Earlier this week, on December 7th, 2011, as reported by the San Jose Mercury, the “San Jose City Council votes 6-5 to place pension reform on June ballot.”

This plan is drawing fierce resistance, but there are two financial considerations that most critics of pension reform don’t take sufficiently into account when making their arguments:

(1) Pension contributions are very sensitive to how much the fund can earn. A pension that earns 3% per year, i.e., allows someone who works for 30 years to retire with a pension equivalent to 90% of their final salary, will require a 10% increase in annual required contributions (as a percent of pay) for every 1.0% the earnings on the pension fund drop. That is, if the contribution to a firefighter’s pension is currently 35% per year (based on employer and employee contributions combined), and CalPERS lowers their expected rate of annual return by just 1.0%, from 7.75% to 6.75%, then the required annual contribution as a percent of salary goes up to 45% per year.

(2) The rate of return being currently maintained by most pension funds, 7.75% per year, is much higher than can be sustained going forward. A key reason for this is because equity growth over the past 20-30 years, and especially over the last 10-15 years, was fueled by increasing debt. By enabling massive borrowing – consumer, commercial and government – more consumer spending was in-turn enabled, which increased corporate profits which increased equity values. Now global debt has reached its maximum, we are going to deal with slower growth and hence lower rates of return for pension funds. The other key reason for the inevitability of lower pension fund returns is demographic. With baby-boomers now beginning to retire, and with public sector workers now retiring with these far more generous pension plans (they were only raised about 10 years ago), there are more people selling equities than ever before in order to finance retirements. Equity values are a function of supply and demand, and public sector pensions are going to be doing a lot more selling to finance pension payouts than ever before. The chances that the major pension funds in the United States can continue to earn 7.75% year after year are virtually zero.

Pension reforms such as San Jose Mayor Chuck Reed’s proposal should be supported.

The San Jose proposal may actually do enough to restore financial solvency to a public employee pension plan. Eventually raising the employee’s withholding to as much as 25% of their pay begins to contribute enough money to fund these plans, especially when combined with accruing benefits at no more than 2.0% per year, and deferring retirement to age 57 or higher.

Here are a few questions and answers about public sector pensions:

QUESTION: Aren’t pension critics, or “reformers,” if you will, trying to ignore the contractual commitments they made as taxpayers, simply because they become more costly than originally expected?

ANSWER: Nobody “agreed” to these contracts as they have turned out. When pension upgrades were sold to politicians by Wall Street lobbyists they were represented as being nearly free to taxpayers because market based returns would cover the costs. Politicians didn’t understand the financial risks and voters were never told about it. To be fair, even the union leadership had no idea what they were getting themselves into.

Let’s put it this way – if somebody sold you a car, and said the payments would be $250 per month, then five years later said the payments would be raised to $1,000 per month, then five years after that said the payments would be raised to $2,500 per month, would anyone “like” that? And how would the holder of the loan appear – when they say “a deal is a deal” and try to force you to pay up?

In any event, opponents of pension reform should review the two financial points made earlier, because bankruptcy will void these contracts, and bankruptcy is staring every city and county in California in the face.

QUESTION: Everyone agrees that some kind of public pension reform is unavoidable, and that is exactly what is underway now. But can people who want to change public sector pension benefits legitimately claim that Chapter 9 is a magic bullet that will suddenly relieve everyone of the legal obligations that have been made on their behalf by their elected representatives?

Now that the bill for pension obligations is coming due, wouldn’t reneging on these obligations constitute theft?

ANSWER: “Theft” is how public sector unions have stolen our democracy and “negotiated” these unsustainable pensions with politicians they elected. Public sector pensions, on average, are five to ten times better than social security. The arcane and onerous details of pension obligations were buried in the fine print of these “contracts.” To imply that taxpayers are somehow the thieves for wanting to reduce pension costs down to the levels they were originally ignores the sheer scale and generousity of these financially unsustainable pensions. The 2010 annual reports from CalPERS and CalSTRS document that the average pension for a newly retired government worker in California after 30 years of work is nearly $70,000 per year. If every Californian over the age of 55 received that much in retirement it would cost $700 billion per year, nearly 40% of the entire GDP of the state! It’s impossible. It can’t go on. It is oppression and a recipe for economic ruin.

The bottom line is this – public sector unions and Wall Street are now in bed together, betting trillions of dollars in the markets with their pension funds, trying to eke over-market returns through aggressive fund management, with the taxpayers forced to pay up when they can’t hit their numbers.

From the CalSTRS Annual Report, page 135:

CalSTRS participants who retired during the 12 months ending June 30th, 2010 (the most recent data), earned pensions as follows:
25-30 years service, average pension $50,772 per year.
30-35 years service, average pension $67,980 per year.
35-40 years service, average pension $86,736 per year.

From the CalPERS Annual Report, page 151:

CalPERS participants who retired during the 12 months ending December 31st, 2009 (the most recent data), earned pensions as follows:
25-30 years service, average pension $53,182 per year.
30+ years service, average pension $66,828 per year.

QUESTION: Isn’t it true that the longer someone works in any pension system, the higher their eventual benefit is likely to be? Doesn’t it work that way with Social Security, up to the cap?

ANSWER: The social security cap is about $31K per year after 40+ years of full time work, which equates to well less than 20% of the payee’s annual income. There is no cap on public sector pension payments, which are averaging nearly $70K per year, and they are averaging over 66% of the payee’s annual income, after only 30+ years of work.

Nearly everyone in America was purchasing more than they could afford during the internet/housing bubbles, but lobbyists hired by public sector unions, alongside lobbyists hired by Wall Street, are trying to make our politicians enshrine the pension liabilities – sold by Wall Street lobbyists to union-backed politicians – permanently into our tax code. And together, Wall Street and public sector unions have made public sector agencies collection agents for Wall Street. Wall Street hedge funds now bypass brokerages to manipulate market liquidity and asset values, and public sector pension funds are the biggest players on Wall Street. This is a corrupt system and cannot be fixed until taxpayer backed pension funds that can extract by “contract” 7.75% returns – either from investment returns or from taxpayers – are dissolved. And why shouldn’t public sector pension funds be the biggest players on Wall Street? Not only do they control about $4.0 trillion in assets, but they have the full backing of the public sector unions, the politicians they control throughout America’s states, cities and counties, and the taxpayers as the final guarantors.

Public sector pension funds and the social security fund should be all merged into a single fund, and the combined assets should be systematically moved into either cash or treasury bills, eliminating the speculators, eliminating most of the expensive financial bureaucrats of all stripes, and getting the government and Wall Street out of the business of fleecing taxpayers. And one, uniform and financially sustainable retirement incentive formula would be offered to ALL retired American workers, public or private.

For much more on the benefits and the feasibility of merging all public employee pension funds with social security, read “Merge Social Security and Public Pension Funds.”