Letter to a State Worker

It must be tough for a California state worker to deal with the rising resentment of private sector workers. It must be easy to consider all of this some sort of plot by big business and billionaires to smack down the public sector workers, now that they’ve finished their nefarious beat-down of the private sector workers. There may be comfort in these notions, but little accuracy. Here are some thoughts for our state worker brethren to consider:

The average CalSTRS pension in 2010 for retirees leaving with 30+ years of service was $68,000 per year (ref. Government Worker Understates Average Pension). This benefit is extremely out of line with what is financially feasible. In the competitive, globalized private sector, the ability to retire before age 60 with an income of $68,000 per year requires amassing a huge amount of wealth. When savings accounts are paying interest of less than 1.0%, and the stock markets have been down for over a decade, might you not want to question the assumption that CalSTRS can earn 7.75% per year, long-term?

A self employed person in the private sector who manages to earn over $80K per year pays 53.25% tax on every extra dollar they make – 15% for employer and employee FICA and medicare, 28% federal, and 10.25% state. That doesn’t include property taxes or sales taxes, or the many taxes embedded in the typical utility and telecom bills. And, of course, if they don’t work, they don’t get paid. They are responsible for finding and paying for 100% of any benefits they enjoy including health insurance. And often, even if they are willing and able to pay the premium, they can’t find an insurance company who will cover them.

It is fine if you public sector workers need some time to accept the fact that your benefits are unsustainable. But to call those of us who have been coping with the impact of globalization and the collapse of the asset bubble for several years (if not decades) “haters,” or to encourage us to villainize big business and billionaires, does nothing to advance this discussion. Think about this:

1 – It is true that Wall Street special interests are to blame for much of our economic challenges, but your public sector pension funds are the biggest players on Wall Street.

2 – It is also true that monopolistic huge corporations are hurting the economic prospects for the rest of us, but you may not appreciate the difference between gigantic corporations who squelch competition and those emerging companies who disrupt the big corporations with faster, better and cheaper products who make our lives easier. And again, the presence of regulations tend to favor the monopolies more than the emerging companies – as do your pension funds.

3 – YOU are not bailing out Wall Street. Private sector taxpayers are footing that bill. When Wall Street conned the entire U.S. population and political leadership (it was totally bipartisan) into thinking we could drown ourselves in debt and hide that debt behind a bubble of phony, over-inflated assets as collateral, you benefited because your pension funds rode the wave of unsustainable growth that the debt created. Now the taxes paid by private sector workers pay for your pension, because Wall Street’s promises of high rates of return for your pension funds turned out to be false. And yes, you pay taxes. But for you to say that you pay taxes is sort of like the guy who stood inside a bucket and pulled on a rope hooked to the handle of the bucket, and wondered why he wasn’t able to levitate.

4 – Yes, in the old days everyone had a better pension. Are you kidding? Go back to pre-1999 payscales and pension formulas, retroactively, and you can keep your pension. It would not be insolvent.

5 – You do NOT pay for most of your retirement. If, for example, you are getting 50% of your salary after 25 years in the form of a pension, that suggests you will spend at least one year retired for every year you worked. How much was withheld from your salary for your pension? 5%? 10%? To accrue at a rate of 2.0% per year, which is what you get in this example, even at CalPERS (and CalSTRS) increasingly preposterous claim that they can earn 7.75% per year over the long term, you would have to contribute 20% of your salary (ref. What Percent of Payroll Will Keep Pensions Solvent). Did you? And if that projected rate earned by CalPERS goes down only two points, to 5.75% per year (ref. CalPERS Projected Returns vs. Reality), you would have to contribute 36% of your salary – again, to get a 50% pension for 25 years after 25 years of work. Have you made these calculations? Have you contributed 36% of your salary into your pension fund?

What you really should think about, beyond these calculations which apparently escape most everyone except the Wall Street puppeteers who are laughing their heads off that they can gamble with taxpayer’s money as long as they buy off the public employees (who set policy through their unions who control the politicians in league with Wall Street lobbyists) with pensions that exceed social security by a factor of about 5x, is that it is impossible to extend pension benefits as generous as you are getting to everyone. It is completely impossible because (1) we have an aging population where more people are going to be retired, and (2) there isn’t enough “return on investment” in the world to relieve the taxpayers of covering most of the costs for these retirees.

You can blame Wall Street all you like. But Wall Street is YOUR benefactor, not mine. Your unions are collection agents for Wall Street pension funds.

CalPERS Projected Returns vs. Reality

Whenever CalPERS, or any government worker pension fund, suggests that a long-term projected rate of return of 7.75% is realistic and prudent, one needs to consider the following: Across every major stock index in the U.S., and on most indexes in the rest of the world, publicly traded stocks have been down for the last 12 years. Here is a chart of the Dow Jones Industrial Averages staring in January 2000, and running through last week:

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 (latest figures) 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. Fine. Let’s take a look at 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.

To be sure, back in 2000, these stock values were elevated because of the internet bubble, which one might argue makes 2000 an unfair choice to pick for the base year. But 2000 was the year when government worker pension benefit formulas, in one government organization after another, were increased from sustainable levels to unsustainable levels, a permanent adjustment based on this bubble. Since 2000, reality has reasserted itself with a vengeance, yet both the government pension fund managers and the union leadership who represent government workers continue to insist that 7.75% is a realistic long-term rate of return. In any event, nobody is arguing that the 2000 stock indexes were overvalued, which skews the last 11.5 years of return data. But are these stock indexes undervalued today?

