What Payroll Contribution Will Keep Pensions Solvent?

July 25, 2011

In a previous post “Pension Contributions Aren’t Enough,” the point is made that for every percentage point that an investment fund lowers their projected rate of return, the required annual pension fund contribution as a percent of salary goes up by over 10%. The assumptions underlying that analysis were 30 years working, 30 years retired, a pension equivalent to 90% of final salary, with the salary doubling (in inflation adjusted dollars) between the first year of employment and the final year of employment. Using the same assumptions, but for a pension equivalent to 60% of final annual salary, for every percentage point that an investment fund lowers their projected rate of return, the required annual pension fund contribution as a percent of salary goes up by a bit less than 10%. The implications of these facts should be clear to anyone involved in the issue of public employee pension benefits.

This post is in response to an email received from someone who, after reading the previous post, asked what the impact might be on required annual contributions to pensions if the assumptions are changed so that the years retired are shortened. The implication was that a 30 year working, 30 year retired scenario is an unlikely average, since on average, employees who log 30 years of government service do not survive an additional 30 years in retirement. But when analyzing the variability of required pension fund contributions based on 20 year and 25 year retirements, while assuming 30 years of work, the results are still noteworthy. Here they are:


In the above table, the first set of four rows show various scenarios based on a pension equivalent to 90% of final salary, the second set of four rows show various scenarios based on a pension equivalent to 60% of final salary. One might suggest the first set of rows depicts public safety workers, representing approximately 15% of California’s 1.85 million state and local government workers, and the second set of rows depicts everyone else working for state and local government agencies in California.

For each pension example, the fund return is calculated at a best case of 4.75% per year, which is the official rate used by CalPERS currently, and is the rate used by most public employee pension funds across the U.S. That return is then dropped by 1.0% in each of the next three rows. It is important to note that these are “real” returns, after inflation, which is typically projected at 3.0% per year. In nominal terms, CalPERS official long-term projected rate of return is 7.75% per year. So in nominal (before adjusting for inflation) terms, the four returns evaluated on this table are 7.75%, 6.75%, 5.75%, and 4.75%. To keep this in perspective, the “risk-free,” nominal rate of return on the 10 year Treasury Bill is 3.0% per year, nearly two percent lower than our worst case scenario in this analysis.

As can be seen by reviewing the first column in the boxed set of data on the table, when someone works 30 years and is retired 30 years, and has a pension equivalent to 90% of their final salary, if you drop just one-percent from CalPERS official long-term projection, you have to increase the annual pension fund contribution by 10.1% of salary – from 30.3% per year to 40.4% per year. But if you want to be more realistic (notwithstanding pension spiking, staggering losses to the funds over the past 10 years, or retroactive pension benefit increases, which this analysis does not take into account, and which make the required contributions much higher), you may consider the next two columns in the boxed area on the table.

If someone works 30 years and retires for 25 years, with a pension equivalent to 90% of their final salary, if you drop just one-percent from CalPERS official long-term projection, you have to increase the annual pension fund contribution by 8.6% of salary, from 27.7% per year to 36.3% per year. If someone works 30 years and retires for 20 years, with a pension equivalent to 90% of their final salary, if you drop just one-percent from CalPERS official long-term projection, you have to increase the annual pension fund contribution by 7.1% of salary, from 24.4% per year to 31.5% per year. Clearly increasing the proportion of years working to years retired reduces the impact of lowered rate of return assumptions, but the impact of a mere 1.0% drop in the projected long-term rate of pension fund returns on the required contribution is still quite dramatic.

Anyone who wishes to explore this further is invited to review two example charts below this post, one that shows the derivation of the required pension fund contribution based on a 90% pension, a 4.75% real rate of return, and 30 years working, 25 years retired, and the other using the same assumptions except for the real rate of return, which is lowered to 3.75%.

The hyper-sensitivity of required pension fund contributions to a lower projected rate of return for the fund is something that terrifies actuaries who are under pressure to release sanguine assessments of pension fund viability. It is further evidence as to why pension fund managers continue to claim that 7.75% returns are achievable despite the fact that we live in an era when the cost of money in real terms is literally negative. In our debt saturated global economy, bubble assets and zero real interest rate are a last, desperate ploy to stave off deflation. As the major currencies of the world – all representing economies that carry debt up to their eyeballs – compete to out-devalue each other, the debt eating panacea of inflation shall remain elusive. Yet the masters of the universe on Wall Street, and in their public employee pension fund bridgeheads throughout America, claim they can still earn the returns they earned when the credit binge was in full bloom.

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