Daniel Borenstein, a columnist for the Contra Costa Times, recently had an interesting piece on pensions and the CalPERS risk that he argues will put future generations at big risk. It makes some interesting points, but perhaps goes too far and falls apart on key points.
One of the critical issues facing the state is how much profit the fund expects over a 30-year period. This is critical because the California Public Employees’ Retirement System defines the benefits received by its recipients so that the less money the fund expects to make over the next thirty years, the higher the contributions need to be.
As we know, for the past several years the fund had projected a 7.75 percent annual rate of return, but based on recommendations and lower than expected earnings over the last twelve months, its chief actuary recommended a reduced rate of 7.25 before the board decided on the middle point of 7.5 percent.
Writes Mr. Borenstein, however, “But the entire debate begs the bigger question many economists are raising: Why should pension systems base contribution rates on guesstimates of anticipated future earnings from often-volatile investments such as stocks and real estate?”
It is an interesting question to ask and, in particular, the question I think we should rightly pose is whether we are taking too much risk.
However, at the same time, I think Mr. Borenstein misses some critical points in his analysis.
For instance, he writes: “Think about it: If you knew you had a large upcoming mortgage or property tax payment that absolutely had to be made, would you put money in the stock market and hope that it would earn enough interest to meet the obligation? Or, would you set aside sufficient funds in a safe investment so that you knew you could cover the payment when it came due?”
That sounds good, but he is actually off with his analogy and thus with his prescribed action.
The answer of course is, if you have an upcoming mortgage, you put your money into a fund that is immediately available for immediate return – that is either a checking account or perhaps a short-term savings account.
But we are not talking about paying one’s mortgage this year. We are talking about paying one’s mortgage in thirty years. Surprisingly enough, the apt analogy to a retirement system is someone’s personal retirement.
And people with their retirement have varying strategies from savings accounts on the safest end, to mutual funds and 401Ks. Some people invest their retirement into more risky endeavors, as well.
The bigger the fund, the more you can offset risk over time by knowing that over a given period of time, you will typically receive a certain percentage return on your investment.
Now where I think Mr. Borenstein makes a stronger point is by arguing that the investment strategy taken by CalPERS is, in fact, too risky.
There is a gamble here and they do assume strong future investment returns – but that is based on past performance over the long term.
Here is the problem, “The CalPERS board members were told by their staff that they had only a 50 percent chance of hitting or surpassing the 7.5 percent target, yet they adopted that assumption. Others say the odds are even worse than that.”
Now they can mitigate that risk because they take a 30-year time horizon and adjust their calculations on the fly.
Mr. Borenstein argues, “If CalPERS loses the bet, as it is likely to, the next generation will pay the shortfall, probably from funds that would otherwise go to public services. We’re already experiencing that phenomenon as California state and local governments divert money to pay pension debt racked up by CalPERS and other retirement systems that exceeds $200 billion.”
He continues, “The private sector operates under more rational rules. Provisions of a 2006 federal law require company plans to set contribution rates as if their assets were invested in lower-yielding, and safer, bonds.”
Mr. Borenstein, in fact, argues for five or six percent. He writes, “The exact rate depends on when workers in the pension plans are likely to retire, but today the rate usually ranges from 5 percent to 6 percent. That means larger upfront contributions by employers and employees and less risk of future shortfalls. These private pension plans can still invest in riskier stocks and real estate, but they can’t factor in those hoped-for extra profits until they actually attain them. Only then can they lower the amounts employers and employees must contribute.”
He adds, “That’s the key difference. In the public sector, the actuaries come up with lower contribution rates today by assuming high returns from riskier investments will be earned.”
This is probably a wiser strategy. But it comes with a price as well. For a locale like Davis which is fairly small, each quarter-percent calculation by CalPERS equals about $1 million all funds. So if CalPERS wants to go to a more modest formula, say the six percent that some advocate, that will cost the city $6 million more per year to fund.
Mr. Borenstein writes, “In the private sector, contributions can’t be lowered until those profits materialize. A key concern driving passage of the private-sector rules was that if earnings fell short and companies went under, the federal Pension Benefit Guaranty Corp. and eventually taxpayers would have to pay the pension benefits.”
He adds, “As for public-sector plans, ‘well’ if the earnings fall short, taxpayers will be left to pay the pension benefits.”
