Pricing A Taxpayer Bailout of California’s Pensions

Last month both of California’s largest government employee pension funds, CalPERS and CalSTRS, released their portfolio earnings numbers for the most recent twelve months. In a statement released on January 24th, “CalSTRS Calendar Year-End Investment Returns Show Slight Gains,” CalSTRS disclosed “Investment returns for the California State Teachers’ Retirement System (CalSTRS) ended the 2011 calendar year posting a 2.3 percent gain.” CalPER’s statement released on January 23rd, was titled “[CalPERS} Pension Fund earns 1.1 percent return for 2011 calendar year.”

These funds, and the rest of California’s many local government employee pension funds, are still clinging to long-term rate of return assumptions of between 7.5% and 7.75% per year. So how much would taxpayers be on the hook for if rates of return stay this low?

The first step towards determining this would be to estimate the average pension paid out to a state or local worker in California, based on recent retirees who have worked a full 30 year career. Despite the claim that “The average CalPERS pension is $2,220 per month” (made yet again in the final paragraph of their above-referenced press release), for a more accurate figure, one must look at the average pension awarded recent retirees, based on a full 30+ year career. The problem with the low figure used by CalPERS and others is that it includes people who retired decades ago when salaries and pension benefit formulas were much lower, and it includes people who may have only worked a few years for the government. Since we will be multiplying this average pension by the number of full time state and local government workers in California, we have to assume a full career when calculating the average pension, since for every worker who only worked 10 years, for example, two additional retirees will also be in the system who have themselves also only worked 10 years. To calculate the cost of a full-career pension, you have to add all three of these part-career retirees together. Here is what these pensions really average, based on CalPERS Annual Report FYE 6-30-11 (page 153), and CalSTRS Annual Report FYE 6-30-11, (page 149):

CalPERS average final salary for 30 years work, retiring 2010: $82,884
CalPERS average pension for 30 years work, retiring 2010: $60,894  –
Pension equals 73% of final salary (average of 25-30 year and 30+ year stats)

CalSTRS average final salary for 30 years work, retiring 2010: $88,164
CalSTRS average pension for 30 years work, retiring 2010: $59,580  –
Pension equals 68% of final salary (average of 25-30 year and 30-35 year stats)

If one extrapolates the CalPERS and CalSTRS data to the many independent pension funds serving local agencies – many of these are quite large, such as the one for Los Angeles County employees – it is probably conservative to peg the average pension going forward for full-career government workers in California at at least $60,000 per year, and at least 70% of final salary.

The next step in figuring out how much state and local government worker pensions could cost California’s taxpayers in the future is to establish the sensitivity of pension contribution rates to changes in the rate of return of pension funds. CIV FI has explored this question repeatedly, with a good summary in the July 2011 post entitled “What Percent of Payroll Will Keep Pensions Solvent?” Using the same financial assumptions as were used in that analysis, here is how the required pension contribution rates – expressed as a percent of payroll – change in response to lower earning rates for the pension funds. This is based on pensions averaging 70% of final salary, and assumes 30 years working, 25 years retired, and salary (in real dollars) eventually doubling between hire date and retirement date:

If the pension fund’s return is 7.75%, the contribution rate is 22% of payroll.
If the pension fund’s return is 6.75%, the contribution rate is 28% of payroll.
If the pension fund’s return is 5.75%, the contribution rate is 37% of payroll.
If the pension fund’s return is 4.75%, the contribution rate is 48% of payroll.
If the pension fund’s return is 3.75%, the contribution rate is 63% of payroll.

What the above figures quickly indicate is not only that the required payroll contributions go up sharply when projected rates of investment return come down, but that the lower the rate of return goes, the more sharply the required contribution rises.

To complete this analysis, one only needs to multiply the number of full time state and local government employees in California by the average payroll for these employees, and multiply that result by the various required contribution rates. Using 2010 U.S. Census data for California’s State Employees and for California’s Local Government Employees, one can quickly determine that there are 339,430 state workers earning on average $68,880 in base annual salary, and there are 1,185,935 local government workers earning on average $69,399 in base annual salary.

To sum this up, there are currently 1,525,365 full time (not “full-time equivalent,” which would be an even higher number, but those part-time employees may or may not have pension benefits) state and local government employees in California. They earn, on average, $69,284 per year in base pay. Here is how much pensions will cost for these workers each year based on various rates of return:

If the pension fund’s return is 7.75%, the state pays $23 billion to pension funds each year.
If the pension fund’s return is 6.75%, the state pays $29 billion to pension funds each year.
If the pension fund’s return is 5.75%, the state pays $39 billion to pension funds each year.
If the pension fund’s return is 4.75%, the state pays $51 billion to pension funds each year.
If the pension fund’s return is 3.75%, the state pays $66 billion to pension funds each year.

