Tag Archive for: are public sector pension investments distorting markets

Teacher Pension Solvency

A fairly typical pension plan for a public school teacher in California is as follows – if they retire at age 55, they receive 1.4% of the average of what they were paid during their three consecutive years of highest pay. If they retire at are 60, the multiplier increases to 2.0%, and if they retire at age 63, it will be 2.4%. Also fairly typical are the following rates of contribution into the pension fund – the employee contributes 8.0% in the form of payroll withholding, and the employer contributes an additional 8.25%. This post is to examine what rate of return on the pension fund is necessary in order to maintain solvency under these terms.

If you check the Actuarial Life Table courtesy of the U.S. Social Security Administration, you will see that the average 63 year old American male has a life expectancy of another 18 years, and the average American female at age 63 has a life expectancy of 21 years. To be conservative, assume the pension fund will need to retain a positive balance for 18 years after retirement – taking the average would require a higher rate of return, but in the interests of always using conservative assumptions, we’ll go with 18 years.

Following this text are three tables that show the results of a baseline case and two what-ifs. In the baseline case, the teacher commences work at age 26, works for 38 years, then enjoys 18 years of retirement. During their career, their real income (after inflation; all figures used are after inflation) doubles between when they are hired and when they retire, increasing at an even rate over the 38 years. In combination with their employer, each year a sum equivalent to 16.25% of their earnings are contributed into their retirement pension fund, where it is invested. The fund earns a real rate of return (after adjusting downwards for inflation) of 4.75%. This is the official real rate of return currently used by California’s major public employee pension funds in their projections.

As table #1 indicates, using these assumptions, the pension fund will remain solvent for 18 years, earning 4.75% on a declining balance, which doesn’t dip into negative territory until the 19th year after retirement. But what happens if the long-term rate of return dips below 4.75%?

For reasons explored in great depth in other posts, it is important to consider the possibility that the real rate of return on a gigantic pension fund, managing hundreds of billions in assets, may not be able to sustain a real rate of return of greater than 3.0%. The point of this post isn’t to explore that question – although that question is THE question that urgently needs to be explored – but to illustrate how dramatically the contributions to this pension fund will need to be increased, if the long-term rate of return to the fund is decreased.

In table #2, the same assumptions are considered with one exception: Instead of earning 4.75% after inflation, the rate of return is 3.0%. And by making this change, the fund becomes insolvent in 9 years instead of 18. Reducing the real rate of return by 1.75%, in this model, cuts the period of positive fund balance in retirement by half.

In table #3, the same assumptions used in table #2 are repeated, that is, the real rate of return is lowered to 3.0%, but the annual contribution is increased to an amount sufficient to render the fund solvent for 18 years. In order to accomplish this, instead of contributing 16.25% per year, the teacher and employer will need to contribute 26.5% per year, an increase of 63%. Put another way, if California’s approximately 770,000 teachers, on average, made $60,000 per year (which is the mid-career average used in our example), and they all were under the pension plan shown here, then the pension fund contribution for all of California’s teachers would increase from $7.5 billion per year to $12.4 billion per year.

Worth mentioning is the fact that return on investment is only one major element in the debate. Less discussed, but equally relevant is why public employee pension funds are investing in the private market at all? Why aren’t they purchasing low-risk treasury bills and staying out of the markets? Why are we seeing America’s public employee pension funds invest $250 billion (or more) per year into Wall Street investments, at the same time as their marketing departments and political consultants bombard naive voters with entreaties to “spare public employees the volatility of 401K funds and greedy Wall Street brokers”? Is there no irony here? No hypocrisy? Why are public employee pension funds pouring money into Wall Street investments in a desperate attempt to get high enough rates of return to preserve solvency, when doing so completely distorts our markets and destroys sustainable investment opportunities for everyone? And if we’re going to ruin our markets with too many passive funds chasing too few active investment opportunities – why isn’t the social security fund also investing into the market? Would that make it too obvious what’s going on? Why are public sector pension funds – our government workers – allowed to buy up and control huge portfolios of private assets? (ref. The Axis of Wall Street and Unions, or Pensions: Giant 401K Plans).

Getting back to our typical California schoolteacher, it is fair to wonder: Why is someone entitled to retire after 38 years and collect, for life, with cost-of-living adjustments, a pension equivalent to 91.2% of the highest salary they ever made, and more to the point, how can anyone possibly think such generosity is financially sustainable? In the real world, a private sector taxpayer who contributes – a 50/50 split with their employer – a combined 12.4% into the social security fund, who makes $85K when they retire at age 63, will receive $17,000 per year from social security for the rest of their life (ref. Social Security Calculator). A public school teacher who makes about this – our example used $80K per year – when they retire at age 63, will get $72,960 for the rest of their life. The public servant, contributing marginally more into their retirement fund, 8.0% vs. 6.2%, or combined with their employer – since that is true compensation, 16.25% vs. 12.5% – collects 4.3x more in retirement benefits. Market returns cannot and will not sustain this differential.

Facts like this make the antics, the agenda, and the ideology of public employee unions very hard to contemplate with equanimity.