“Those who argue for the public-sector accounting system point out the difference between companies and government employers. The latter, they argue, won’t go away so there will always be funds available to tap in case of shortfall,” he adds. “That ignores the growing prospect of municipal bankruptcies and, moreover, the intergenerational transfer of debt that leaves future taxpayers to cover our current bills. We’re gambling with our children’s money.”
Mr. Borenstein does not take the next obvious step, which would be the transfer of risk from government to the employee. This can be done in a number of different ways. One is the movement from a defined-benefit system which guarantees each employee a certain amount upon retirement, to a defined-contribution system, similar to a 401K – whereby the contributions are fixed and the returns will depend on the market.
The governor is working on a hybrid system which would keep some features of the defined benefit system but also mix in aspects of a 401K system.
There is another way to go, which would be to keep the defined-benefit system, but over time shift the risk over to employees by increasing their contributions.
It is an interesting argument that Mr. Borenstein makes, but when you take a look at the 30-year yield, you are inclined to believe that the current system simply needs to be tweaked rather than gutted.
From our standpoint, the fixes are more likely to slow the rate of growth of upper employee salaries, eliminate spiking, go to a three-year average for final salary, raise the retirement age, and eliminate 3% at 50 for safety employees.
—David M. Greenwald reporting
[quote]For instance, he writes: “Think about it: If you knew you had a large upcoming mortgage or property tax payment that absolutely had to be made, would you put money in the stock market and hope that it would earn enough interest to meet the obligation? Or, would you set aside sufficient funds in a safe investment so that you knew you could cover the payment when it came due?”
That sounds good, but he is actually off with his analogy and thus with his prescribed action.
The answer of course if you have an upcoming mortgage, you put your money into a fund that is immediately available for immediate return – that is either a checking account or perhaps a short-terms savings account.[/quote]
I don’t think this is what Boronstein was saying. He advocated the possibility of putting the money in a “safe investment”, which would not necessarily mean a checking or short term savings account. It could also mean safer investments, such as bonds for instance, as opposed to some of the riskier investments that CalPERS is alleged to have dabbled in…
[quote]From our standpoint the fixes are more likely slowing the rate of growth of upper employee salaries, eliminate spiking, go to a three year average for final salary, raising the retirement age, and eliminate 3% at 50 for safety employees.[/quote]
It is certainly a good start, but I’m not sure it will be enough of a “fix” to get us out of the mess we are in…
ANY investment strategy that doesn’t mix investment types is likely to fail against time/inflation. Putting your money in a mattress is not “safe”.
[i]”… based on recommendations and [b]lower than expected earnings over the last twelve months[/b], its chief actuary recommended a reduced rate of 7.25 before the board decided on the middle point of 7.5 percent.”[/i]
The actual basis for lowering the rate was not quite what you say. It was based principally on [i]a lower expectation of future inflation.[/i] The actuary’s report (which copied a consultant’s analysis) said that the expected real rate of return–that is, nominal rate minus inflation–will be the same as it has ever been. However, the consultant believes that because the Fed has inflation whipped, it is unrealistic to expect equally high nominal rates of return. It was for that reason the actuary called for a lowering of the assumed rate to 7.5%.
There was, however, a second part of the analyst’s recommendation. It said that market volatility has substantially increased. And when you have every day cash needs like a pension fund has, you need to protect yourself on the downside with a lower expected rate of return. For that reason, the analyst recommended dropping the assumed rate another 25 basis points.
The report said that with lower inflation a 7.53% return is a reasonable expectation. But that, the consultants said, was too little above 7.50% to handle market swings. And hence, assuming 7.25% would provide the safethy margin needed.
[i]”The bigger the fund, the more you can offset risk over time by knowing that over a given period of time, you will typically receive a certain percentage return on your investment.”[/i]
The size of a fund does not really matter in this equation. Time does. If you are simply a sole investor and you take a constant percentage of your gross earnings every paycheck and buy an unmanaged index fund (like the S&P 500 or the Russell 5000) and you reinvest all of your dividends and you keep up this strategy for 30 years or more, you will get a “market rate of return,” one which would be higher than CalPERS makes but for tax considerations. (You will have to pay income tax on your dividends and sometimes capital gains taxes, even if you don’t sell.)
What is a market rate of return? It’s about 10% to 12% nominal before tax considerations. Most recently it was 11.03%.