One way to answer this question is to look at the aggregate price/earnings ratios for the stocks in the S&P 500. For the last half of the 20th century, the aggregate P/E for the S&P 500 was 16.48  (ref. Price to Earnings ratio of the S&P 500 well above historical average,” by Howard Spieler, written in 2002). Turning to data compiled by Robert Schiller from the Yale Dept. of Economics, S&P 500 PE Ratio by Year, one can see that in 2000 the aggregate P/E for the S&P 500 was an unsustainable 43.77. But one can also see that today that ratio is a lower, but still higher than normal 20.34. Corporate earnings are healthy. If there is a rational basis for anyone to expect U.S. equities to go up, I’d like to hear it.

It is in this context that government worker pensions, which taxpayers guarantee when Wall Street’s rosy promises greet reality, must seem a bit extreme to those of us who may only expect to receive social security at age 68. The fact is, government worker pension funds are the biggest players on Wall Street, and the unions who negotiate pension fund benefits for government workers and force taxpayers to pay tithe, are nothing more than collection agents for Wall Street.

Anyone who is just beginning to realize that government worker pension funds, who promise 7.75% returns in an environment of crippling consumer debt and asset deflation, are basically agents of Wall Street with government worker unions as their collection agents and enforcers, should read the July 25th New Yorker article “Mastering the Machine.” In this article, a spectacularly successful hedge fund manager who includes among his clients government worker pension funds, has this to say: “In order to earn more than the market return, you have to take money from somebody else.” This is absolutely true – over the past 10+ years, as Wall Street speculators have gotten spectacularly rich, government worker unions have been bought off with promises by their pension funds of over-market gains. But the indexes have been down during this period. Small investors have indeed been decimated, at the same time as taxpayers have seen increasing amounts of their taxes sent to Wall Street to sustain the solvency of government worker pension funds.

Referring to government employees who retire in their mid-fifties with pensions that average well over $60,000 per year as “working people” is more than an insult to working people who retire in their late sixties with social security benefits that average $15,000 per year, it is a crime, perpetrated by Wall Street, with government worker unions providing the political muscle. More money is paid out each year to retired government workers, who comprise barely 20% of the workforce (but 30% of retirees because they retire so much earlier), than is paid out via Social Security to the entire remaining retired population.

The way to start to reform this mess is to take any taxpayer funded retirement program – such as social security, along with any taxpayer guaranteed retirement program – such as government worker pensions, out of the hands of Wall Street speculators. This would require a pay-as-you-go system, where assessments on current workers are used to pay benefits to retired workers. In turn, this would finally expose Wall Street’s last, biggest con, the idea that somehow 7.75% rates of return can relieve taxpayers of having to pay for government workers to enjoy retirement security literally five times better (or more) than social security.

How Interest Rates Affect the Federal Budget

The relationship between stagnant economic growth and high levels of total market debt should be clear to anyone trying to manage a household where their home mortgage payment consumes 50% or more of their entire household income. Similarly, the relationship between economic growth and the ability to borrow should be clear to anyone who has enjoyed the ability to purchase anything and everything in sight right up until they reached the point where every credit card they owned was maxed, and every dime of home equity available to them was already borrowed and spent. These comparisons hold true at the macroscopic level as well.

In the case of the federal government, borrowing has been facilitated by the ability to borrow money at cheap rates of interest. According to the official website of the U.S. Treasury, the Total Outstanding Public Debt, i.e., the total amount of money currently owed by the U.S. federal government is $14.3 trillion. From the same source, the Interest Expense on the Debt Outstanding for the first 9 months of fiscal 2011 (through June 2011) is $389 billion, which equates to an annual expense of $519 billion. Does anyone see anything wrong with this picture? The U.S. federal government is only paying interest on its debt at a rate of 3.6%. What happens if this rate of interest goes up?

In the table below, the best case scenario is presented, since it excludes “Intragovernmental Holdings,” which is debt the federal government owes to other government agencies, which accounts for about a third of the total debt. If you account for payments on all 14.3 trillion of federal debt, the half-trillion that the federal government currently pays at a composite rate of 3.6% already consumes about 14% of the federal budget. And as the table indicates, for every 1.0% that the rate of interest goes up, interest payments consume an additional 3.0% of the federal budget. Back in the early 1980’s , the maximum 30 year treasury bill peaked at about 16%, so the extreme case in this table, 7.5%, is not far fetched.

A more sobering way to present this data might be to consider what percentage of government revenues (about $2.1 trillion) are consumed by interest payments on total government debt ($14.3 trillion), since currently the federal government only collects about 60% of what they’re spending. By this reasoning, at an interest rate of 3.5%, the federal government is paying 24% of every dollar it collects in taxes right back again in interest payments. That’s today, at low rates of interest. If the federal government had to pay 7.5% interest, today, then the federal government would pay just over 50% of every dollar it collects in taxes right back again in interest payments.

It is interesting to wonder if inflation can erode the principal value of the federal debt. Without presenting an avalanche of what-if spreadsheets, here are some of the problems with inflation as a panacea for debt: To the extent inflation increases government revenues to service debt, interest rates rise in parallel with the rate of inflation, meaning the amount of debt service goes up, offsetting the benefit of the diminished value of the principal. The only way these countervailing forces can end up favoring the borrower is if the real interest rates – i.e., the rate of interest less the rate of inflation – fall, but in the higher risk environment of an inflationary economy, real interest rates are likely to rise. More significantly is the fact that real interest rates are at all-time lows today. With inflation – official vs. unofficial – hovering somewhere between 2.0% and 5.0%, real interest rates on federal borrowing are arguably negative.