It is interesting to note that both CalPERS and CalSTRS failed to even achieve a 3.75% return in calendar year 2011, the lowest amount used in these examples and the lowest amount that can even keep pace with inflation.

When one takes into account the fact that only about five million households in California pay net taxes, the impact of the pension con job Wall Street brokerages have enlisted the support of public sector unions to foist onto taxpayers is even more dramatic. Because if, during the great deleveraging that likely will consume this economy for at least another decade, California’s pension funds only deliver 3.75% per year, instead of 7.75% per year, that will translate into $8,600 per year in new taxes for each and every taxpaying California household.

Preserving America’s Middle Class

To say America’s middle class is threatened is a common refrain. But there is no malevolent force operating to shrink America’s middle class. America’s middle class is challenged by the momentum of history. Technology automates jobs at the same time as the capacity of foreign manufacturers continuously improves. At the same time, American taxpayers confront the challenges of providing for an aging population as well as choosing what is affordable from an expanding array of social welfare and safety-net choices. In some respects, America’s middle class is a victim of its own success – we live longer, we have better medical technology, our productivity is continuously improving, and American military power – expensively purchased – enables competitive global commerce. Here then, relieved of ideological cant, are the reasons for America’s shrinking middle class:

(1) More money is needed to take care of retirees, and investment returns will no longer cover most of the costs. America’s aging population creates higher demand for liquidity, because retired people need to sell assets to generate cash to pay bills. As an ever higher percentage of America’s population are retirees, there will be more sellers in the investment market, dampening prices and price appreciation. This will lower rates of return on retirement investments and, in turn, all assets.

(2) Advancing technologies have automated millions of jobs. From office information systems to robotic manufacturing, innovation has eliminated the need for millions of highly educated, highly skilled workers. Despite rising productivity, workers have been relentlessly displaced. Entire industries have experienced steady growth at the same time as they have reduced their workforces.

(3) International competition to export products has never been more challenging. Nations create jobs more easily if they are net exporters. During the half-century beginning around 1950, America went from being the only industrialized nation left standing in the wake of WWII to being reduced to 25% of global GDP. Still the world’s largest economy by far, the U.S. has not been a net exporter for nearly twenty years – instead the U.S. relies on foreign purchases of U.S. assets to offset chronic trade deficits.

(4) The ability of the U.S. economy to sustain a trade deficit via debt accumulation is not unlimited. The sheer size and diversity of the U.S. economy buys time, but Americans already carry an unusually high debt load. To the extent that interest payments are remitted to offshore creditors or offshore corporations, American borrowing to finance imports is sending cash and jobs overseas.

(5) Failure to regulate speculative lending, combined with the internationalization and automation of trading in stocks and other assets has enabled America’s debt bubble to reach unprecedented levels. The last time the total market debt in the U.S. exceeded 300% of GDP, America’s economy experienced the great depression. Total market debt in the U.S., not including derivatives, approaches 400% of GDP.

The way to preserve America’s middle class requires embracing disruptive innovation and competition.

In a age where the U.S. no longer owns virtually all the productive assets in the world, the ebb and flow of trade balances between nations requires them to take turns either relying on debt accumulation and asset inflation to finance their trade deficits, or being nations that eliminate debt and have positive cash flows through being net exporters. Because innovations deliver increasing productivity, this ebb and flow can yield aggregate net asset values of all nations combined continuously increasing. As long as these asset values increase, debt accumulation does not have to stop completely. If collective global asset formation has sufficient momentum, even nations who are net importers and are accumulating debt can still improve their debt to asset ratios, rendering them economically healthier.

The key to economic growth, however, is not just to increase productivity through supporting technological innovation, which is difficult enough by itself. Nations also must support policies that lower the costs for basic resources, energy, water, land, materials. This requires competitive resource development, something that is resisted by powerful special interests, corporate, labor, environmentalist and government, who all benefit from high prices and high profits for basic necessities. But if competitive resource development enabled these commodities to be consumed at lower prices, this would release capital for investment in, as well as consumption of, entirely new classes of assets that technological innovation is delivering at an accelerating rate. Increasing productivity through technology is creative destruction, and, crucially, results in asset deflation and lower profit margins in the monopolistic sectors being disrupted, but this is nonetheless desirable because it is the only way sufficient capital can flow instead into investments in entirely new classes of valuable, previously nonexistent assets. Only by creating new assets in new industries can technological innovation ensure a continuous increase in global economic wealth, and hence more collateral to improve debt / asset ratios. These new areas for investment and asset formation will issue from ongoing and dramatic technological innovations in the fields of health care and life-extension, entertainment and transportation, expansion of settlements and industry into outer space and the deep ocean, and myriad other compelling products and services we can’t yet imagine.

