from the status quo. Ongoing court challenges, along with growing public pressure on local elected officials, may eventually offer relief. For these reasons, raising taxes and cutting services in order to fund pensions may eventually become a false choice.

This article originally appeared on the website of the California Policy Center.

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REFERENCES

CalPERS Annual Valuation Reports – main search page
CalPERS Annual Valuation Report – San Marino, Miscellaneous Employees
CalPERS Annual Valuation Report – San Marino, Miscellaneous, Second Tier
CalPERS Annual Valuation Report – San Marino, Miscellaneous Employees (PEPRA)
CalPERS Annual Valuation Report – San Marino, Safety Employees, Fire, Second Tier (PEPRA)
CalPERS Annual Valuation Report – San Marino, Safety Employees, Police (PEPRA)
CalPERS Annual Valuation Report – San Marino, Safety Employees, Fire, First Tier
CalPERS Annual Valuation Report – San Marino, Safety Employees, Fire, Second Tier
CalPERS Annual Valuation Report – San Marino, Safety Employees, Police
CalPERS Annual Valuation Report – San Marino, Safety Employees, Police, Second Tier

Moody’s Cross Sector Rating Methodology – Adjustments to US State and Local Government Reported Pension Data (version in effect 2018)

California Pension Tracker (Stanford Institute for Economic Policy Research – California Pension Tracker

Transparent California – main search page
Transparent California – salaries for San Marino, 2018
Transparent California – pensions for San Marino 2018

The State Controller’s Government Compensation in California – main search page
The State Controller’s Government Compensation in California – San Marino payroll, 2018
The State Controller’s Government Compensation in California – raw data downloads

California Policy Center – Resources for Pension Reformers (dozens of links)
California Policy Center – Will the California Supreme Court Reform the “California Rule?” (latest update)

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Merge Social Security and Public Pensions

When solutions to the challenge to provide retirement security to American citizens in the 21st century are considered, they typically address either social security or public sector pensions, but rarely focus on both of these systems together. But when considered together, as systems that each have unique strengths and weaknesses that might be combined in a single program available to all Americans, options present themselves that might otherwise be ignored.

With both social security and public sector pensions, the challenge of maintaining financial sustainability is dramatically affected by the demographic reality of an aging population. As increasing numbers of people live well into their eighties and nineties, the ratio of workers to retirees edges closer and closer to 1.0.

There are four ways to address the reality of an aging population: (1) Increase withholding from current workers, (2) Increase the retirement age, (3) Lower the level of retirement benefits, and (4) Increase the amount the retirement trust fund can earn. Before delving into each of these further, however, it is important to identify one crucial advantage the USA enjoys vs. virtually all other major developed nations. America, alone among major nations, is projected to have a perfectly even distribution of ages within her population.

AMERICA’S DEMOGRAPHIC ADVANTAGE

America, like all developed nations, has an aging population. But as the four charts below indicate, unlike all other major developed nations, America’s population is replacing itself at an even rate. It is difficult to overstate the serendipity of this phenomena, nor the advantage that it imparts to policymakers intent on engineering sustainable retirement security for American citizens. Not only does having an even age distribution, with an equal number of people in every age group, guarantee that America’s worker-to-retiree ratio will be more favorable – higher – than that of other major nations – but, as will be seen, this higher proportion of productive workers yields other significant economic benefits.

Here are the projected age distributions in 2030 for the 2nd, 3rd, and 4th largest economies on earth, China, Japan, and Germany (the Eurozone economies, in general, have an age distribution similar to Germany’s):

For each of these nations, what can be seen are a large proportion of individuals who are either in their late working years or retired. In each case, the number of people under the age of 10 are only about half as numerous as the number of people aged 55-65. These nations are on track to have a worker to retiree ratio – all else being equal – that is literally half as favorable as the USA, as can be seen on the next table:

America’s success in replacing her population to create an even distribution of ages makes meeting the challenge of retirement security far more feasible than it will be in the rest of the developed world. This advantage, however, does not mean that America’s retirement programs do not face wrenching challenges. America may be on track to have a sustainable population, which is good, but America is still an aging nation. Starting in 1946 with the so-called Baby Boom, American’s produced about 4.5 million babies each year. This was an unprecedented number of children being born in the U.S., which meant that even as the WWII generation retired and enjoyed life average expectancies that set new records, their children grew up and populated the workforce in numbers that greatly exceeded the number of retirees. Now that the baby boomers themselves are retiring, the ratio of workers to retirees in America is lowering. Because, unlike the Europeans or East Asians, Americans are replacing themselves, this will be a one-time lowering. But it represents a huge adjustment.

THE COST OF PUBLIC SECTOR PENSIONS VS. SOCIAL SECURITY

Complicating the challenges of funding retirement security for an aging population is the generosity of the pension programs that have been granted government workers in America. It is difficult, if not impossible, to get exact amounts paid in aggregate to retired government workers, but here is a useful equation that allows one to estimate and compare the amount paid to government workers, in total, to the amount paid to social security recipients, in total. The case can be made that we are already on track to spend more each year on public sector pensions to retired government workers, who represent 20% of the workforce, than we spend on social security to the entire population of retired private sector workers, representing 80% of the workforce:

(public sector pensions)   1.5S x 67% x 30%  >  S x 33% x 70%   (social security)

In the above equation, “S” denotes the average salary of a private sector worker. Because the average government worker earns 50% more, on average, than the average private sector worker, their salary is denoted as “1.5 S.” The next variable is a percentage showing what, on average, the typical public sector pension is as a percent of final salary, 67%, vs. what, on average, the typical private sector social security benefit is as a percent of final salary, 33%. Finally, the last percentage in each equation shows the percentage of the retired population receiving a public sector pension, 30%, vs. the percentage of the retired population receiving social security, 70%. An observant reader will immediately question why a 70/30 ratio of retired public sector workers to private sector workers is used, since public sector workers only comprise 20% of the workforce. This is because the average public sector worker retires ten years earlier than the average private sector worker, hence they may only represent 20% of the working population, but they are 30% of the retired population.