The problem with inflation as a cure for federal debt is also compounded by the fact that everyone’s trying it. For inflation to endure, currency must devalue, and every nation on earth – definitely including the Chinese whose debt problem is only obscured by their asset bubble – is determined to devalue their currency. Compared to the Europeans and the Chinese, the U.S. dollar remains quite durable, and is unlikely to devalue.

What could present itself in the next few years, because inflation not a very likely scenario, is that debt service becomes so burdensome for governments in the U.S., federal, state and local, that defaults begin to occur, which will require raising the risk premium in order to attract lenders, which will further add to the burden represented by payments on debt. The deflationary impact of unsustainable debt is the true boogeyman of the global economy, and is the reason they are burning up the printing presses down at the United States Mint to print more currency, and why the Federal Reserve Bank will keep interest rates as low as they can for as long as they can.

The cure for stagnant growth caused by maxed out debt is to lower the cost of living, which creates liquidity to eliminate debt and invest in new industries. This is precisely the opposite of what we are seeing stimulus money spent on. The powerful combination of environmentalist interests and government unions are blocking development of cheap energy, water storage, and abundant open land, which would lower the cost of the basic necessities of life – energy, water and shelter – and stimulate consumer spending and business expansion. Instead of building this infrastructure, they are spending stimulus money to maintain overmarket compensation and benefits for public employees, and “green jobs” whose only impact is to offer consumers products and services that cost more than existing conventional solutions. This is the path to a debt-fueled deflationary collapse, and there is an alternative.

Related posts:

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

The China Bubble, June 8, 2010

National Debt and Rates of Return, December 12, 2010

When is Debt Unsustainable, February 4, 2011

For much more, refer to “What Percent of Payroll Will Keep Pensions Solvent?,” July 23, 2011, and the couple dozen links to related posts provided below the text.

The Impact of Pension Spiking

While much has been made of the impact of pension “spiking,” it is helpful to quantify just exactly how much pension spiking will cost taxpayers, and how ill-prepared an otherwise adequately funded pension account is for this practice. In the two sets of examples below, the same assumptions and the same analytical model is used as in the previous post “What Percent of Payroll Will Keep Pensions Solvent?“; 30 years working, 25 years retired, pay in real dollars doubling between the hire date and the retirement date, and various rates of return.

In this analysis, each block of data has three rows. The first row shows the amount by which the final pay is “spiked,” i.e., increased by a disproportionate amount through a large pay raise, cashing in of accumulated sick time, or other methods that increase pay more than it would ordinarily increase. The second row shows how much would have to be set aside as a percent of payroll each year and contributed into the employee’s pension fund, in order to ensure the fund would have sufficient assets to pay out the calculated retirement pension for 25 years. The third row puts this another way, by showing how much money would need to be in the employee’s pension fund at the time they retire. There are three sets of three rows, representing the results under three different return on investment scenarios; a 4.75% rate of return over the life of the fund (after adjusting downwards for 3.0% inflation), which is CalPERS official rate of return, along with most other public employee pension funds, then a 3.75% real rate of return, then a 2.75% real rate of return. One is encouraged to remember that a 2.75% “real” rate of return equates under these assumptions to a 5.75% actual, or nominal return. To keep this in perspective, the risk-free 10 year treasury bill earns a 3.0% annual rate of return.

In the example immediately below, this model is applied to calculate the impact of a 10%, 20% and 30% spiking of final year pay (columns 2, 3, and 4) for a public safety employee, retiring after 30 years with a pension equivalent to 90% of their final year of pay. The baseline case of zero spiking is provided in column one. This analysis is not to suggest that all public safety workers, who represent about 15% of California’s roughly 1.85 million state and local government workers engage in spiking, or, for that matter, that the other 85%, the “non-safety” government employees in California, engage in spiking. Pension spiking is a reality that is pervasive in some agencies and jurisdictions, and nonexistent in others. In some cities and counties in California it is having a dramatic impact on pension fund solvency and the rates of contribution necessary to compensate for it. The purpose of this analysis is not to identify where and when spiking is occurring, only to quantify how much it costs when it does occur. The worst case example of spiking used here of 30% is not unusual.

To understand the above table, compare the 2nd row in each three-row block of numbers, starting with the case that uses a 4.75% real rate of return for the pension fund. The impact of an employee collecting a pension equivalent to 90% of their final pay who successfully increases their final year of salary by 30%, in order to increase their pension by the same amount, is to require their employer to contribute not 27.7% of their salary into a pension fund every year for the entire 30 years they work, but 35.7%. That is, when an employee collecting a 90% pension manages to spike their final salary by 30%, it means an additional 8.0% of salary would have had to have been contributed to their pension fund every year for their entire 30 year career working. Referring to the 3rd row in each three-row block, one can see that the impact of a 30% final year spike in pay is to require the pension fund at the time of retirement to have nearly $1.7 million accumulated, vs. $1.3 million in the baseline case.