This is one of the unheralded tragedies of a malthusian “setting limits” mentality common to environmentalists and coopted by corporate and union cartels. Despite daunting challenges that span every continent and culture, human civilization is experiencing a golden age of technological advancement – steady improvements to the collective global per-capita standard of living – and that golden age may be denied fruition by misguided policies designed to curtail development of energy and other basic resources. By encouraging competition to provide these commodities at lower prices, capital becomes available to eliminate debt and invest in new industries. This allows for more rapid increases in per capita wealth and lower birth rates. Ultimately, tomorrow’s global energy consumption and resource depletion will be less if rapid energy development occurs today.

America’s middle class faces new rules, but these new rules are actually the historical norm for peoples in the world. The aftermath of WWII, which bestowed on the U.S. a pent-up ability for consumer product innovation, a uniquely intact industrial base, and an explosion of births that, for a while, kept pace with advances in life-span, was an aberration without precedent in human history. The good news is that the absolute median standard of living for Americans continues to improve. From the poorest person to the richest in America, as well as throughout the polarizing middle, the available amenities consistently exceed, year after year, what has come before.

America’s middle class is indeed threatened, insofar as the economic distance between those at the top and those at the bottom is widening, and the percentage of people in the middle is declining. But by embracing competition and innovation of all types, Americans, who remain at all strata better off than they have ever been, can climb out of their debt quagmire and usher in the next phase of the digital renaissance.

The Faces of the Forgotten 33%

Last month a post entitled “America’s Forgotten 33% ” described those Americans who are not members of the elite 1% super-rich, nor part of the privileged 20% who work for the government, nor among the nearly 50% of America’s population who are, apparently, poor enough to avoid taxes altogether.

Who are these forgotten 33%? Who is this one-third of America, people who, compared to the other two-thirds, pay far more in taxes than they receive in return? Who are the faces of the forgotten 33%?

  • They are small business owners who can’t compete with the crony capitalist captains of big business, who use their financial influence with legislators to enact regulations that small businesses can’t possibly afford to comply with.
  • They are independent contractors who work multiple jobs to earn a mid-five-figure annual gross income, yet pay nearly 50% in taxes on every extra dollar they make (25% federal, 9% state, 13% social security and medicare).
  • They are small investors whose retirement savings lose value at the same time as government employee pension funds beat the market using high-frequency trading and other manipulative tactics that individual value investors can’t hope to emulate (and hold taxpayers accountable to cover the difference when they don’t beat the market).
  • They are parents who can’t get a decent education for their children in public schools, because the teacher’s union makes it impossible to fire bad teachers, and creates a self-serving bureaucracy where administrators outnumber teachers. Parents who have no chance to influence local or state education policy because the teacher’s union will spend literally millions to elect their puppets on school boards.
  • They are elected public officials at the state and local level – especially in the large urban centers – city councilmen and county supervisors – who have to close parks and libraries, and defer maintenance of roads and other infrastructure, because they are bound to pay local government employees wages and benefits that are often more than twice what people might earn for similar work in the private sector.

And the forgotten 33% have friends among the rest of the American people.

  • There are the millions of government workers who deliver an honest day’s work and do their jobs well, yet watch people who merely show up get the same compensation and enjoy the same job security as they do, thanks to union work rules and collective bargaining. And there are additional millions of government workers who are tired of seeing their union dues used to promote politicians and causes they don’t support.
  • There are activists, entrepreneurs, educators, and many others within the disadvantaged communities who have seen for themselves the destructive impacts of government welfare and other social programs.
  • There are members of the elite 1%, the super rich, who want to invest in America but face record high taxes, and industry after industry controlled by special interests who have created regulations designed to protect their turf and deter genuine competition.

How long can the alliance of the big – big government, big finance, big labor, and big business – continue to render more and more citizens dependent on entitlements, buy off the unionized government workers with pay and benefits that greatly exceed market norms, and pursue fiscal and monetary policies that channel more and more wealth to the elite 1% (ref. “The Extremists of the Status Quo“)?

How long can the alliance of the big continue to rely on taxing the forgotten 33% to fund the entitlements, the pensions, and the Wall Street bailouts?

What combination of the forgotten 33% along with their friends among the other two-thirds of America’s electorate might form a new alliance – the alliance of the accountable? How might such an alliance strike an optimal balance between preserving individual incentives and providing ALL workers a reasonable taxpayer-funded safety net for health and retirement security (ref. “Merge Social Security and Public Pensions”)? A critical first step towards forming a political coalition powerful enough to take on the alliance of the big is for voters to recognize that public sector unions are just as much of a barrier to achieving those goals as the monopolistic corporate and financial interests.

