How the Tax System Favors Government Workers and Punishes Independent Contractors

The 2016 tax filing deadline is now just one month away. Which makes it timely to point out how unfair our tax system is to middle class workers who want to prepare for their retirements. It is also timely to explain how there is a completely different set of retirement rules, far more favorable, that apply to unionized government workers.

If you are a member of the emerging “gig economy,” or a sole proprietor running a small business, or an independent contractor, and if you are reasonably successful, then you paying nearly 50% of every extra dollar you earn in taxes. The following table shows the marginal tax burden for independent contractors who earned more than $81.5K and less than $118.5K in 2015:

Marginal Tax Rate for Independent Contractors
(for 2015 earnings > $81.5K and < $118.5K)


The challenges posed by this reality bear closer examination. Let’s say, for example, that someone in this category needs to earn more money, and they have an opportunity to earn a few extra bucks by taking on a side project. For these earnings, they will pay 25% federal, 8% state, 12.4% Social Security (as employee and employer), and 2.9% Medicare. And by the way, the employee’s portion of their Social Security contribution is NOT tax deductible. What if they decide to put that money into a 401K?

According to current tax law, private sector taxpayers can only defer up to $18,000 of their income into a 401K, up to $24,000 if they are over the age of 50. Contrast this to the unionized public employee’s pension fund.

If the payments into a public employee’s retirement account exceed $24,000 per year – which they usually do – they remain tax deferred. A California Policy Center study (ref. table 4) examining 2011 compensation for City of San Jose employees showed that the average employer contribution for a police officer’s pension (not even including whatever they may have also contributed via withholding) was $53,222 in 2011, more than twice the amount they would have been able to avoid paying taxes on if they were private citizens. For San Jose firefighters it was even more, their average employer pension contribution was $62,330 in 2011. And even for the miscellaneous employees, the city’s contribution exceeded the tax deferred amount allowed private citizens, averaging $26,164 – again, not including whatever pension contributions these employees may have paid themselves through withholding. San Jose’s case is typical.

So why aren’t public employees paying taxes on whatever annual pension contribution they make in excess of $18,000, or $24,000, depending on their age? Because there is NO practical limit on how much can be contributed into a defined benefit plan while still avoiding taxes. The IRS created the limit on how much you can put into a 401K in order to discourage people creating “abusive tax shelters.” But they did not apply this moral standard to defined benefit pensions.

Meanwhile, there’s not only a ceiling on how much the taxpayer can put into their 401K, but, of course, there’s NO guarantee that those 401K investments will perform. When a middle class self-employed person confronts a 48.3% marginal tax rate, if they can afford it, they are pretty much compelled to put money into their 401K. Then they can watch the S&P 500 and knock on wood. Since the S&P 500 is currently at the same level it was at back in June 2014, with governments and consumers across the world engulfed in maxed-out debt which renders them unable to continue to consume at the rates they used to, and global overcapacity idling shipping from Rotterdam to the Strait of Malacca, they’d better knock very hard indeed.

As for the pension funds for unionized government workers? If they become underfunded, though faltering investment returns, or retroactive benefit enhancements, or “spiking,” private citizens make up the difference through higher taxes and reduced services.

One final injustice must be noted: Once the private sector independent contractor retires, if they’re lucky they’ll collect around $25,000 per year in exchange for a lifetime of giving 12.4% of their gross income to the Social Security fund. And if that, plus their S&P 500 savings account’s 2.5% per year dividend income isn’t enough to live on, they’ll have to keep working. But wait! If that work earns them more than $15,710 per year, their Social Security benefit is cut by $1.00 for every $2.00 they make.

Let’s recap. A middle class private sector independent contractor pays a 48.3% tax on any income they earn between $81,500 and $118,500, which includes a 12.4% payment into Social Security on 100% of that income. Half of that 12.4% isn’t even deductible. If they invest money in a retirement account, there is at most a $24,000 ceiling on how much they can invest per year. If their retirement account tanks, there’s no bail-out. And if they still have to hold a job after they’ve finally qualified for full Social Security benefits after 45 years of work, there is a 50% tax on that benefit for every dollar they earn in excess of $15,710 per year.

By contrast, a unionized government worker in California collects a pension that averages – for a 30 year career – well over $60,000 per year (ref. here, here, here, and here). At most they contribute 12% into their pension fund via payroll withholding, in most cases much less. Their pension fund earns 7.5% and if it does not, the taxpayers bail it out. And when they retire, if they want to go back to work, there is NO penalty whatsoever assessed on their pension income.

Ensuring reasonable retirement security for Americans against the headwinds of unsustainable debt and an aging population is one of the great challenges of our time. And the biggest obstacle to finding solutions is that American workers do not adhere to the same set of rules. There is rather a continuum of rules, with unionized government workers at one privileged extreme, and independent contractors – those glibly lauded members of the “gig economy,” at the opposite end, paying for it all.