If you calculate these variables, you will see that expenditures per year to support public sector workers in the U.S. are on track to exceed the total social security payments by a ratio of 1.3 to 1.0. This ratio doesn’t currently apply, because many public sector workers retired at a time when the benefit formulas were far less generous than they are for current workers (ref. Government Worker Understates Average Pension).

For a much more expansive analysis of the disparity between social security payments and public sector pension benefits, including links to source data, using California as an example, ref. The Cost of Government Pensions. Here are some charts from that analysis that underscore the point made in the preceding paragraphs:

In the above table, it can be seen the result of an average retirement age of ten years earlier for public sector workers translates into a 1-to-1 ratio of workers to retirees, since the U.S. enjoys an even distribution of ages within the population. This is based on assuming an average age to commence working of 25 and an average life expectancy of 85. In all, a 60 year span between beginning work and death is probably reasonable. Under this scenario, the private sector workforce is on track, at an average retirement age of 65, to have a 2-to-1 ratio of workers to retirees.

In this table, using data for California (ref. source links in The Cost of Government Pensions), it can be seen that the average public sector worker makes 1.5 times as much in base salary than the average private sector worker. Based on data from CalPERS and CalSTRS, the average pension for public sector retirees in California who have worked 30+ years and have recently retired is well in excess of $45K per year, but 66% is a good conservative benchmark to use for comparison, particularly since it is difficult to access a national average for all state and local government workers. The $15K per year national average for social security is well-documented, and equates to about 33% of the average annual private sector wage.

This table puts together the preceding data for California’s retired population and projects a $110B per year outlay in pension payments to support 2.4 million retired public sector workers (local, state and federal), compared to a projected $95B per year outlay for 6.1 million retired private sector workers. What both the equation “1.5S x 67% x 30%  >  S x 33% x 70%” as well as the three tables above are intended to convey is a startling fact: The United States taxpayers going to be spending MORE on payments to public sector retirees, comprising 20% of the workforce, than they will spend per year on social security payments to the entire population of private sector retirees, comprising 80% of the workforce.

DUBIOUS PREMISES OF PUBLIC SECTOR PENSION FUND INVESTING

Before delving into scenarios whereby the social security fund and the public sector pension funds in the United States can be combined into one single system where the same formula is applied to all citizens, it is important to explore something unique to public sector pension funds; the fact that these funds are invested, and that returns on these investments yield additional capital that can be used to help meet pension payment obligations to retired government workers.

There are a host of fallacies and dubious premises that accompany the practice of relying on investment returns to shield taxpayers from fully funding government worker pensions. While all of these are debatable, they would include the assumption that government workers, funded by taxpayers, shall reap the financial rewards of investment returns, yet social security recipients shall not. Or the assumption that these government employee managed, labor union influenced, massive pension funds – pouring hundreds of billions through Wall Street brokerages every year – do not exercise a distorting influence on market returns, inordinately influence corporate governance, carry a political agenda, invest offshore, or aren’t themselves engaging in a mutually corrupt partnership with aggressively managed hedge funds that extract over-market returns using manipulative tactics in a zero sum market – i.e., causing lower-than-market returns for small investors who rely on their 401K investments for their retirement. But the most dubious premise of all is the myth that these pension funds can project long-term annual rates of return (after inflation) of nearly 5.0%.

There are two reasons that rates of return of 7.75% per year cannot be achieved (4.75% after adjusting downwards for inflation – this is CalPERS and CalSTRS official long-term projected rate of return, and is fairly typical of the rates used by most other public sector pension funds). They are the trends of demographics and debt. In the case of the public sector pension funds, the demographic challenge is compounded by the fact that new retirees, on average, receive far more generous benefits than existing retirees.

THE DEMOGRAPHIC CHALLENGE

The demographic challenge to 7.75% rates of return is a matter of simple supply and demand. When the worker-to-retiree ratio for public sector workers reaches 1-to-1, and when long-time public sector retirees are enjoying pensions that are derived using the same formula as workers just entering retirement – both of these things will happen if current policies aren’t changed – then for the first time, the massive government employee pension funds, currently managing about $4.0 trillion in assets in the United States, will be selling as many equities as they are buying. With funds this large, this will completely change the dynamics of the market.

The larger private sector workforce also is trending towards a smaller worker-to-retiree ratio, moving from today’s approximate 3-to-1 ratio to a 2-to-1 ratio by 2030. Presumably these private sector retirees will collectively own additional trillions in equities. In 2030, for every two private sector workers purchasing equities to eventually use when retired, there will be one retiree who is selling equities. This move from a 3-to-1 buyer-to-seller ratio to a 2-to-1 buyer-to-seller ratio will also have a dramatic macroeconomic impact on stock prices. There will be less demand for stocks and other passive investments because there will be more sellers than ever.

