Tag Archive for: sustainable pensions

Pensions: Giant 401K Plans

One of the biggest apparent misconceptions on the part of those who believe public sector pension benefits can remain unchanged is that somehow there is a difference between 401K plans and public sector pension funds. The only difference is one of scale. Individual citizens save money and invest the money in a 410K plan or other individual retirement account. Public sector pension funds take vast sums of money and invest it in the very same places – primarily Wall Street equities.

While it is true that an institutionally managed, massive and diversified pension fund may be less volatile than an individually managed retirement account, it is also true that massive pension funds are far less likely to enjoy returns that beat the market. They’re too big. So when the market value of stocks and other assets fall, it is impossible for large pension funds to not also see their values also fall.

If you recognize this – the fact that public sector pension funds are just as subject to economic ups and downs as individual 401K funds, and that they are invested in exactly the same things – then comments by defenders of keeping the public pension benefit system unchanged become inexplicable.

President Obama, in a speech last month where he lambasted the nonexistent Republican plan to privatize social security, said “I’ll fight with everything I’ve got to stop those who would gamble your Social Security on Wall Street.” But public sector employee pension funds are themselves gamblers on Wall Street.

SEIU Executive Vice President Eliseo Medina, in a Sept. 3rd commentary on the Huffington Post entitled “Wall Street is to Blame for Pension Shortfalls,” claims “For generations, Americans have counted on three sources of retirement income: social security, employment pensions, and personal savings. Wall Street is bent on undermining all three by pushing risky social security privatization schemes…” and further states, “Their goal is to strip away guaranteed pensions and force more workers into 401k-style plans that put all the risk onto workers while putting more money into the bankers’ own pockets.” But Wall Street returns are the only way pension funds can project solvency. Wall Street has already robbed the private sector taxpayer, and now those same taxpayers will have to also cover the losses of the pension funds, who gambled taxpayer’s money on Wall Street?

The President of the Los Angeles Police Protective League, Paul Weber, in an editorial published last month entitled “Public employee pension ‘reforms’ recipe for disaster” wrote “the 401K approach to retirement savings is, and will continue to be, an absolute disaster for this country.” In the same editorial, he goes on to say “while public pension plans have also taken severe hits, they have a long-term investment outlook, and their obligations aren’t due in full in the next five, 10 or even 20 years.” But all this means is that pensions are gigantic 401K plans, administered by professionals, managed over decades, but still reliant on Wall Street to survive.

What Obama, Medina, Weber and others don’t seem to fully recognize is that (a) massive public employee pension funds are themselves gambling with Wall Street just as much as any 401K plan participant, (b) the Wall Street crash was the result of a debt bubble that was built with the avid collusion of Wall Street, the government, and feckless consumers, and (c) long-term return on investment projections for large pension funds based on a 40 year expansion of unsustainable credit are too high for the era we now live in, where collateral continues to shrink and credit lines collapse apace.

Here are some additional thoughts:

(1) Social Security serves 80% of the retired population with benefits that on average are one-fourth what public sector pensioners receive, because they pay out 1/3rd vs. 2/3rd of recent salary, and because they begin payments 10 years later than public pensions.

(2) The absolute dollars necessary to pay Social Security to 80% of our retired population are therefore approximately the same amount as the absolute dollars necessary to pay public sector pensions to 20% of our retired population. The same size liability for one-fourth as many people!

(3) While in the past public sector employees made less than their counterparts in the private sector, in exchange for better benefits, that hasn’t been the case for over ten years. The average private sector worker in California earns less than $60,000 in total compensation (including all benefits). The average public sector worker in California earns about $100K in total compensation – nearly twice as much.

(4) Social Security is not in danger of going insolvent – it can be fixed with incremental changes; a higher ceiling on withholding, a higher percentage withholding, an older retirement age, and slightly lower benefits. Social Security is an appropriate taxpayer funded system of retirement security. In conjunction with personal savings, eliminating debt, and no new taxes, Social Security enables retired workers to live with dignity.

(5) Public sector pensions rely on the whims of Wall Street just as much as 401K plans. To demonize Wall Street at the same time as resisting calls to reduce public sector pension benefits is grotesquely hypocritical. Public sector pension funds are in bed with Wall Street, transferring over $250 billion dollars of taxpayer’s money through Wall Street brokers every year.

(6) If the inflation-adjusted projected rate of return for public sector pension funds were lowered from 4.75% to 2.375%, the contribution rates into these funds would rise from between 20-35% of salary (non-safety vs. safety) to between 40-70% of salary. This is not possible. This is why pension fund managers are making increasingly risky investments on Wall Street instead of admitting they will not be able to sustain 4.75% rates of return any longer.

(7) The solution to public sector pension plan insolvency – and they are all insolvent once you admit 4.75% returns will no longer accrue to trillion dollar funds in a debt-saturated, stagnant economy – is to move to a pay-as-you-go system, just like Social Security. Current tax receipts should be used to pay current retired workers.

Defenders of the status quo seem to embrace the seductive notion that Wall Street will solve all of our retirement security problems for public sector workers at the same time as they indulge the urge to demonize Wall Street for the failures of 401K plans. This contradiction escapes them, as they expect private sector taxpayers cover not only the downside of their individual retirement savings losses, but also whatever losses may accrue to the public employee’s pension funds.