Where did I come up with 11.03%? I took the 30 year period beginning January 1, 1982 and ending December 31, 2011. The compound annual growth rate of the S&P 500 for that period was 11.03%. (Source ([url]http://www.moneychimp.com/features/market_cagr.htm[/url]).)
It is a little different for each 30 year period, but most have ranged from 10% to 12%, with low inflation probably being a reason for lower rates of return in the oldest periods:
January 1, 1982 to December 31, 2011 — 11.03%
January 1, 1977 to December 31, 2006 — 12.50%
January 1, 1972 to December 31, 2001 — 12.29%
January 1, 1967 to December 31, 1996 — 11.89%
January 1, 1962 to December 31, 1991 — 10.27%
January 1, 1957 to December 31, 1986 — 9.88%
January 1, 1952 to December 31, 1981 — 9.89%
[i]Mr. Borenstein argues, “If CalPERS loses the bet, as it is likely to, the next generation will pay the shortfall, probably from funds that would otherwise go to public services. We’re already experiencing that phenomenon as California state and local governments divert money to pay pension debt racked up by CalPERS and other retirement systems that exceeds $200 billion.”[/i]
I don’t think there is all that much reason to panic. The PERS board adopted a 7.5% assumed rate when the consultant said it should be 7.25%. That’s not that much of a difference for a year or two. If it seems too high in a couple of years, the PERS board will simply lower the assumed rate to 7.25% at that time.
[i]”There is another way to go, which would be to keep the defined-benefit system, but over time shift the risk over to employees by increasing their contributions.”[/i]
There is a realistic limit in that. Already in Davis, sworn police are paying 12% of their gross pay (9% employee share + 3% employer share) to fund their pensions. Pretty soon fire will get this same deal. And misc. will soon enough all be raised to 8%.
The better long-term fix for Davis is to change the pension formulas for all new hires. Instead of giving 2.5% at 55 for misc. and 3% at 50 for safety, we need to adopt 2% at 60 and 2% at 55 for these employees. Those less generous pension plans are much cheaper to fund. I recently calculated that if the 45 firefighters were on 2% at 55 instead of 3% at 50, the employer contribution savings would be over $500,000 per year.
[i]”…we need to adopt 2% at 60 and 2% at 55 for these employees. Those less generous pension plans are much cheaper to fund.”[/i]
I absolutely agree with Rifkin. Then, if the individual wants to fund a richer and/or earlier retirement, he/she can sock it away like the rest of us. As far as I know, even with a pension, workers can take advantage of pre-tax and tax-deferred retirement savings. PERS has a 403b (public side 401k equivalent) that all covered members can contribute to.
Our retirement planning is supposed to cover both ends of our personal financial statement. We are supposed to have most of our debt retired, have finished funding our kid’s college education… basically reduced our personal expenses so we can survive comfortably on a reduced income. Our date of retirement should depend on our ability to cover our personal expense nut.
Any employee expecting 80% or 90% of his salary at retirement would not be as motivated to reduce his expense nut leading to retirement. He would be thinking he can buy that bigger house and the more expensive new car because he has a reliable flow of cash. So, not only does he lead a more lavish lifestyle while retired, but he lives higher-on-the-hog the entire time.
I know many fire professionals, and a few police professionals, that routinely drive more expensive cars, live in bigger homes, take more extravagant vacations… than do people working in the private sector having greater income. I know some of these police and fire professionals are deep in debt when they hit retirement. They often get a second job or even a second career to help them pay down the debt so that they can REALLY retire.
The current public sector retirement system is not only unsustainable, but it is unfair. It corrupts the entire concept of retirement into being more like a mid-life permanent paid vacation. I think a retirement of 60% of compensation after 30 years should be the maximum pension benefit any public sector employee should ever get. It is ridiculous that we do anything more.
[quote]PERS has a 403b (public side 401k equivalent) that all covered members can contribute to. [/quote]Basically correct, except it’s a 457 plan. I’ve never been able to fathom the practical difference. Generally, there have are not been employer contributions to such a plan. Some agencies support a 401(k), and at least until relatively recently, provided an employer match, up to a limit of 1-3%. Davis has not.
Mr Boone… when you say that no public employee should receive. over 60% ‘pension’ in retirement, does that include Social Security? Some State employees get 2% @ 60 AND Social Security (These are often referred to as “coordinated” plans. So would you propose that a State employee, under such a plan, who has worked for 30 years, and who had to contribute to SS would be limited to 60%?