THE DEBT CHALLENGE

The debt challenge to 7.75% rates of return is, if anything, more daunting than the demographic challenge. The accumulation of debt in the U.S. enabled faster economic growth than would have otherwise occurred. Inflated asset values, especially private homes, enabled trillions in borrowing at unusually low rates. These trillions were immediately plowed back into the economy on consumer products or more homes, fueling both corporate profits and home prices – which raised the value of corporate equities and enabled further borrowing. The table below, documented with links to source data in the post “National Debt and Rates of Return,” shows the aggregate total market debt for the United States economy as a percent of GDP for the last 120 years:

The data for the above table is gathered from three sources, which all corroborate a sobering fact – the total debt in the U.S. is currently higher than it was during the great depression in the 1930s. Currently the reported total debt / GDP ratio in the United States is 370% and rising. At the height of the great depression, total debt / GDP was barely 300%. The above table breaks the last 120 years of American history into four 30 year financial eras. In all four 30 year periods, the total U.S. debt fluctuated between 140% and 160% of GDP. Two of the 30 year periods, the those beginning in 1890 and 1950, respectively, saw debt as a percent of GDP display very little variation. For example, between 1890 and 1920 the maximum debt/GDP ratio was 165%, and the minimum debt/GDP ratio was 125%. For the period beginning in 1950 the variation was even more unremarkable, with the 1950 beginning level of 140% comprising the lowest ratio, and the 1980 ending level of 160% comprising the highest ratio. This parallel between the two relatively stable periods makes any parallel one may infer between the two relatively unstable periods quite ominous. Because the 300% debt/GDP extreme achieved in 1930 took 20 grueling years to unwind.

During this same 20 year period, between 1930 and 1950, the Dow Jones Index moved from 286.10 downwards to 206.05. To the extent this stagnancy was caused by slower economic growth due to mandatory deleveraging, there is no reason to expect any growth whatsoever from publicly traded equities in the U.S., since debt today is a higher percentage of GDP than it was in 1930. The reality of an aging population, which increases the seller-to-buyer ratio in the equities markets creates an additional downward pressure on returns that was not present in the 1930’s.

These trends occur against the backdrop of a stock market that never recovered from the crash of 2000. As referenced in the post CalPERS Projected Returns vs. Reality, here is a chart of the Dow Jones Industrial Averages staring in January 2000, and running through mid-August 2011 (they haven’t changed significantly since then):

What is immediately clear from viewing this chart is that where the index began, nearly 12 years ago, and where it is now, are pretty much the same. To be precise, the Dow entered the week of January 4, 2000 at 11,522, and the Dow entered the week of August 8, 2011 at 11,269 (ref. Yahoo Finance – DJIA 1-2000 to 8-2011). The Dow has actually declined over the past 10.5 years.

Moreover, this loss of equity value should be measured using inflation adjusted dollars, not nominal dollars. If you review the Consumer Price Index from the U.S. Dept. of Labor, you will see that in January 2000 the index stood at 168.8, and in June 2011 the index stood at 225.7. This means that it would take $1.33 today to purchase what $1.00 would have purchased in 2000. From this perspective, the Dow index today would have to stand at 15,406 just to have kept up with inflation. Put another way, in real dollars, the Dow has lost 2.67% per year for the last 11.5 years.

One might argue that the Dow is not representative of the U.S. equities market, because the arcane formula that governs its calculation only incorporates a handful of blue-chip companies. Below is the S&P 500, an index that tracks 500 of the largest publicly traded companies, most of them based in the U.S. and traded on the New York Stock Exchange:

On this chart it is obvious that even in nominal dollars, the S&P 500 is lower today than it was nearly 12 years ago. As it is, the S&P 500 entered the week of January 4, 2000 at 1,441, and the Dow entered the week of August 8, 2011 at 1,179 (ref. Yahoo Finance – S&P 500 1-2000 to 8-2011). When you take into account inflation, the S&P 500 today would have to be at 1,927 just to break even with where it was 11.5 years ago. Put another way, in real dollars, the S&P 500 has lost 4.19% per year for the last 11.5 years.

PENSION FUND CONTRIBUTIONS ARE VERY SENSITIVE TO RATES OF RETURN

When analyzing the variability of required pension fund contributions based on 30, 25, and 20 year retirements, while assuming 30 years of work, the results on required contributions are dramatic. These calculations, including tables showing their complete methodology, using as examples the typical pension plans offered California’s safety and non-safety public sector workers, are explored in depth in the post “What Percent of Payroll Will Keep Pensions Solvent.” Here is the summary:


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. And if you want to be even more realistic when estimating necessary public sector pension fund contributions going forward, take into account pension spiking, staggering losses to the funds over the past 10 years, and retroactive pension benefit increases.

To expound further on what may be a realistic rate of return for multi-trillion dollar retirement funds in an economy with an aging population is beyond the scope of this analysis. For the proposed options to follow, the operating premise is that such funds, at best, will not yield returns that exceed the real rate of broader economic growth. Especially due to the aging population which creates more retirees who are sellers in the market. And mid-single digit economic growth will remain elusive as long as total market debt exceeds 370% of GDP.