This is the context in which we have recently witnessed the irresistible alliance of Wall Street pension bankers and government union leadership annihilate the latest attempt at pension reform in California. Tax season brings it home in all its bitter glory.

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Ed Ring is the president of the California Policy Center.

City Contributions to CalPERS Continue to Rise

Last year, CPC published a study on California City Pension Burdens. Most of the data for that study came from plan-specific actuarial valuation reports published by CalPERS. These reports show how much local government employers must pay CalPERS in the coming fiscal year and projects contributions for several years into the future.

At the end of 2015, CalPERS published updated valuations, and we at CPC have started to study them. The message buried in these reports is that many California public agencies face sharply increased pension expenses that are likely to crowd out money for other services or even tip them into bankruptcy.

Pension contributions are often expressed as a percentage of covered payroll. Local governments calculate how much they must pay CalPERS by applying this percentage to their employee’s salaries. In the case of four cities, CalPERS now projects that their contribution rates for certain public safety employees will exceed 70% by fiscal year 2022. Those four cities are Costa Mesa, Santa Ana, Torrance and Vallejo.

In our original study, we found that Costa Mesa had the second highest ratio of pension contributions to revenue among all California cities. Based on the trajectory of its public safety contribution rates, the city’s pension burden can be expected to become even heavier in the coming years. CalPERS projects that contributions to the city’s police pension plan will rise from 55.6% of payroll in FY 2017 to 70.9% in FY 2022.

Santa Ana’s relatively high public safety contribution rate appears to be the result of the consolidation of the city’s fire department into the Orange County Fire Department in 2012. The city now has fewer public safety employees – police only – over which to allocate the pension costs of retired safety officers. Relative to city revenue, pension costs are less worrisome than in they are in Costa Mesa. In our 2015 study, the city’s pension contribution to revenue ratio ranked 150th.

Torrance’s contribution rate is projected to reach 70% for its police officers only; the projected 2022 contribution rate for the city’s firefighters is only 59.7%. The city ranked 51st in our pension burden study.

Vallejo is notorious for its Chapter 9 bankruptcy filing in 2008. It was the harbinger of a minor wave of insolvencies that hit American cities during and after the Great Recession. Although bankruptcy should provide a window for filers to adjust their obligations to make them sustainable, Vallejo does not seem to have taken advantage of this opportunity. While bondholders took a haircut, police officers and firefighters retained their platinum benefits. The city’s safety plan contribution rate is now projected to rise from 59.8% in FY 2017 to 74.8% in FY 2022.

CalPERS projected contribution rates could overstate the actual rates that will be imposed in FY 2022. The projections assume a 7.5% annual return on CalPERS portfolio. Given adverse stock market conditions in recent months, we can be almost certain that FY 2016 CalPERS returns will be well below that level. The result will be higher-than-expected contribution rates. On the other hand, CalPERS projections do not include the effects of California’s 2013 Public Employees’ Pension Reform Act (PEPRA). Under PEPRA new hires receive less generous pension benefits. As these new hires replace older officers, the growth in overall contribution rates will be restrained.

We will continue to study the CalPERS reports and share other findings in the coming weeks.

When Union Bosses Become Employers

Sanctimonious labor leaders treat their employees very differently than their members.

While tales of union hypocrisy are as common as instances of Donald Trump sticking his Ferragamos in his mouth, there is one facet of union two-facedness that is under-reported – the role of union as employer. As mentioned in my post a couple of weeks ago, when union becomes management, it acts like any company trying to protect its bottom line.

In June 2014, the Association of Field Service Employees was upset that its contract had expired, and management had been slow to agree on a new one. Mike Antonucci points out, “This wouldn’t be all that unusual, except management is the National Education Association and AFSE is one of the unions representing staffers.” Clearly photos of picketing workers had to be an embarrassment for NEA, but when the bottom line is at stake, even the largest union in the country becomes a tough-minded employer.

When it comes to pension plans, public employee unions (PEUs) insist on defined benefit pension plans for its members. This means that boom or bust, retired government workers get paid the same amount of money each month in perpetuity. If there is a shortfall – and there invariably is – the taxpayer is on the hook for the difference. (To read about public pension issues and the havoc they wreak, go to In a defined contribution plan – the 401(k) is typical for many employees in private industry – workers and their employers set aside a certain amount each month and that money is invested. When the employee subsequently retires, they are entitled to whatever money has accrued in their retirement account.