The next table provides this same information for non-safety government employees, in cases where after a 30 year career they collect a 60% pension. This would represent pretty much the absolute lowest pension a state or local government employee in California might expect after 30 years. Teachers, for example, after 30 years of service are eligible to apply a 2.5% factor to the number of years they worked, which equates to a pension equivalent to 75% of their final salary. In this example, again referring to the first three-row set of data, which represents our best case, since it utilizes CalPERS official 4.75% real rate of return on invested funds, without spiking, the employee would have to contribute 18.5% of their pay into their retirement plan for 30 years, and would have to accumulate $870K at the end of their career in order to fund a 25 year retirement. If they manage to spike their final year of pay by 30%, they would have had to contribute 23.8% of their salary into their retirement plan for 30 years, and they would have to amass $1.13 million in their retirement fund by the end of their career.

These examples indicate that the impact of spiking is dramatic. Whenever a government employee exploits loopholes in their pension formulas and rules in order to spike their final year’s pay, there is a huge cost to taxpayers. Referring to the charts again, if a retiree earning a 90% pension only spikes their final year of pay by 10%, their payroll contribution for the 30 years they worked would still need to have been increased by nearly 2.7%. If they spike their final pay by 20%, their payroll contribution for the 30 years they worked would need to have been increased by over 5.4%. In many cases, just these relatively small amounts of spiking, 10% and 20%, spell a required increase to the annual contribution to the pension fund that is greater than the entire amount they themselves contribute via payroll withholding. The taxpayer pays nearly everything.

A final disquieting observation can be had by referring to the two boxes in each example, one in the upper left corner of the data set, and one in the lower right corner. The boxed datapoints in the upper left indicate how much is typically set aside for pensions based on the official projected real rate of return, 4.75%, and zero spiking of final salary. In the case of the 90% pensioner, 27.7% of payroll must be set aside, and at retirement those accumulated set asides, plus interest, must equal $1.3 million. In the case of the 60% pensioner, 18.5% of payroll must be set aside, and at retirement those set asides, plus interest, must equal $871K. But what happens if both pension spiking occurs, and the pension fund is required – by the intervention of reality – to lower their projected real rate of return for their funds by 2.0%, down to a real rate of return of 2.75%, or a nominal rate of return of 5.75%? The compounding effect of these combined outcomes is truly frightening.

In the case of the 90% pensioner who spikes their final salary by 30% at the same time as the pension fund reduces their long-term earnings projection to 2.75%, instead of setting aside 27.7% of payroll each year, they would have had to set aside 61.4% of payroll each year. Instead of accumulating $1.3 million in their pension account by the year of their retirement, they would have had to accumulate $2.1 million.

In the case of the 60% pensioner who spikes their final salary by 30% at the same time as the pension fund reduces their long-term earnings projection to 2.75%, instead of setting aside 18.5% of payroll each year, they would have had to set aside 40.9% of payroll each year. Instead of accumulating $871K in their pension account by the year of their retirement, they would have had to accumulate $1.4 million.

This is not an extreme scenario. While pension spiking is not pervasive, it is common. And anyone who thinks the worst case investment returns contemplated here are unlikely – a nominal return of 5.75% – needs to consider how long public sector pension funds that manage over $3.0 trillion in assets can continue to rely on hedging and other high-risk Wall Street tricks to outperform the risk-free rate of the 10 year U.S. Treasury bill, which is only 3.0% per year. Pension spiking causes dramatic increases to the amount necessary to fund pensions all by itself. When viewed in combination with what may well be an inevitable reduction in the projected rate of return for pension funds, pension spiking can play a material role in making an extraordinarily challenging situation even worse.

What Percent of Payroll Will Keep Pensions Solvent?

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

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

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

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

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

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

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

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

Related posts:

Why Pensions Are Grossly Underfunded –  June 27, 2011

Preserving America’s Retirement Security –  June 4, 2011

Government Worker Understates Average Pension –  May 31, 2011

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

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

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

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

The Cost of Government Pensions –  March 11, 2011

When is Debt Unsustainable?
–  February 4, 2011

China’s Economic Challenges –  December 28, 2010

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

National Debt and Rates of Return –  December 18, 2010

Teacher Pension Solvency –  December 12, 2010

Entrepreneurial vs. Casino Capitalism –  November 11, 2010

Pension Reform Options –  November 1, 2010

Pensions: Giant 401K Plans –  September 14, 2010

Sustainable Retirement Finance –  September 11, 2010

Avoiding Global Deflation –  July 18, 2010

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

The China Bubble
–  June 8, 2010

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

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

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

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Proposed California Laws to Protect Special Interests

The agenda of California’s union-controlled state politicians is to do whatever they can to increase the amount of tax revenue flowing into the government, and increase the amount of dues revenue flowing into the coffers of government worker unions. This isn’t news, and any law they pass can be appropriately viewed in this context. But beyond grasping for tax revenue ala AB 155, which imposes sales tax on internet purchases, or grasping for union dues revenue ala SB 104, which (vetoed this time) would have imposed unionization via “card check” on agricultural workers, California’s union-controlled legislature is enacting laws that will change the ground rules of politics and governance.