TAXPAYER-FUNDED RETIREMENT SECURITY REQUIRES ONE-FORMULA FOR ALL

If one strips away the reliance on investment returns and compares social security to public sector pensions based on payroll withholding from current worker’s providing 100% of the funds required to make current payments to retirees, it quickly becomes obvious that public sector pensions are completely unsustainable, whereas social security can be rendered permanently solvent with relatively minor tinkering. Here’s why:

Public sector pensions pay retirees, on average, 2/3rds of what they made when they worked, and based on an average retirement age of 55, there will be one worker in the public sector for every retired public sector worker. This equates to 66% withholding on current government workers to fund retired government workers. Social security, by contrast, pays retirees, on average, 1/3rd of what they made when they worked, and based on an average retirement age of 65, there will be two private sector workers for every retired worker collecting social security. This equates to 16% withholding on current private sector workers to fund workers who have retired on social security.

Social Security and public sector pensions have something in common; they are both defined benefits. Retaining the defined benefit at some level to provide a minimal safety net to all citizens is something for which most Americans would agree. Determining what level of defined benefit is both adequate and financially sustainable is harder. But the exercise is simplified if you eliminate the inherently corrupt practice of investing taxpayer’s retirement funds in speculative investments. It is also simplified by the fact of America’s even age distribution, which makes the actuarial calculations far less complex. Using these assumptions, a average defined benefit equal to 1/3rd of salary can be provided to all American’s, if they are willing to contribute 16% of their salary to a retirement fund.

There are two elements to social security’s defined benefit formula that are absent from the defined benefit enjoyed by public sector workers. The first is the progressive nature of social security. A low wage earner may actually collect a social security benefit equaling as much as 50% of their income, whereas a high wage earner’s social security benefit will probably be closer to 10% of their income, or less. The second is that the social security plan adds up the entire career earnings of each beneficiary in order to calculate their entitlement, whereas public sector pensions are typically calculated by multiplying the number of years a beneficiary worked by a factor (usually between 2% and 3%), and multiplying that result by their final year’s earnings. Both of these elements belong in a merged plan; one to create more equity for low income earners and to place a cap on the maximum benefit, the other to take into account the total earnings history of each beneficiary to more equitably calculate how much they may receive.

By incorporating progressive benefits, imposing a cap on benefits, and raising the annual ceiling at which earnings become exempt from withholding, it may be possible to sustainably pay out an average pension to low and middle income wage earners that exceeds 33% of their average career earnings. Raising the retirement age to improve the worker-to-retiree ratio can also accomplish this. When exploring retirement security options based on this pure pay-as-you-go system, one can quickly visualize both a reasonable, sustainable retirement safety net for all citizens, as well as grasp just how problematic it becomes to raise taxpayer funded retirement benefits much beyond 33% of average annual career earnings.

AMERICA’S ECONOMIC ADVANTAGES

While the U.S. confronts an aging population and crippling levels of total market debt, the U.S. is nonetheless clearly positioned as having the strongest and most resilient economy in the world. America’s age distribution, while in transition to an older average age, has the unique virtue of being perfectly evenly distributed. New workers are replacing retiring workers at a 1-to-1 ratio, and the overall ratio of workers to retirees will never dip below 2-to-1. No other major economy has this advantage; most of them face a desperate shortage of new workers. This will ensure not only sufficient payees into any retirement security scheme, but it will ensure adequate numbers of workers to produce goods, and adequate numbers of workers to consume them. It is difficult to imagine how America’s sustainable demographic profile will not grant her a significant economic advantage over the other major economies of the world over the next 20-30 years.

Surprisingly, America’s debt profile, while dire, is comparable to most other major nations. The chart below shows the estimated amount of available credit, by major economy, based on known levels of total debt in each economy, compared to their estimated collateral expressed as a multiple of GDP. For the purposes of comparison, available credit is calculated by assuming a nation’s collective borrowing remains viable up to an amount equivalent to 50% of their collective assets. As can be seen, the absolute value of each nation’s GDP has a decisive effect on the calculation, since countries with much larger GDPs such as the U.S. have as much remaining borrowing capacity – 19.8 trillion – as the much smaller Chinese economy – 22.4 trillion – despite the fact that China has a debt/equity ratio of 5% vs. America’s 36%.

At first glance this chart suggests that the U.S., with a debt/equity ratio of 36%, is in considerably worse shape than the Eurozone and China. But this chart was compiled nearly a year ago (ref. National Debt and Rates of Return) and is based on a huge assumption: Debt in the Eurozone and China were simply assumed to be triple their reported government debt.

Starting with Europe, the problem with this assumption is that the European banks have issued Euro bonds that aren’t calculated on any national balance sheet. Retirement obligations and current worker entitlements in Europe have stressed their borrowing capacity and threaten the very existence of their currency. China’s economy, while logging formidable growth over the past 20 years, is overly reliant on exports and construction. While the Chinese don’t appear to have a serious debt problem based on the simplistic assumption that their total debt is merely 3x reported government debt, their banking system is opaque, their real estate assets are grossly overvalued, and their exports cannot possibly continue to grow at the rate they have. Just a slowdown in the rate of export growth could have a sharply negative impact on China’s asset values – and when collateral collapses, debt as a percent of equity rises accordingly. And China’s fitful progress on human rights, along with Europe’s attempts at integration which may have peaked, guarantee these economies will struggle with social distractions unheard of in the U.S.

Finally, because of their impending demographic implosion for which neither of them are prepared, Europe and China face a very uncertain economic future. Japan, by contrast, has already experienced twin implosions – demographic and collateral – and with the worst behind them, Japan may surprise the world in the coming years. But Japan, with a $5.0 trillion economy and an imploding population, will never seriously rival the U.S. as the premier global economy.