[i]”Basically correct, except it’s a 457 plan.”[/i]
I wondered what the difference between a 403(b) plan and a 457 plan is under the Internal Revenue codes? It turns out this is the distinction: [quote] [u]IRC 403(b)[/u] – The organization must qualify as a [b]public educational organization[/b] or be exempt under IRC 501(c)(3).
[u]IRC 457[/u] – The organization must be a [b]state or local government[/b] or a tax exempt organization under IRC 501(c). [/quote]
[i]”when you say that no public employee should receive. over 60% ‘pension’ in retirement, does that include Social Security?”[/i]
hpierce, good question.
Of course this is just my opinion, but it is based on my general sense that our expectations for retirement lifestyle have gone too far. When Social Security was first enacted, the retirement age of 65 was selected because this was the current life expectancy. The social program was to help cover those that lived longer than average. The basic expectation was that average Americans would work until they dropped.
I have no problem with people saving throughout their working life to retire with higher income or to retire at a younger age. However, for all tax-payer-funded retirement, I think a 60% aggregate retirement benefit (including pension AND Social Security) is fair and right. I think anyone getting a full government pension should be excluded from getting Social Security.
I also think that we should extend the mandatory retirement age to 58 for safety and 62.5 for all others and make the benefit 2% at 30 years with a 60% cap. Remember too, most of these employees are getting free healthcare after retirement.
On the private sector side, defined benefit pensions are gone. No problem since few private-sector employees ever received the benefits because of vesting rules, back-loaded benefit accrual, and labor mobility. In 2009 dollars, the average DB pension payout was $4,500 per year. Among current retirees with private-sector retirement plan income (now defined contribution plans), the median amount of income received per person in 2009 was a measly $6,000 per year. So, even though the system is better after ERISA, the payout is still not enough to make a dent in retirement.
Contrast this to the public-sector were the 2009 median annual pension benefit was $14,800.
Do the math… that is more than double what the poor sap working for the private sector gets for a retirement benefit. Even considering the case where the public sector pensioner gets no Social Security, it still comes out significantly higher.
However, we are not talking about the “average” government pensioner… we are talking about our special Californian government workers… the ones getting six figure annual pension payments. We are also not factoring the value of life-time healthcare coverage… something that no private-sector worker has except for a few union jobs.
Rich – Thanks for the definition of public side 401k plans. I always get those two mixed up.
Yes, Rich… thank you for pointing out the difference between 457 and 401/403… can’t believe I was so stupid to think there might be differences…
[quote]I also think that we should extend the mandatory retirement age to 58 for safety and 62.5 for all others [/quote]To clarify… no person, public or private should have [u][b]any[/b][/u] ‘pension’ (public/private/social security [publicly funded]) unless they work to age 62.5? Including someone who works 42 years, but not attain age 62.5? But someone who stays in school, loafs around, and starts working at age 30 should get SS, pension, etc, if they retire @ 62.5?
[quote]When Social Security was first enacted, the retirement age of 65 was selected because this was the current life expectancy. The social program was to help cover those that lived longer than average. The basic expectation was that average Americans would work until they dropped. [/quote]True story.. I do not dispute that statement, but to clarify, it was also designed to protect the survivors (generally women at that time) who had no benefits of their own, and who tended to out-live the men.
Those in public service (under PERS), have little to no expectation to benefit from a spouse’s SS. A municipal employee, under PERS, will have to take ~ 6.5% reduction in benefits to cover a spouse for THEIR life (I believe this is NOT the case in SS). And, they will get little or no benefit from their spouse’s contribution to SS.
If Mr Boone expects both spouses to be similarly employed, that is an interesting assumption (does it apply to him?).
I’m not saying that public employee pensions should not be scrutinized, I’m saying that the ‘private sector’ should be scrutinized as well… there are many SS recipients who wil draw farther benefitts that they paid for. SS folks pay no SS taxes beyond ~ $106,000 of income. Publivc employees, under PERS, do.
[i]”… no person, public or private should have any ‘pension’ (public/private/social security [publicly funded]) unless they work to age 62.5?”[/i]
I don’t mean to butt in to your discussion, other than to say that I believe a consideration needs to be made for “retirees” who cannot work because they became disabled, especially from a serious work accident. While I favor discouraging early-aged retirements*, I don’t think Davis should be hard-hearted to those who truly can no longer work due to disability. (I wonder, though, if anyone ever checks to see if a person who retires on disability is faking it or has recovered his health?)