The purpose of these laws, too numerous to compile, is to consolidate the power of public sector unions and ensure that government of the government workers, by the government workers, and for the government workers, will be the perpetual fate of California. As citizens awaken to the fact that government workers in California, on average, make twice as much money and work half as many hours in their careers as the taxpayers who support them, a seismic wave of reform sentiment gathers. To prepare for this tsunami, California’s government worker unions are building a seawall of regulations, many of them buried within budgets and unrelated new statutes. Here are just a few:

AB 114 – Dramatically reduces local financial control of school districts; prohibits layoffs; removes requirement for school districts to perform financial analysis to ensure they can balance their budgets. Here are a few articles providing more details about this grossly irresponsible legislation: “AB 114: A Blatant Attack on California’s Schools,” by Larry Sand, on July 12th, 2011, UnionWatch, “Stealth attack on California’s schools,” Editorial, July 8th, 2011, Los Angeles Times, “State law is stunning in its irresponsibility,” Editorial, July 2nd, San Diego Union Tribune.

AB 506 –  Restricts ability of municipalities to declare bankruptcy. Another bill moving through California’s state legislature will restrict the ability of local governments in California from declaring bankruptcy, which is virtually the only way they can get out from under literally tyrannical collective bargaining agreements. As reported on June 2nd by the Sacramento Bee, the bill has already passed the assembly “Assembly approves bill to slow local government bankruptcies.”

AB 455 –  Allows unions to appoint 50% of the members of personnel management boards for local governments and agencies. This bill is a perfect example of legislation that sounds innocuous, but has far reaching impact. Personnel management boards oversee the enforcement, modification, and interpretation of union negotiated work rules. From overtime benefits to staffing levels to job descriptions, having an unbiased board is essential in order to have any chance of reforming work rules that may hinder improving the efficiency and effectiveness of a public agency. Allowing the union to appoint 50% of the voting membership of these boards guarantees them veto power over any actions of these boards. This bill has been barely noticed by the media.

SB23-1X –  Grants local governments the power to raise taxes. This bill, which is undergoing legal scrutiny and will undergo many revisions, nonetheless aims to grant local governments to enact increases tax increases denied at the state level by the 2/3rds vote requirement. As reported on June 4th in the San Jose Mercury in an AP article entitled “Bill would grant local power to raise taxes,” this legislation “would allow a local government, county office of education and community colleges district to levy local personal income taxes up to 1 percent, vehicle taxes up to 1.35 percent, and up to $1 per pack of cigarettes.”

These four bills, respectively, will trample on local control over school district budgeting and staffing, effectively prevent local bankruptcies, assert union control over personnel management boards, and extend the option to local governments to collect income taxes. The purpose of these bills and many others is clear – to forestall an anticipated uprising of taxpayers against the most powerful special interest in California, public sector unions.

Over the past 20+ years, as California’s state and local governments have grown far faster than the rate of inflation and population increase, the one reliable defense left to taxpayers has been the citizen initiative process. But the initiative process is under attack. No fewer than four active bills are working their way to Governor Brown for signature. Here they are:

ACA 6 –  Prevents passage of initiatives that reduce tax revenues. According to bill sponsor Assemblyman Mike Gatto, ACA 6 “will require initiatives that spend money or create a new program or mandate to identify and specify the funding to pay for it.” The practical effect of this bill, which would require language in any initiative specifying a new source of tax revenue for any costs attendant to enforcing the initiative in excess of $5.0 million, would be to only allow initiatives onto the ballot that raised taxes. This law would leave the decision regarding the financial impact of a proposed initiative in the hands of the State Dept. of Finance, where they could anoint bills they favored, and subject the ones they don’t like to a slanted financial analysis, or, worse, delayed indefinitely in the limbo of an ongoing analysis.

SB 448 –  forces circulators of those kind of petitions to wear a button that tells whether they are paid or volunteer. Sponsored by Sen. Mark DeSaulnier, SB 448 would require that people who collect signatures wear signs around their necks announcing whether they are a paid signature-gatherer or a volunteer signature-gatherer, and whether they are registered to vote.

SB 168 –  Bans ballot committees and individuals from paying people who circulate petitions for initiatives, referendums and recalls on the basis of the number of signatures they collect. Instead of paying signature gatherers based on their productivity, these workers would be required to receive an hourly wage. Equally troubling, they would be required to be hired as full time employees – an utterly impractical approach to what is seasonal, temporary work. The practical effect of this law will be to double or triple the cost of putting an initiative onto the ballot, which drives out the grassroots organizations but leaves intact the prerogatives of powerful special interests.

ACA 10 –  Would allow the Legislature to amend or repeal voter-initiated statutes after they have been in effect for four years. Again, the practical effect of this would be to force grassroots taxfighting organizations back into expensive initiative battles every four years, making it very difficult to implement lasting reforms.

Ultimately, what California’s union-dominated legislature is doing is nothing but a holding action. Restrictions on education budgeting and staffing decisions, as well as restrictions on the ability of municipalities to declare bankruptcy, are preempted by an even harder reality: Default. Stacking the membership of personnel management boards with union operatives, or enabling municipalities to raise taxes – along with evisceration of the initiative process – are all craven actions of a special interest that has overreached.

Nonpartisan Public Sector Union Reformers

To declare that union reform, public sector union reform in particular, is a nonpartisan cause, is certain to attract vociferous challenges from defenders of unions, but events continue to trump ideology.

As documented in an earlier post “The Democratic Party War,” even in California, a state where public sector unions wield nearly absolute control, there are increasing numbers of prominent democrats who are standing up to the unions. They include Los Angeles Mayor Antonio Villaraigosa, former State Senator Gloria Romero, President of the California NAACP Alice Huffman, San Francisco Public Defender Jeff Adachi, former Assembly Speaker Willie Brown, and Matt Gonzalez, former President of the San Francisco Board of Supervisors. From education reform to pension rollbacks, Democrats are lining up to make hard choices in California, staring down union power in the process.