America’s Forgotten 33%

Much has been made of the 1% vs. the 99%; the “super-rich” vs. the rest of us, who are presumably the hard working, loyal Americans who’ve been left behind. But who are the rest of us, and how does who we are affect how much we pay in taxes, and how we may vote?

The chart below depicts the American electorate divided not into two groups – the 1% vs. the 99%, but four groups – the 1% super-rich, then 20% representing government workers, 46% representing citizens who either pay zero taxes or negative taxes (ala the “earned income credit”), and the remaining 33% who are neither super-rich, government employees, or not paying taxes. One might term this group the forgotten 33%, because no special interest will speak for them. They have neither the numbers nor the financial wherewithal to decisively influence elections.

The choice of colors – red for the 20% political class AND for the 46% entitlement class, is not accidental. These voters have an identity of interests that automatically inclines them to favor more government spending; government workers because more government spending means more job security, higher pay and benefits, and more expansion of their organizations, and citizens who pay no taxes because their economic status is enhanced through receiving entitlements for which they bear no share of the costs. This identity of interests between the political class and the entitled class has created a supermajority of voters in America who have a self-interest in supporting big-government.

Perhaps the most appalling – and unchallenged – fallacy promoted by the big-government supermajority, primarily through their spokespersons in the public sector unions, is that the super-rich are “trying to destroy the middle-class by pitting the private sector workers against the public sector workers.” Nothing could be further from the truth.

The middle class can indeed be represented by the 20% of the population who works for the government, combined with the 33% of the population who works in the private sector and make enough money to pay income taxes. But the similarity ends there. Government workers have pay and benefits that are, on average, twice what private sector workers earn. Their pension funds offer defined retirement benefits that are literally five times better, on average, than what private sector workers collect from social security.

While the government worker union spokespersons want us to believe that Wall Street is trying to divide and conquer the middle class by pitting private sector workers against government workers, the truth is this: Government workers have joined with Wall Street and turned against the private sector taxpayers, because it is in their mutual economic interests to do so. Nothing illustrates this fact more clearly than the existence of nearly $4.0 trillion in government employee pension fund assets, paid for by taxpayers, invested and managed by Wall Street, with taxpayers guaranteeing the returns (if the investments fall short, taxes go up), and government workers guaranteed the defined benefit that allows them to retire, on average, 10-15 years earlier than private sector workers, with pensions that average 3-4 times as much money as social security.

The “super-rich” embody, of course, more financial interests than just those of Wall Street bankers. But Wall Street bankers, who used their bipartisan political influence to over-build America’s financial sector and defer any sort of meaningful regulations that might have introduced competition and accountability into their industry, are the ones who most deserve the ire of the American electorate. They are also the ones who are most co-dependent with the political class, because there is no source of money pouring into Wall Street that comes anywhere close to the hundreds of billions each year that taxpayers have to fork over to the public employee pension funds.

To turn around and suggest that somehow the super-rich are aligned with the forgotten 33% – those middle-class private sector workers who make enough to pay taxes – strains credulity. Both the super-rich as individuals and the super-rich to the extent they are associated with corporations or financial institutions are completely bi-partisan in their political contributions. For that matter, Republicans are only scarcely less addicted to big government programs and higher taxes than Democrats. Many of the super-rich are not capitalists in the most virtuous and productive sense of the word – they aren’t trying to altruistically imagine innovations that will make our lives better, then fighting to convince people to voluntarily purchase these products – they are using their political influence to lock out competitors, access government subsidies, and force people to purchase their products through laws and regulations.

Here are reasons why the super-majority of the political class and the entitlement class is unsustainable:

(1) The much higher compensation and benefits for government workers relative to private sector workers, and the nearly unassailable political influence they now wield through their unions, are both factors that have slowly emerged over the past 10-20 years, but never before existed.

(2) Only now are the demographic implications of an aging population (along with recently enhanced retirement benefits for government workers) making a real impact on government budgets.

(3) Medical treatment options are now so effective and expensive that medical spending must legitimately occupy a greater percentage of GDP than historically, and funding this cannot occur if 66% of the population pay no taxes.

(4) The size and extent of government and government regulations are greater than ever, putting additional pressure on the economy.

America’s forgotten 33%, those who are neither entitled to avoid all taxes, nor members of the political class who pay no taxes, nor the super-rich, might be called “The Atlas Generation.” They carry the world on their shoulders. Their challenge is daunting – they must convince the political class to support sustainable taxpayer funded benefits under formulas that apply equally to ALL workers, public or private, without relying on Wall Street speculative investments to pay for this. Equally challenging, they must convince the entitled class that there is an alternative to identity politics, the politics of envy, and the cycle of government dependency. And they must convince a critical mass of the politically influential super-rich to embrace and advocate a political economy that nurtures competition instead of crony capitalism.