Monday, May 21, 2012

More on Public Pension Funds and Promises ... Who Pays?

Public Employee Pension Underfunding Overview ... Watch Out, Kids and Grandkids

Today we'll employ the powerful KISS method as we dig deeper into the huge underfunded public employee pension issue which will most likely be faced by our kids and grandkids down the road.

We'll begin with the completely obvious, mindful of how hard it is to see sometimes. As newscaster Edward R. Murrow famously said "The obscure we eventually see.  The completely obvious, it seems, takes longer."

So it is with public sector pension funding and even pension funding in general. Thus, let's start simple.

Now let's deal with the question of who really pays for public employee pensions. Of course, who pays is important to We the People, but in the end it may prove to be even more important to our kids and grandkids. That's why we'll stay with the KISS methodology when discussing this stuff.

The Example

(We'll assume I'm a teacher earning $100 annually, intending to work for 30 years and then live another 30 years on the money I'll save while teaching. I'll plan to spend 50% in retirement of what I spend while working.)

Thus, if I work as a teacher and earn $100 annually, after 30 years I will stop earning $100 annually and retire to a life of leisure. If I then live another 30 years and plan to spend in retirement 50% of what I spent  while working, I'll need to save a considerable sum of money while working. Much bigger than you may think, I'll wager.

Using KISS math, income - consumption = savings = available retirement income. Expressed in dollars, that's $100 - $67 = $33 = $33.

{We'll ignore taxes, inflation, investment returns, productivity, and the likelihood of dying sooner or later than expected when estimating  my financial retirement needs.}

Thus, if I spend the entire $100 earned each year, I won't have any savings to live on when I'm no longer working. That would give me zero money for my retirement income. $100 - $100 = 0 = 0.

But if I act responsibly and manage to set aside enough to live on during retirement, I'll save $33 annually while spending twice that much, or $67 each year. Thus, my savings rate will be 33% of the total earned. It needs to be 33% of the total earned to provide me with 50% of what I spent while working.  Got it?

Of course, if I work longer and retire later, I'll need to save less money, since I'll not live another 30 years upon retiring. That means I can save less each year and still have the 50% I'll need for spending during retirement. Or if in retirement I spend less than 50% of what I earned while working, I'll also need to save less while working. In any event, you get the basic idea, I'm sure.

But in case you don't get the basic message, here it is again. While working, I'll need to plan ahead, implement my plan and then adjust that plan as I go along.

The more I save each year while working, the more years I work and the less I spend each year in retirement, the better off I'll be.

The fundamental point is that I have to save enough during my working years to provide me with sufficient income during retirement.

The Impact of Productivity

What about productivity gains while working and their impact on my earnings? To repeat, we'll assume that I worked as a teacher in a typical public school setting.

During my 30 year career, the class size that I taught became smaller. When I began, there were 24 pupils in my class and when I retired, the class size was 16.

Assuming the school wants to pay the same amount per pupil to the new teacher, my replacement  teacher will be paid 33% less than I was, since there are now 33% fewer students per teacher.

Or if the school decides to keep teacher pay constant, it can increase its total cash outlay for teachers to $150 (1.5 teachers) instead of the $100 it paid me.

Pension Funding

Now let's have the school pay teacher pensions instead of the individual teacher being responsible for his own retirement income. And we'll further assume the school's promised pension payment to me amounts to 75% of my annual earnings.  Here's the math and here's what happens to the taxpayers.

The school, aka taxpayers, will pay the replacement teacher $100 and then pay another $50 for a part of another teacher due to reduced class size. Of course, it will need to pay my retirement benefit of  $75 each year, too, since no money was set aside to fund my pension.

Thus, what used to cost the school an annual cash outlay of $100 now costs the school $225 each year. That's what it costs the taxpayers when I retire with a promised retirement benefit that hasn't been properly pre-funded and when teacher productivity has decreased as well.

Summing Up

With the school doing the pension funding, I'll have been able to spend $100 while working and be able to spend $75 during retirement. That's much more than the $67 and $33, respectively, that was assumed when I had to provide for my own pension benefit.

And who pays the difference? The taxpayers, of course. Sooner or later, and in this case later.

We'll dig deeper into all this "can kicking #101" as we go along, but that's the basic idea.

In KISS speak, we either save and invest part of what we earn while we earn or someone else pays "extra" in the end.

In the public sector, that someone else paying "extra" in the end is the taxpayer of the future. Our kids and grandkids, in other words.

Thanks. Bob.