A series of similar reality checks are happening all over the United States, as Democrats realize the agenda of public sector unions is often in direct conflict with their ability to fund government programs and infrastructure projects. As reported in the New York Times earlier this week in an article entitled “Cuomo Secures Big Givebacks in Union Deal,” a democratic governor in a union stronghold is making tough decisions in an attempt to restore budget solvency. As reported on June 21st on the website “Intercepts,” in a post entitled “Rage Against the Machine,” Democratic lawmakers in New Jersey have joined with Republican Governor Christie to require public employees to contribute more to their own pensions and health care premiums, and Rahm Emanuel, the newly elected Democratic Mayor of Chicago, has canceled cost of living increases for the public school teachers in that city. None of this sits well with public sector unions. And none of this would be happening without Democratic lawmakers.

Another nonpartisan phenomenon gathering momentum is the willingness of major news organizations to editorialize in favor of public sector union reform. In California, the Los Angeles Times, of all newspapers, just published an editorial entitled “‘Card check’ empowers unions, not union workers,” in reference to a bill recently passed by the California legislature. And in California’s capitol city, the liberal Sacramento Bee recently editorialized that “Union concessions are city’s only hope,” referring to the fact that the city of Sacramento cannot hope to balance its budget without reducing the over-market pay and benefits afforded their public workforce.

As documented in our post “Is Union Reform Partisan,” fully 95% of political contributions by unions over the past 10 years in America have gone to democratic lawmakers. But increasingly, democratic lawmakers are realizing they must stand up to the union agenda. This is testimony to the fact that public sector unions have clearly overreached, and that politicians of both parties now realize this. That even democrats, who stand to lose their primary source of funding, are beginning to enact public sector union reform, is a most hopeful sign.

Why Pensions Are Grossly Underfunded

The San Diego Union Tribune ran a report on June 17th entitled “Escondido firefighters do contribute to pensions.” Apparently this report was to correct an error from a previous article in which the Tribune stated that Escondido’s firefighters did not make any contribution to their pension. In reality the firefighters contribute to their pension fund an amount, in the form of payroll withholding, equivalent to 9% of their salary.

While it is commendable that Escondido’s firefighters do pay something towards their pensions, considering how many safety employees in California still pay nothing, it is important to place this 9% contribution within the perspective of how much it really costs to fund a “3 at 50″ pension.

The following table depicts how much, in terms of percent of salary, an employee will need to have contributed into their pension fund in order to maintain solvency based on various rates of return for the fund.

This table uses after inflation numbers, which makes the returns appear small. In reality, CalPERS, CalSTRS, and most other pension funds, project a long-term rate of inflation of 3.0%. This means that the nearly best case scenarios here, 7.5% before inflation (showing as 4.5% after inflation on the table), are representative of the current official long-term projections used by most pension funds. Based on the official rates of projected returns for pension fund investments, a 30 year veteran, retiring on a “3.0% at 50″ pension, will collect 90% of their salary in retirement, and they will need to contribute 32.5% of their pay into their pension fund every year they work. On that basis, 9% is less than one-third what will be necessary to fund their retirement pension. But what if the pension funds return less than 4.5% (7.5% before inflation) per year?

As can be seen, for every 1.0% the real rate of return drops, the required contribution increases by over 10%. That is, if CalPERS can only deliver a 6.5% return (3.5% after inflation), the contribution goes up from 32.5% of salary to 43.4% of salary. If CalPERS rate of return goes down to a 5.5% return (2.5% after inflation), the contribution goes up from 32.5% of salary to 57.9% of salary.

Nobody seriously questions the fact that police and firefighters deserve to be paid a premium for the work they do. But how much of a premium is appropriate? A self-employed independent contractor has to pay the employer and employee share of social security. That means they have to pay 12.5% of every dime they make into the social security fund. And if they are fortunate enough to earn, at the end of their careers, what the average veteran police officer or firefighter makes – let’s lowball that at $100K – they will get a social security benefit, at most, of $30K per year at age 68. This equates to a pension formula of roughly “0.75% at 68″ vs. “3.0% at 50.”

Public sector workers, all of them, should consider these apples-to-apples comparisons to the taxpayers in the private sector who support them, when they suggest that 9% is an appropriate or commendable amount for them to be contributing to their pension funds. They should be prepared to explain why they aren’t contributing at least 50% of the cost for their pensions, with that contribution going up whenever projected rates of return for their pension funds go down.

California Legislature Aims to Kill Initiative Process

California’s legislature is moving a bill forward that will throttle back the ability to place citizen initiatives on the statewide ballot. As noted in Ballot Access News on May 10th in a post entitled “California Democratic Legislators Advance Bills Injuring Ballot Access for New Parties, Initiatives,” the bill is nearing passage by both houses of California’s legislature:

“On May 9, the California Senate passed SB 168, which makes it illegal to pay circulators on a per-signature basis, if they are working on initiative, referendum, or recall petitions. On the same day, the Senate passed SB 448, which forces circulators of those kind of petitions to wear a button that tells whether they are paid or volunteer. These bills also passed on party line votes, with all Democrats voting “yes” and all Republicans voting ‘no.'”