ECONOMIC GROWTH IMPROVES RETIREMENT SECURITY OPTIONS

For the United States to flourish economically, she will have to reduce debt as a percentage of GDP while somehow managing to log rates of economic growth in the mid-single digits. More than anything else, this will require engaging in deficit government spending that yields long-term economic returns, rather than simply to pay out entitlements and inflated wages and benefits to government workers.

The economic problems in the rest of the world guarantee the U.S. dollar will remain a hard currency. They mean that the Chinese yuan will not deliver a sustained appreciation against the dollar, even if they finally float their currency on open markets. They mean that the Euro, even if it survives, will also be regarded as less stable than the dollar. The size and diversity of the American economy, the demographic sustainability of the American population, the stability of American society, and the historic status of the U.S. dollar as the reserve currency of the world are all contributing factors to the likely appreciation of the dollar for the next few decades.

The infrastructure projects of the 1930’s should provide inspiration to policymakers and economic planners today. The impact of these roads, dams, and power infrastructure were clear – they lowered the cost of living at the same time as they raised the standard of living. Unlike today’s seductive but economically disastrous “green” initiatives, infrastructure investments of the 1930’s made transportation, water and power cost less. This policy decision of the 1930’s – investing government funds to lower the cost of living – gave people more discretionary income to purchase new inventions – radios, cars, home appliances. And these new inventions created new asset classes which created new collateral, improving the overall national debt/equity ratio.

This is where government investment should go, into 21st century versions of the big projects of the 1930’s whose legacy still provides benefits to the American people. We need practical public works projects that will lower the cost of transportation, water and energy. We need upgraded freeways with “smart lanes” where ultra-efficient cars and buses will eventually drive themselves. We need to upgrade existing rail lines and limit the building of “bullet trains” to where they might be cost-effective; maybe Washington to Boston but probably nowhere else. We need to develop nuclear power, clean coal, shale oil and gas, and lower the cost of energy. We need to build cost-effective desalination plants and new water storage and distribution infrastructure – and to make these massive projects affordable and for the greater good, we need to roll back or eliminate unnecessary environmental regulations, environmentalist lawsuits, and project labor agreements.

Along with infrastructure investments, the federal government should invest in high-technology, which is essential to maintaining economic preeminence. A mission to Mars, a lunar base, and multiple orbiting outposts would consume hundreds of billions in funds, but result in almost unimaginable commercial growth and technological spinoffs. The federal government should also increase investments in basic science and medical research. As infrastructure investments lower the costs for energy, water, and transportation, and technology investments create new options for entrepreneurs, entirely new industries can spontaneously emerge in the private sector, from space commercialization to life extension, to things we can’t imagine today.

To fund these investments without increasing the deficit requires revisiting entitlement reform and eliminating special, cripplingly expensive pensions for government workers. While some classes of government workers may qualify for a premium when calculating their retirement compensation, such as those who operate in the military or high-risk public safety jobs, there is no reason why the vast majority of government workers should get anything other than a new and upgraded, economically sustainable social security benefit.

In order to minimize disruption to the markets, public sector pension funds can be liquidated systematically over a ten year period. They can be moved slowly but steadily into investments of minimal risk, such as ten year treasury notes, and placed under the administration of the Social Security Trust Fund. Moving these funds into T-Bills will also help finance the deficit until GDP growth raises tax revenues. And to preserve America’s demographic advantage as well as nurture her technological prowess, immigration laws need to be restructured to emphasize admission of highly educated and highly skilled workers.

These are prescriptions for economic growth, which will improve the options for whatever retirement benefit formulas are adopted.

If the U.S. were to merge all taxpayer supported retirement entitlements into social security, it would fund the revitalization of the U.S. economy. Redirecting government spending into productive investments instead of entitlements would create an economic boom that would create opportunities for all Americans. By moving the government out of the business of making speculative investments through Wall Street brokerages, that special interest as would see a significant erosion of its power and influence. Perhaps most important of all for a global perspective, the 21st century might then follow the 20th as another American century, a most desirable outcome for those who believe in the American experiment, in democracy, in pluralism, in competition and capitalism, innovation, progress, and the optimism and big ideas that have always defined America in the eyes of the world.

Sustainable Retirement Finance

When assessing the financial sustainability of any government administered plan to provide retirement security to their citizens, it is important to consider two factors, (1) the nation’s overall population demographics, and (2) the economic model of the plan. In-turn, when evaluating the economic model of the plan, it is important to consider the plan’s sustainability apart from reliance on returns from passive investments. It is important to assess how well a government-funded retirement benefit plan can be supported via a pay-as-you go system, where each year, tax assessments on current workers are used to pay retirement benefits for retired workers.

In the United States, there are two government operated financial systems that administer our collectively funded, i.e., taxpayer funded programs to pay retirees a certain amount each year that they may live comfortably. One may assume a great range of thresholds to define “comfortably” but in any event these two systems are very distinct, in ways that are fairly easily explained. They are social security, for which about 80% of the U.S. workforce participates, and public employee pensions, for which about 20% of the U.S. workforce participates.

Social security is based on the assumption that participants work, on average, from the age 25 to 65, then are retired from age 66 to 85, i.e., there are two participants in the work force for every one recipient who is retired. Social security, on average, also may assume that payments to retirees average one-third what earnings are by workers. On this basis, on-sixth of a worker’s wages, or about 16%, are required to be additionally assessed in order to fund payments to retirees on a pay-as-you-go basis. Social security clearly can remain sustainable, as long as it maintains the current two-to-one ratio of workers to retirees, and also pays on average one-third in retirement benefits compared to what current workers earn.