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*How do we encourage early retirement? Bby giving full retiree medical before a normal retirement age and by giving some employees 90% of their final salaries for some even under age 50. These provisions make it so staying at work is financially not worth it.
[i]”I don’t mean to butt in to your discussion, other than to say that I believe a consideration needs to be made for “retirees” who cannot work because they became disabled, especially from a serious work accident.”[/i]
Please butt in at any point.
There is already an extensive body of laws and procedures for dealing with disabilities and I largely support them. For example, an employee that is qualified as disabled on or off the job could get coordinated long-term disability payments and early retirement for himself and his family.
This subject is actually a very important one for me. Unfortunately too many people abuse disability benefits and this has created a “guilty if not proven innocent” approach from most employers.
After my Davis cop bother in-law and friend took his life, we discovered that he had been diagnosed as having pre-Parkinson symptoms that were exacerbated by stress and lack of sleep. Of course, like a good cop protecting everyone else besides himself, he kept this secret from everyone… including his wife. His fear of job impact from others noting his periodic tremors caused him more stress. He was a detective and apparently so good at his job that his supervisor pushed him to handle most of the more difficult cases… cases where he would go for days without sleep while undercover. Unbelievably, his medical records included a suggestion from a doctor that drinking alcohol would reduce the occurrence of tremors. So drink alcohol he did… to excess. Again, keeping it secret from everyone over fear of hurting others.
He applied for disability. It was denied. He took his own life soon after.
I don’t know what the answer is for improving the process to help employees with genuine disabilities, while vetting out those willing to lie to get a free ride. Right now is seems that all HR departments initially reject most disability claims to weed out the weaker claims. My idea is for HR to first interview supervisors and coworkers as to the demonstrated moral strength and weakness of the person requesting benefits, and be more facilitating for those assessed higher scores. My brother in-law would have received one of the highest scores. He should be alive and on disability and early retirement today.
[i]”To clarify… no person, public or private should have any ‘pension’ (public/private/social security [publicly funded]) unless they work to age 62.5? Including someone who works 42 years, but not attain age 62.5? But someone who stays in school, loafs around, and starts working at age 30 should get SS, pension, etc, if they retire @ 62.5?”[/i]
hpierce, I was born in 1960. My Social Security retirement age is 67. Considering that age, then 58 and 62.5 sound generous do they not?
To answer your question…
First, we could standardize on the expectation that the model safety employee would work from age 22 to 58 (1.67% @ 36 years), and the other employees would work from age 22.5 to 62.5 (1.5% @ 40 years). So then retirement age would be based on years of service, or age… which every came first. For example, if a safety employee started working at age 20, then she could retire after 36 years of service at age 56. However, if she loafs around and does not start working until she is 30, then she would be able to retire at age 58, but her pension would be 46.76% at retirement instead of maximum 60%.
The other thing I would do is a 50% vesting period between say age 50 to 58 for safety and age 55 to 62.5 for non-safety. Using the previous example, if the safety employee decided to retire early at age 50 after 20 years of service, she would receive a pension of 16.7% (half of 33.4%). The reason for this is to provide some retirement compensation-incentive for burned out workers without creating too much of an incentive for other employees to leave before their time.
But, actually, what I would really rather do… get rid of all defined benefit programs and replace them with pre-tax-payroll-withholding, safe harbor, employee-matching, defined contribution plans (401k type plans). Have a graduated vesting of 5% per year for the employer contributions so that after 20% years of service you own it. One big reason that I like DC so much more than DB is that I don’t want any employee working because he is waiting around for his pension. I only want him working if he is passionate and energized about his work. If he is not vested he will have to stick around waiting for the day. If he owns his 401k balance and likes his job he will stick around to add to it. If he does not like his job, then I want him gone… taking his 401k balance with him to his next job where he can continue to build up the balance.
[quote]I don’t know what the answer is for improving the process to help employees with genuine disabilities, while vetting out those willing to lie to get a free ride. Right now is seems that all HR departments initially reject most disability claims to weed out the weaker claims. My idea is for HR to first interview supervisors and coworkers as to the demonstrated moral strength and weakness of the person requesting benefits, and be more facilitating for those assessed higher scores. My brother in-law would have received one of the highest scores. He should be alive and on disability and early retirement today.[/quote]
I actually think this is an excellent suggestion…