The impact of this legislation, which is expected to pass the Assembly and get signed by California Governor Brown, will be to double (or even triple) the price of successfully placing a citizen initiative onto California’s state ballot. Anyone who has tried to raise money to qualify a state ballot initiative knows what an advantage the powerful special interests have in this high-stakes political niche, whether they are public employee unions or large corporate interests. Only grassroots organizations with limited access to funding, from taxpayer groups to progressive organizations, are negatively impacted by this legislation.

From Citizens In Charge, a website dedicated to protecting the initiative process across the U.S., here’s more on how SB 168 is going to undermine the ability of Californians to do anything about their out-of-control, over-paid government worker unions who are systematically consolidating their absolute domination of California’s state and local governments:

Citizens in Charge Opposes California Senate Bill 168, March 15, 2011 – “SB 168 bans ballot committees and individuals from paying people who circulate petitions for initiatives, referendums and recalls on the basis of the number of signatures they collect. It would mean that a person who paid his daughter $100 if she’d work until she gathered 100 signatures could spend a year in jail, and his daughter up to six months. Campaign committee members of a group that awarded a free dinner at a local restaurant for the volunteer who collected the most signatures that day could likewise be arrested and incarcerated or fined. There are several important reasons to reject SB 168. The legislation will drive up the cost of petitioning a measure onto California’s ballot. Because paying petition circulators by the signature gives them an incentive to work harder, it is the most cost effective means available.”

SB 168 is not the only way that powerful public employee unions are moving to protect their power and preserve the overmarket pay and benefits they have “negotiated” with the politicians they elect. Another bill moving through California’s state legislature will restrict the ability of local governments in California from declaring bankruptcy (ref. AB 506 text), which is virtually the only way they can get out from under literally tyrannical collective bargaining agreements.

The idea that SB 168, which will preserve the ability of corporations and unions, who will still have ample financial resources to file initiatives, but will edge out of the field grassroots organizations, should put completely to rest the idea that these unions represent “working people,” or are trying to “save the middle class.” They are America’s version of Soviet Russia’s nomenklatura, a bureaucratic elite that enjoys special privileges. Through their pension funds which confiscate the earnings of private sector taxpayers for the benefit of government workers, these public employee unions are accomplices of Wall Street, and they are in collusion with the very largest corporations to eliminate competition.

The agenda of the leadership of public employee unions, whether or not they admit it even to themselves, is to create a nation where they have empowered the corporate monopolies, the super-rich, and their growing ranks of government worker protectors, while maintaining a precarious symbiosis with a similarly multiplying but impoverished, minimally productive class of citizens who who pay zero (or negative) taxes and have been rendered utterly dependent on government entitlements. Those who remain, outnumbered, outspent, and outvoted, nonetheless drive the economy and improve our lives through their job-creating entrepreneurship, disruptive innovation, perilous risk-taking, and unrelenting hard work. Yet they are left to be tainted and taxed into oblivion, because they are the evil “capitalists.”

Preserving America’s Retirement Security

An interesting analysis was published last week on Reason.com by Emily Ekins entitled “Differences on Social Security Reform.” In her article, Ekins presented data from a poll that asked whether or not the respondent would support or oppose reducing Social Security taxes and allow individuals to invest in their own retirement instead.

The results were stratified by age, education, income, ethnicity, gender, political ideology, party affiliation and union membership. Some of the results were predictable and showed strong polarization – the older the respondent was, for example, the more likely they were to favor preserving social security as it is, and the younger the respondent was, the more likely they were to favor reducing social security taxes and benefits. Another obvious result from the survey was the split between progressives and libertarians, where the mirror image expressed by their sentiments – progressives 58% vs. 35% opposed, libertarians 57% vs. 31% in favor – bordered on parody.

Crucially, Hispanic voters, rising demographically in the U.S., were opposed 52% vs. 38%; African Americans also opposed lowering social security taxes and benefits, 59% vs. 32%. One needn’t read too much into that, while Hispanics may be destined to become the decisive swing vote in elections of the future, if not already, their political sentiments may change. But reality is about to trump the political debate between those who believe in the ownership society and those who believe in the great society.

The most glaring example of “ownership society” ideology in practice, ironically, is that of the government employee pension funds, and their union apologists. They not only believe, like many libertarians, that investment returns can yield a lifestyle in retirement far, far greater, per input, than one fueled merely through transfer payments from taxpayers, but they have put it into practice. Unlike libertarians, of course, the government employees expect taxpayers to cover the difference when their collectively invested inputs fail to yield the lifestyle in retirement they’ve defined for themselves.

The problem with all this “ownership,” however, rests on two twin phenomena that will derail extravagant, investment return fueled retirements whether they are those of collectively invested public employee pension funds, or individually invested 401K accounts. They are the reality of the American (and global) economy’s debt hangover that has just begun, which is going to cause real returns on invested funds to drop precipitously, combined with the reality of an aging population both inside and outside the public sector. The private sector worker-to-retiree ratio in America will drop from roughly 3-to-1 today to 2-to-1 within the next 20 years; the public sector worker-to-retiree ratio is on track to move from today’s 2-to-1 to nearly 1-to-1 within the next 20 years (based on their lower retirement ages).