This relatively sanguine outlook for the future of social security is supported by that other key factor, demographics, particularly in the United States. For people born between the years of 1956 through the present, there about 20 million citizens for every five year age-group, from zero to 5, through 50 to 55. This means these projections will not be undermined by an aging population. The United States has a serendipitously even stream of people insofar as every age group is equally represented numerically, from today’s babies through baby-boomers born in the 1950s (ref. Funding Social Security vs. Public Pensions).  America’s social security system as it is currently formulated is financially sustainable, and unless it dramatically changes its benefit formulas, will be for at least the next 50 years based on existing age demographics; probably much longer. The formula of 16% withholding for one-third average earnings in Social Security payments is eminently sustainable, without reliance on investment earnings.

When one considers the average years retired vs. worked, and the average annual pension as a percent of average annual per worker earnings, and compares public sector pension benefit formulas with social security benefit formulas, a completely different picture emerges. Public sector pension benefits, when evaluated on a pay-as-you-go basis – wherein current workers support retirees via current assessments – require far more withholding from total compensation. Here’s why:

The average public sector workers enjoys a one-to-one ratio of working years to retired years, unlike the social security system, which only provides a benefit based on a two-to-one ratio of working years to retired years. Public sector workers on average work from age 25 to 55, then are retired from age 55 to 85 years, one-to-one. Private sector social security recipients work from age 25 to 65, then are retired from 65 to 85, a two-to-one ratio. But the disparity doesn’t end there.

The average public sector worker – averaged based not on formulas for safety vs. non-safety workers, but at a blended rate incorporating the collective reality of all government workers – enjoys a retirement pension that is not, on average, one-third of what the average worker earns, but is instead two-thirds of what the average worker earns, twice as much. So if public sector worker retirement systems were funded via pay-as-you-go assessments, with each worker being responsible for supporting one retiree, they would have to have the system allocate an amount equivalent to 66% of their salary, an additional two-thirds on top of what they make, to be paid out to a public sector pensioner.

The financial sustainability of public sector pensions depends on 66% of each worker’s earnings being simultaneously paid out to a public sector retiree, the financial sustainability of social security depends on 16% of each worker’s earnings being simultaneously paid out to a social security recipient, less than one-fourth as much. No wonder public sector pension funds have become a collection agency for Wall Street, as their aggregated 401K plans tumble and toss upon the speculative waves of global finance, and are chary to simply ask for twice as much or more to be collected, from the taxpayers, now and forever to sustain public employee retirement pension payouts. As it is, about $250 billion per year of new money pours into Wall Street via public sector pension fund collections from state and local government payrolls (ref. The Axis of Wall Street & Unions).

It is ironic at best how spokespersons for public sector employee unions (also known as “associations.”) and even spokespersons for public sector employee pension funds are fond of accusing taxpayer groups and others concerned about unsustainable public sector pensions of “throwing us to the same fate as those private sector workers and their underwater 401K retirement funds.” Don’t they realize these taxpayer-funded public sector pension funds are themselves still merely gigantic 401K plans? Don’t they see the irony of holding private sector taxpayers accountable not only for our own losses at the hands of those Wall Street sharks, but also holding private sector taxpayers accountable for public employee pension fund losses at the hands of those same Wall Street sharks? Are government workers and their associations, however well-intentioned, complicit in or at least condoning this sustainability disparity because they like to retire collecting twice as much money for ten extra years?

California Firefighter Compensation

On August 4th an interesting analysis of public sector compensation was posted on the blog Inflection Point Diary entitled “How to Figure Out How Much Money a Local Government Manager Makes.” In this decidedly conservative analysis, the conclusion was that “real annual compensation [is] at least 33 percent higher than the ‘salary’ the city would have told you about if you called to ask this question.”

This 33% is typically called salary overhead, and must include the current year funding required for everything not included in straight salary – such as the value of all current employee benefits, as well as the current year funding requirements for all future retirement benefits for the employee. In the private sector, a generous overhead percentage would be about 25% – about 9% for the employer’s contribution to social security and medicare, a 6% employer contribution to the employee’s retirement savings account, and roughly another 10% for the employer’s contribution towards the employee’s current health benefits.

If only the difference between private sector employee overhead were only 33% vs. 25%, however. In reality, because public sector employees receive defined retirement benefits that are anywhere between 3x and 10x (that’s right 10x, ref. Social Security Benefits vs. Public Sector Pensions) better than someone with a similar salary history can expect from social security, and because these future benefits must be funded as part of a public employee’s total compensation each year, public sector salary overhead can often reach 100%. This is particularly true for public employees who work in safety-related occupations, such as police officers and firefighters (ref. The Price of Public Safety). With all this in mind, how much do firefighters really make?

To perform this analysis I obtained payroll data for the firefighters employed by the City of Sacramento. The data is for the most recent 12 months, and does not include the top management of the fire department. It does include data for 543 individuals. The numbers are probably a bit low, on average, because there are undoubtedly people on this list who didn’t complete a full year of work, but the calculations to follow will assume all of the payroll data represents 12 months of full-time work.

