That Which is Unsustainable Will Go Away: Pensions (May 15, 2012)
Publicly funded pensions and Medicare are two examples of unsustainable systems that will go away in the decade ahead. Today we look at pensions, tomorrow we examine Medicare.
One of the few things we know with certainty is that which is unsustainable will go away and be replaced by another more sustainable arrangement. Whether we like it or not, or are willing to accept reality or not, unsustainable public pensions will go away.
What makes "defined benefit" pensions unsustainable? 1) Promised cash/benefits packages that are not aligned with the fiscal realities of what can be contributed annually to the pension funds 2) New Normal low yields on low-risk investments and 3) skyrocketing costs of healthcare benefits.
This is easily illustrated with basic math. Recall that defined pensions are not "pay as you go" plans like Social Security, where the taxes paid by today's workers fund the benefits distributed to today's retirees; "defined benefit" pensions are supposed to be paid out of a pension fund which generates returns sufficient to pay the retirees' benefits.
In a typical small coastal city (112,000 residents) in California, senior police officers receive annual pensions in excess of $100,000. Generous benefits (healthcare coverage, etc.) for life add another $20,000 or so a year, so the annual payout is roughly $120,000 a year per retiree.
Less senior city employees receive pensions and medical benefits around half that amount, or $60,000 a year.
These pensions are not out of line with what other cities on the Left and Right coasts have promised their employees.
The city has 1,637 full-time employees and 518 part-time employees. The average full-time wage (not including benefits and pension contributions) is $85,726. The estimated median household income for the city is $60,625.
Assuming the pension funds are managed conservatively, how much money would have to be set aside to fund a single pension/benefits payout of $120,000 a year and one of $60,000?
The yield on 10-year Treasury bonds is less than 2%, about in line with the average dividend on stocks.
That means that a conservatively managed portfolio of stocks and bonds now yields around 2%. At this rate, a pension fund would need $6 million in cash to fund the $120,000/year cash/benefit payout--$6 M X .02 = $120,000. The fund would need $3 million in cash to fund the $60,000/year cash/benefit payout.
If the senior police officer worked 30 years, then the city would need to contribute about $200,000 a year to assemble the $6 million in cash. That's $16,700 per month for 30 years. The $60,000/year cash/benefit pension would require "only" $8,350 to be contributed every month for 30 years.
(Yes, the interest earned on the early years of contributions would reduce the total contributions needed to reach the $6 million total, but in the real world cities stopped contributing to their pension funds during the "good years" of high returns, and pension funds assets decline in market downturns, wiping out years of gains in a few months. Assumptions and projections do not track reality.)
To fund 100 senior retirees and 200 less-senior retirees, the city pension fund would need $1.2 billion, roughly equal to 10 years of the city's entire general-fund annual budget. To fund 600 retirees, the fund would need $2.4 billion.
Recall that the Federal Reserve has implicitly promised to hold interest rates to near-zero indefinitely. The 2% annual yield is not an aberration, it is the New Normal.
Those pension funds that attempt to increase their yield by gambling on stocks, derivatives, real estate, etc. will blow up when these risky markets decline/implode, as all risky markets do over time.
Please "do the math" on your own city, county and state's pension promises, the skyrocketing cost of the promised medical/healthcare benefits, the yield pension funds can safely earn in the real world, and the total assets currently in the pension funds. There is no way to make the math work such that the pensions and benefits promised can be paid in the real world.
Wishing the math were different does not make it different. We can play around with yields and payouts, but adjusting the margins doesn't change the basic reality that the promised pensions are structurally underfunded in a 2% yield world.
Important addendum: Correspondent Y.W. provided this actuarial analysis of the numbers I projected:
I have been an avid reader of yours for a while now, and your latest titled "That Which is Unsustainable...." contains what I think is a bit of an error. You wrote that to fund a $120K cash benefit pension, a pension fund would have to sock away $6,000,000 dollars ($6 million X 0.02 = $120 thousand). However, this is only true if the pensioner lives forever, all else being equal. In the real world, the accumulated capital would be slowly drawn down to pay an increasing portion of the cash benefit over time until it was exhausted.
Thank you, Y.W. for this informative and insightful commentary. With this more accurate assessment, the conclusion is still staggering: to fund the senior rank public pension, the city will still need to contribute $90,000 a year, roughly equivalent to the wage of a full-time city worker ($85,000/year average), for 30 years.
Since the median pay in the U.S. is about $26,360 annually, then that means the $2.74 million that must be set aside for each senior-level pension is equivalent to three workers' entire lifetime earnings--35 years X $26,360 = $920,000 X 3 = $2.76 million. Since these workers must pay taxes and fund their own retirements, we can guesstimate that the $2.74 million is equivalent to the entire net lifetime earnings of four workers. The standard-level cash/benefit "defined benefit" pension will require the entire net lifetime earnings of two workers.
Even reducing the total contributions by half still leaves an impossible sum of total contributions to be made: to make the promised cash/benefit payouts, every city/county must set aside the equivalent of between 5 and 10 years of the entire general fund budget.
This does not even touch on two other sobering realities: the number of public employees who are in the "pension pipeline" and who will be retiring within the next decade is exploding as the Baby Boomers exit the workforce, while at the same time the public workforce is being reduced to align with dwindling permanent-recession tax revenues. Both of these trends further exacerbate the structural misalignment of promises made, low yields, fiscal limits on how much can be contributed annually and the current size of pension funds.
Tomorrow we examine the unsustainability of Medicare.
"Renouncing debt would be the way forward and eventually that will
happen everywhere--either the currencies will go to zero, what people call
hyperinflation, or the debt will be defaulted on."
For small gardens:
The Simple Garden - Special price: $29.95 + $8.00 shipping
Resistance, Revolution, Liberation: A Model for Positive Change (print $25)
(Kindle eBook $9.95)
We are like passengers on the Titanic ten minutes after its fatal encounter with the iceberg: though our financial system seems unsinkable, its reliance on debt and financialization has already doomed it.
If this recession strikes you as different from previous downturns, you might
be interested in my book
An Unconventional Guide to Investing in Troubled Times (print edition)
Kindle ebook format. You can read the ebook on any
computer, smart phone, iPad, etc. Click here for links to Kindle apps and Chapter One.
The solution in one word: Localism.
Of Two Minds Kindle edition: Of Two Minds blog-Kindle
"This guy is THE leading visionary on reality.
He routinely discusses things which no one else has talked about, yet,
turn out to be quite relevant months later."
NOTE: gifts/contributions are acknowledged in the order received. Your name and email remain confidential and will not be given to any other individual, company or agency.
Or send him coins, stamps or quatloos via mail--please request P.O. Box address.
Subscribers ($5/mo) and contributors of $50 or more this year will receive a weekly email of exclusive (though not necessarily coherent) musings and amusings.
At readers' request, there is also a $10/month option.
The "unsubscribe" link is for when you find the usual drivel here insufferable.
All content, HTML coding, format design, design elements and images copyright © 2012 Charles Hugh Smith, All rights reserved in all media, unless otherwise credited or noted.
I would be honored if you linked this essay to your site, or printed a copy for your own use.
Terms of Service:
|Survival+||blog fiction/novels articles my hidden history books/films what's for dinner||home email me|