The basis for these worker-to-retiree ratios, as well as calculations that estimate how much taxpayers will pay, and retirees will receive, under various realistic assumptions, are explored in depth in the posts “The Cost of Government Pensions” and “Funding Social Security vs. Public Sector Pensions,” but here’s a summary:

On a pay-as-you go basis, if a retiree receives a defined benefit equal to 2/3rds of their average career salary, and there is one worker for each retiree, then each worker must set aside 2/3rds of their paycheck to fund their retirement. This is a roughly accurate presentation of what the public sector faces. On the same basis, if a retiree receives a defined benefit equal to 1/3rd of their average career salary, and there are two workers for each retiree, then each worker must set aside 1/6th of their paycheck to fund their retirement. This is a roughly accurate presentation of what social security faces.

As calculated in the post “The Cost of Government Pensions,” because public sector workers, on average, make 50% more in base salary than private sector workers, the projected amount of retirement payments for the 20% of the working population who are government employees will actually exceed the projected amount of social security payments to the entire remaining 80% of America’s workers (to calculate this, you have to also take into account the fact that government workers, because they retire earlier, comprise 30% of all retirees even though they are roughly 20% of all workers, i.e., if “S” represents salary, [(S + .5S) x .66 x .30] > [S x .33 x .70]). And the government worker unions who cling to the fiction that these levels of benefits are sustainable suggest that this disparity doesn’t matter, because investment returns will obviate the need for pay-as-you go funding. Those libertarians who actually think that an “ownership” society, where social security is scrapped and everyone invests, will enable everyone to enjoy this level of retirement benefits, are even more delusional. Government employee pension funds that cover 20% of the workforce are already the biggest players in the investment market – they must beat the market to deliver the returns they claim they can deliver for decades on end. Libertarians apparently think that 401Ks invested by 100% of the workforce can beat the market too. You can’t beat the market when you are the market.

This is perhaps the prevailing financial question of our time: What real rate of return can be siphoned out of retirement accounts to augment taxpayer generated pay-as-you go retirement funding, when there are only two workers for every retiree, and 100% of retirees depend on these investment returns? Put another way, if retirees who number 1/3 of the entire population are pulling money out of invested funds, can those funds, in aggregate, even match the rate of general economic growth, much less exceed it?

Seen in this context, it may be that ideology and wishful thinking will be trumped by economic and demographic reality. Public sector pensions and 401Ks alike may not be able to perform to expectations when more people are retiring than ever, and economic growth itself is constrained because growth is no longer catalyzed by debt accumulation. In this environment, social security, which already (notwithstanding a most irresponsible temporary lowering of the rate of employee withholding) claims through the employee and employer a combined 12.5% of payroll, is revealed as pretty much sustainable. At a rate of withholding increased to 1/6th of pay, or 16.7%, social security benefits will be solvent forever. If that rate of withholding, from 12.5% to 16.7% is unpopular with voters, than means-testing, raising of the retirement age, raising of the absolute ceiling on withholding, or reduction of benefits can make up the difference. But the adjustments necessary to preserve social security, which is a defined benefit, are incremental.

On the other hand, when pension funds acknowledge that their projected rates of return cannot be achieved (the idea they can earn 7.75% per year when the Fed borrows money at less than 1.0% per year is absurd), they will be revealed to be completely insolvent (for more on this read the posts “How Rates of Return Affect Pension Contribution Rates,” and “How Rates of Return Affect Required Pension Assets“). On a pay-as-you go basis, public employee pensions would have to contribute 66% of base pay from current workers to support retirees. On an aggregate basis, the funds necessary to pay retired public employees, who represent less than 20% of the workforce, will actually exceed the funds necessary to pay social security benefits to everyone else, representing more than 80% of the workforce.

The good news here is that as investment returns are revealed, through economic and demographic reality, to be far from adequate means to sustain America’s retired population, taxpayer funded defined benefits will be the only choice left. This, in-turn, in order to be sustainable and equitable, will mean that while public employees will continue to receive defined benefits, and while for many strata of the public sector workforce these defined benefits may still exceed what social security would pay, overall their benefits will have to be greatly reduced. Taxpayers cannot be expected to contribute 16.7% of their payroll to keep social security solvent in the future, yet at the same time also pay taxes that would amount to another 16.7% of their payroll simply to keep public sector pensions (as they are currently formulated) solvent as well.

The solution to providing for retirement security in America is to retain defined retirement benefits for everyone, providing all workers a defined benefit in the form of social security, with premiums granted in some cases to government workers who endure risks in their professions. This will require a modest increase in the rate of social security withholding, from 12.5% to 16.7%. If the social security trust fund and all public sector pension funds were then invested in short-term T-bills, it would both hedge these funds against inflation, eliminate their volatility, and provide a market for federal debt. It would also remove speculative taxpayer-funded Wall Street gamblers from the market – public sector pension funds who pursue risky investment strategies, motivated by a need to deliver over-market returns.

Rationalizing the taxpayer-funded elements of retirement security in the ways just described would also return the market to individual investors. Eliminating taxpayer funded, aggressively managed, trillion dollar pension funds, whose sophisticated machinations extract over-market returns, would allow privately managed funds and individuals to again receive market-rate returns on their investments without having to engage in inordinate risk. Breaking the tyranny of Wall Street pension funds, and their last, biggest suckers, the government worker union leadership who – again quite ironically – believe these trillion dollar pension funds can beat the market forever, will provide Americans the best of both worlds. They will all have secure, sustainable defined retirement benefits, and they will have a market for their supplemental 401Ks that again delivers a decent return to small investors.