In terms of basic pay, the “base hourly earnings” of Sacramento’s firefighters was $74,000 per year. Overtime, on average only added $10K to that total, which suggests that – at least in Sacramento’s case – overtime is not creating a crippling additional burden to the department expenses. But when you add “incentive earnings,” “holiday payoff,” “other earnings,” “sick payoff,” “other payoffs,” and “vacation payoff” to the total, the average firefighter in Sacramento makes $101K per year. This does not include health and retirement benefits, however.

To get to the true number, I then reviewed the current Labor Agreement in force between the Sacramento Firefighters Union Local 522, and the City of Sacramento. I then verified with a senior attorney with the City of Sacramento that certain of my assumptions were correct. In particular, the City pays 100% of firefighters current and retirement health insurance benefits, and the City pays 100% of firefighters retirement pension contributions. So what is all of this worth?

Calculating the value of current benefits is relatively easy, particularly if you simply want to pick a conservative number. In the firefighters labor contract, health insurance benefits are covered up to a maximum of $1,200 per month, and after 20 years of service, the City pays 100% of this coverage for life. The City also pays a uniform reimbursement of $871 per year, tuition reimbursement of up to $1,500 per year, along with life insurance, and subsidized parking or subsidized mass transit benefits. There are certainly other benefits not identified in a relatively cursory review of the 81 page labor agreement Sacramento’s firefighters are under, but it is fair to assume the value of current benefits averages about $12,000 per year, raising the total compensation for the average Sacramento firefighter to $113K per year. But we haven’t yet accounted for the current year funding requirements for future benefits, such as retirement health and pension payments.

If you refer to Sacramento’s reported payroll data, the average pension fund contribution per firefighter per year is $31K, which means – since the City pays 100% of this contribution and the firefighters contribute zero in the form of payroll withholding – the average compensation for the average Sacramento firefighter is actually $144K per year. But it doesn’t end here, because these pension fund contributions are based on CalPERS official return on investment projection for their fund, which is 4.75% per year, after adjusting downwards for inflation. I would argue that the chances that CalPERS is actually going to earn this sort of real, inflation-adjusted return is zero. For much more on why it is absurd to expect a 4.75% year-over-year return on hundred billion dollar funds in this era, read The Razor’s Edge – Inflation vs. Deflation, Pension Funding & Rates of Return, and Sustainable Pension Fund Returns.

For these reasons, a truly conservative fiscal strategy for pensions would be a pay-as-you-go model, where pension fund allocations aren’t even invested because the present value of the money is not discounted. Using such assumptions would go a long way towards guaranteeing solvency to pension funding, and would dismantle the pernicious alliance of public sector pension funds and Wall Street brokers and speculators (ref. The Axis of Wall Street & Unions). And why should public sector employees collectively invest taxpayer’s money into public equities and other private sector investments where they (1) exercise influence over the management of these companies as shareholders, (2) reap the sole benefit of windfall returns from these investments when they occur, and (3) compel taxpayers to make up the shortfall whenever these investments do not perform adequately? But just in the interests of presenting a realistic calculation of what firefighters in Sacramento are really making each year in total compensation, let’s use a rate of return that might actually be achievable, one-half the rate CalPERS clings to, a return of 2.375%. What happens?

As explored in the posts Maintaining Pension Solvency, and Real Rates of Return, where charts are depicted showing the entire logic of this calculation, if you assume 30 years working, 30 years retired, a pay history wherein annual salary doubles in real dollars over the employee’s career, and a retirement pension based on 90% of the employee’s final year of pay, at a fund return of 4.75%, to maintain a solvent pension fund you would have to set aside 30% of the employee’s salary each year. This 30% calculation is a bit lower than the percentage actually being set aside by the City of Sacramento for their firefighters. The 34.9% of salary that Sacramento contributes into CalPERS for each firefighter probably reflects the fact that CalPERS is currently underfunded, plus other more conservative assumptions than are made in this simplistic example. The point is this: If you make these assumptions and use a projected rate of return of half what CalPERS still claims they can earn, you will get a result that is, if anything, too low. And based on a rate of return of 2.375%, it is necessary to contribute 60% of salary into CalPERS each year to keep each firefighter’s pension solvent.

Total compensation has to include current year funding requirements for future benefits. Using a realistic rate of return of 2.375% (after adjusting downward for inflation), pension funding requirements double, which means the average firefighter in Sacramento – if these pension commitments are honored – is really making $174K per year. And while the City of Sacramento doesn’t accrue for, much less fund, their future obligation to provide retirement healthcare benefits to their firefighters, it is still a liability, and it is still necessary to apply the present value of these future costs to the years these employees are actually working. This fact will easily put the annual total compensation for the average Sacramento firefighter at $180K per year.

So how much do firefighters in Sacramento work, in order to earn $180K per year on average? Returning to the labor agreement, firefighters working the “suppression” shifts, i.e., most of them, the guys who staff the firehouses and are on call 24 hours per day, typically work two 24 hour shifts every six days. That is they work a 24 hour shift one in every three days. During these 24 hour shifts, most of the time, they have time to eat and sleep, in addition to performing their duties. But if you review the agreement, you will see that by the midpoint in their careers, after 15 years, firefighters will earn the following quantity of 24 hour shifts off with pay – 6.53 for holidays, 9.33 for vacation, and 2.0 for personal time. This means, not including sick leave, the average firefighter works 2 shifts of 24 hours every 7 days. Two days per week. This estimate is not significantly skewed by overtime pay, since on average, Sacramento firefighters are only logging about 8% overtime hours.

