Part 1 – Understanding Public Pensions
If you are under 40, you should stop reading this, stop planning to buy a house and stop planning to start a family. Just find a second job (or first, even), and become a wage slave to public pensions. You have work to do, and you aren’t doing enough of it to pay for your police chiefs’ and teachers’ retirement.
Why? Recent analysis indicates that the unfunded liabilities of America’s state and local pensions are over $4 trllion, and the nation expects you to shut up, get to work, and pay for that shortfall.
Before one can understand the full meaning of the public pension mess, they need to know how public pensions work. Next, they need to understand what “underfunded” means relative to public pensions.
How Pensions Work
The vast majority of public pensions (at least the ones causing all the trouble) are called “defined benefit” plans. The idea is that if the worker and employer pay into the system, the system will pay them a “defined benefit” when they retire. As you are about to learn, the “benefits” are the problem.
Think of it like a bathtub for capital. Worker contributions, employer contributions and investment income flow into the tub, and benefits (along with some incidental costs) flow out. Therefore, a defined benefit pension system must execute two primary tasks. It must a) invest the money it receives so that it produces a rate of return, and it must b) pay benefits to its “beneficiaries” as they retire. How hard can that be? Pretty hard, it turns out.
If public employees are promised a certain amount at retirement, it isn’t hard to estimate how much money you need a) in the [pension] tub, b) flowing into the tub, and c) flowing out of the tub as people retire. As you estimate how much you need, you look into your tub and see how much you have. The difference (if any) between what you need and what you have equals the level of underfunding.
In short, “underfunded” means that, at current rates of return, and with the people now paying into, and people taking out of, the system, you don’t have enough money to pay what you promised. In California, that number (shortfall) is $112 billion (for state employees alone). As we mentioned above, nationally, that number is between $1 and 4 trillion.
At this point, you might ask “between $1.25 and 4 billion, that’s a wide range. Where does that come from? Good question.
Currently, your local pension fund board is probably assuming it is going to get 8 or 8.5% rate of return on their investments. If they do, the shortfall will be smaller ($1.25 Tr.) On the other hand, more realistic analysts, who aren’t interested in cooking the books, think that a 4% rate of return is more realistic. If it’s that low, then a $4 trillion shortfall is a much more realistic number.
Illinois and pension un-sustainability
If you’ve been following this issue in the media, you may know that Illinois is the poster child for underfunded pensions, with the Teachers’ Retirement System being the most troubled. According to their Comprehensive Audited Financial Report (CAFR), it clocks in at 46.5% funded (53.5% shortfall), and that’s assuming an unrealistic 8% rate of return.
I pick on Illinois’ TRS because it illustrates, more than any pension in the nation, the source of the problem – the massive expansion of benefits.
There are arguments that the state didn’t pay its “fair share.” It did. Some will point to the downturn, and blame the recession. That’s only a small part of the problem.
If you want to retain just one idea from this article, it is this. The real source of the problem is the level of benefits. Illinois and its TRS pension plan illustrate that the level of benefits slathered on the retirees by the legislature is what “broke the bank.” Whatever the impact of other factors (investment returns and state funding), the fact is you can’t pay actuarially impossible benefits. You will run out of money. Furthermore, if you increase taxes to pay for these promises, you will run out of tax payers (see the exodus from Illinois).
Here is how this mess steals from the younger generation. As these costs escalate, they crowd out funding for existing government services. Education programs, police, and infrastructure all suffer, as the taxes flow into pensions funds that are bleeding out. Society’s investment in the young dries up to pay for public retirees and their benefits gravy train.
High taxes force high earners and businesses to leave. They take jobs, tax revenues, and economic vitality with them, leaving those who remain on the hook for even more spending. It’s an Illinois economic death spiral, and I’ve been predicting it for years.
In my next piece, I’ll lay out the specifics on how Illinois benefit levels are to blame. The important thing to remember, as you learn more about this issue, is that, after a certain point, no amount of taxpayer support or investment returns can pay for benefits un-tethered from actuarial reality.
If you aren’t talking about cutting benefits, you aren’t serious about pension reform. Either that, or take that 2nd and 3rd job, and become a pension tax slave.
Links for background reading