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That Which Is Unsustainable Will Go Away: Pensions


by Charles Hugh Smith from Of Two Minds

That Which Is Unsustainable Will Go Away: Pensions

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.

Tomorrow we examine the unsustainability of Medicare.

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