One can make as much or as little as one wishes with these numbers. There is nothing here suggesting firefighters are overpaid or underpaid. Because before having a discussion regarding whether or not firefighters are overpaid or underpaid, it is important to simply present the facts – here is how much firefighters are paid. It is left to each reader, voter, financial analyst, policymaker, and firefighter to ask themselves:  Should firefighters make $180K per year, on average, to work two 24 hour shifts per week, and can we afford this? And should the premium, in terms of salary overhead, for public safety personnel be nearly 100%, if not more?

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The Price of Public Safety

There is nothing wrong with paying a premium to public safety personnel because of the risks they take. And while it is true there are other career choices that are riskier than public safety jobs, and while it is also true that on average, public safety personnel in California – according to CalPERS own actuarial data – have life expectancies that are virtually the same as the rest of us, it is still appropriate to pay public safety personnel a premium. After all, we never know when these people may stand on the front lines when something extraordinary happens – such as what occurred in New York City on Sept. 11th, 2001. People who work in public safety live with this knowledge every day, and they should be compensated appropriately for that.

The question is how much of a premium is appropriate, and how much of a premium can we afford as a society? Should a fire fighter make more than a medical doctor? Should a police officer make more than an engineer?

In order to get an idea of what public safety employees in California actually make, I obtained a roster that showed the total compensation paid to each employee of a Southern California city. Out of respect for the employees noted on this roster, I won’t identify the city, much less reveal the names of these individuals. And it is fair to state this city probably has a median income somewhat higher than the average for California. It would certainly be interesting as follow-up to obtain this sort of information for other California cities. But even taking all of these factors into consideration, the amounts these folks are making is startling – particularly when you adjust for realistic current year funding obligations for future retirement health and pension benefits.

In our example city, using actual data, the fire department has about 100 full time positions. The average annual compensation for these firefighters, if you include current benefits and current funding for future benefits, is $179K per year. But it doesn’t end there, because the pension funding percentage is calculated at 34% of earnings. As argued in “Maintaining Pension Solvency,” if you calculate pension funding requirements for a safety employee in California based on after-inflation returns of 3.0% instead of CalPERS official rate of 4.75%, you need to increase the pension withholding as a percent of payroll by 20%! Making this adjustment yields an average firefighter compensation of $202K per year. And even this figure probably fails to adequately account for current funding requirements for future supplemental retirement health benefits.

For our example city’s police department, using actual data, the police department has about 150 full time positions. The average annual compensation for these police officers, if you include current benefits and current funding for future benefits, is $174K per year. If you increase the pension withholding percentage by 20%, in order to reflect realistic rates of future pension fund returns, you will calculate an average police officer compensation of $197K per year – again, probably not including enough to fund future supplemental retirement health benefits.

It is important to emphasize these amounts – roughly $200K per year each – are not for senior management, or even senior employees. This is the average, taking into account entry level public safety employees as well as senior public safety employees.

It is interesting to note what the rest of the employees, the non-safety personnel, make in our sample city – making the same adjustments, their total compensation averages $118K per year. That is still quite a bit, considering many of these jobs are relatively unskilled. To put this in perspective, the average private sector worker in California averages $40K per year in compensation – one third what the non-safety workers average in our sample city.

Should a non-safety local public employee workforce, one including a large percentage of relatively unskilled positions, have an average compensation per employee of $118K per year? Should safety employees make, on average, $200K per year? Can we afford this?

What is clear over the past several years is that as pay stagnated in the private sector, public sector employees continued to receive regular cost-of-living increases. Over the past 10-15 years, public employees also received dramatic increases to their retirement benefits. And as housing prices soared, millions of Californians borrowed against their home equity, and many of them are now paying dearly for that mistake. There are undoubtedly many public sector employees who were caught up in the borrowing frenzy, and are now on the edge financially – but it is fair to wonder why they should be immune from the same cutbacks that have left so many people in the private sector unemployed, or under-employed, or compensated at rates that are a fraction of what they were during the bubble booms.

It is also fair to wonder why public sector employees should not be obligated to plan and prepare and save, if they want a comfortable retirement. For non-safety personnel in public service, it is fair to wonder – since they now make more, not less, than private sector workers for similar work requiring similar skills – why in their retirement they shouldn’t simply collect social security and medicare like the rest of us. And even if public safety employees should collect something better than social security in recognition of their role as first responders, it is fair to wonder why their retirement pensions should be literally five times more than the social security payments due retired private sector workers with similar salary histories. As documented in “Funding Social Security vs. Public Sector Pensions,” the fiscal crisis facing social security is trivial and easily solved, whereas the fiscal crisis facing public sector pensions is catastrophic and can only be solved either through massive benefit cuts or crippling new taxes.

It is difficult to dispute the contention that the price of public safety cannot be too high. It is difficult to overstate the appreciation anyone should feel for people who stand between us and chaos – the people who protect us, the people who rescue us, the people who save our property. But those people themselves should understand the price we’re currently paying is elevated because of collective bargaining and overwhelming political clout, and is dangerously out of touch with market realities. It would be helpful for everyone to consider the choices involved – cuts to pay and benefits vs. cuts to services, cuts to pay and benefits vs. crippling taxes and economic decline, cuts to pay and benefits vs. investments to advance our technology, our infrastructure, and our military security. All of these elements must be balanced, yet are currently grossly out of balance, because in one way or another, all of them may quite legitimately be described as issues of safety and security for California and the nation.