Real Rates of Return

It would be easy to condemn as irresponsible the City Council of Vacaville, California, for their vote last week, granting “3% at 50” benefits to their firefighters. At this point, don’t we all know these are financially unsustainable promises? But on the other hand – isn’t “3% at 50” the standard for municipal firefighter contracts? Shouldn’t these firefighters earn pensions at the same level as their counterparts in other cities? Indeed they should. The real question is this – can Vacaville invest 23% of their firefighter’s salaries into a pension fund each year – Vacaville’s current commitment – and expect it to earn a sufficient amount to fund these upgraded retirement benefits? The answer hinges on what real rate of return their pension funds can expect to earn over the next few decades, and what variables will influence these returns upwards or downwards.

In this analysis, we assume a firefighter retires after 25 years work at age 50, which at 3% per year, would mean this firefighter would collect 75% of their final salary throughout their retirement. At various real rates of return on investment, for how many retirement years would this firefighter have a solvent pension fund? In the tables following this post are three cases which I believe use real rates of return – i.e., adjusted for inflation – that might be reasonably projected over the next few decades, 3%, 4% and 5% per year. Depending on which of these returns you choose, surprisingly different funding scenarios ensue, with dramatically different implications for policy.

At a long-term real rate of 3% annual return on investment, with a 23% of salary fund input per year, and salary of $90K per year reached in year 19 of a 25 year service (3% inflation-adjusted salary increase per year), retiring at age 50, this retiree’s fund will be out of money by the time they reach 70 years of age.

At a real rate of 4% return on investment, under the same assumptions, the retiree’s fund will run out of money by the time they reach 77 years of age. But the pleasant surprise is what happens to these funds if they can yield just one more point per year.

At a real rate of 5% return on investment, under these assumptions, the retiree’s fund will not be out of money until they are 102 years of age. If a 5% return is all it takes, why can’t we provide everyone this level of security? Is it realistic to expect to invest 23% of everyone’s salary each year into their retirement fund? And how much of this 23% (or more) should be deducted from paychecks, instead of kicked in by the employer?

Returning to the question of what annual rate of return should be considered realistic for a pension fund in the long term, a fund as large as the collective public pension funds of state, city and county employees across the USA, cannot be expected to grow at a real rate of return that exceeds that of the economy in which this fund is invested. This is why returns of 8% per year or more, earned when these funds were smaller, and earned during a time of unsustainable broader economic growth, cannot be expected in the future. In order to determine whether or not even a 5% real rate of return is realistic, one must consider the historic rate of growth of the global economy, which was about 2% per year through the eve of the industrial revolution, growing to about 3% per year by the dawn of the 20th century, reaching 3.5% during the first half of the 20th century, and 4.0% during the second half of the 20th century. What is a sustainable rate of future global economic growth?

On one hand, the 4.0% real economic growth of the global economy during the 2nd half of the 20th century was perhaps inflated by the internet bubble and rising levels of debt. But given the dramatic and ongoing leaps in technology we have seen in the past decades, it is nonetheless not unreasonable to assume that today’s long-term rate of real global economic growth is going up, not down. The question is what, other than unwinding excessive debt, will derail global economic growth?

The biggest challenge to global economic growth exceeding 5% per year are environmentalist restrictions on resource development. International lending should not exclude projects that lead to efficient, inexpensive production of energy and water, and this question – how much cost-effective genuine resource development can we fund – is what should inform national and international infrastructure planning. A gravity fed canal from the Volga to the Aral Basin, for example, or a rail link from Alaska to Siberia, or breeder reactors in Texas. National and international wealth are created when the precursers to a prosperous civilization, the public infrastructure necessary for inexpensive delivery of energy, water, transportation and shelter, are built and delivered cost effectively.

The constraints that limit global economic growth are not driven by scarce resources, or technological inadequacy, or due to a prohibitive expense for the requisite infrastructure to deliver an excellent quality of life to virtually anyone on earth. Instead the primary constraints on economic growth are the result of fanatical environmental activists – backed by powerful special interests – who have consistently blocked development projects, and they are more powerful now than ever.

Economic growth and wealth are gained by making public services less expensive, not more expensive. This means the policies governing investments in water, energy, transportation, and land use should emphasize clean burning, cradle-to-cradle cleanliness, but should not go beyond these reasonable safeguards to artificially create prohibitive costs. Environmentalist restrictions on resource development have combined to cripple the USA’s economy, along with much of the rest of the world, and this is the real challenge – overcoming this injustice and tragic folly. Moreover, it is false to believe economic growth causes inevitable environmental harm, because along with refining and upgrading our physical infrastructure, technology-driven future economic growth can continuously and indefinitely be directed into very low-impact, high-value new economic sectors to service a stable, aging, prosperous global population of humans – android caregivers for the elderly, neurologically activated exoskeletons for personal mobility enhancement, space industrialization, life-extension, and planetary remediations of extraordinary scope, to name a few.

In order to achieve real rates of economic growth of 5% or more, year after year, which is necessary before upgraded retirement benefits can be sustainably extended to everyone, political leaders must recognize the importance of encouraging resource development, instead of emphasizing self-serving and punitive surveilance and rationing tactics, higher taxes, fees, carbon “trading” proceeds, and other green extremist policies that require minimal investment but curtail future growth.

Freedom from green extremism is the only way the global economic pie can grow at up to 5% per year, and provide us the wealth to adapt to whatever natural phenomena may come, clean our many footprints, and all know the benefits of global abundance. Reforming environmentalism is crucial to raising real rates of economic growth, and consequently, to raising real rates of return on retirement funds, so we might all live as well in our retirements as the firefighters of Vacaville.

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