You would think that staffers who work for PEUs would be “entitled” to a defined benefit pension also. This is rarely the case, however, with the scenario in Philadelphia being the norm. As reporter Evan Grossman writes, “Pennsylvania labor union leaders blast 401(k) plans they offer their own staff.” Typical of union leaders, Philadelphia Federation of Teachers president Jerry Jordan has long railed against using 401(k) retirement plans for PFT members as a way to curb skyrocketing pension costs. In fact, he and hundreds of thousands of teachers from Philly have been and will be recipients of a defined benefit pension and fight any bill – like Senate Bill 1, which would have moved teachers into a more taxpayer-friendly 401(k) plan.

But what about the 34 office workers employed by PFT? Yup, they are enrolled in a 401(k) plan. And the union leaders have never explained – because they can’t – why defined benefits are good for its members but not for its own staff.

As is well-documented, teachers unions all over the country insist on seniority and tenure “rights” (though these days, union leaders have taken to referring to tenure as “due process”) for its educators. But in March, the California Teachers Association up and fired Katie Howard-Mullins, president of California Staff Organization (CSO), the union for “professional departmental and Regional UniServ Staff.” No reason or explanation was given by CTA for its action. Whether or not Howard-Mullins had tenure or seniority didn’t matter. She got the boot. But CTA members, whether they are pedophiles, sexual assaulters or just plain lousy teachers – are provided much better treatment and much more protection.

CSO called CTA on its hypocrisy in its newsletter, saying that the union did not use progressive discipline, a “hallmark of a positive labor-management relationship” in dealing with Howard-Mullins. CSO summed up its position by encouraging its members to talk to CTA board members and let them know that “the principles of restorative justice, due process, and progressive discipline are not just good for students, not just good for teachers. Those principles should be applied to the people who stand with you every day to make your union stronger.”

Makes sense. But when you are a powerful union, you get to behave any way you want. Fairness, openness and due process are principles that only others must abide by.

Larry Sand, a former classroom teacher, is the president of the non-profit California Teachers Empowerment Network – a non-partisan, non-political group dedicated to providing teachers and the general public with reliable and balanced information about professional affiliations and positions on educational issues. The views presented here are strictly his own.


Important note for those of you in Southern California: At 3pm on Sunday, September 27th, the California Teachers Empowerment Network, along with the Association of American Educators, will be hosting an informational event in Long Beach. We will examine the Friedrichs and Bain lawsuits which could fundamentally alter the state of education nationwide, affect teacher freedom, and substantially change the political landscape in California.

I will moderate a panel discussion featuring lawyers and plaintiffs from both cases, and an audience Q&A will follow. The event and refreshments are free but seating is limited so registration is necessary To access a poster for the event, go here; to attend, go here.


Pension Reformers are not "The Enemy" of Public Safety

“You will find that powerful financial and investment institutions are the ones promoting the attacks on your pensions. Firms like Berkshire-Hathaway and the Koch brothers are backing political candidates and causes all over the country in the hopes of making this issue relevant and in the mainstream media. Why? Because if they can crack your pension and turn it into a 401(k), they will make billions. Your pension is the golden egg that they are dying to get their hands upon. By the way, it was those same financial geniuses that brought about the Great Recession in the first place. After nearly collapsing the entire financial system of western civilization, they successfully managed to deflect the blame off of themselves and onto government employee pay/benefits.”
– Jim Foster, Vice President, Long Beach Police Officers Association, posted on PubSec Alliance website

These comments form the conclusion to a piece published by Foster entitled “What does “unfunded liability” mean?,” published on, an online “community of law enforcement associations and unions.” If you review the “supporters” page, you can see that the website’s “founding members,” “affiliated organizations,” and “other groups whose membership is pending” are all law enforcement unions.

In Foster’s discussion of what constitutes an unfunded pension liability, he compares the liability to a mortgage, correctly pointing out that like a mortgage, an unfunded pension liability can be paid down over many years. But Foster fails to take into account the fact that a mortgage can be negotiated at a fixed rate of interest, whereas a pension liability will grow whenever the rates earned by the pension system’s investments fall short of expectations. When the average taxpayer signs a 30 year fixed mortgage, they don’t expect to suddenly find out their payments have doubled, or tripled, or gone up by an order of magnitude. But that’s exactly what’s happened with pensions.

Apart from ignoring this crucial difference between mortgages and unfunded pension liabilities, Foster’s piece makes no mention of the other reason unfunded pension liabilities have grown to alarming levels, the retroactive enhancements to the pension benefit formula – enhancements gifted to public employees and imposed on taxpayers starting in 1999. These enhancements were made at precisely the same time as the market was delivering unsustainable gains engineered by, as Foster puts it, the “same financial geniuses that brought about the Great Recession in the first place,” and “nearly collapsing the entire financial system of western civilization.”

This is a huge failure of logic. Foster is suggesting that the Wall Street crowd is to blame for the unfunded liabilities of pensions, but ignoring the fact that these unfunded liabilities are caused by (1) accepting the impossible promises made by Wall Street investment firms during the stock market bubbles and using that to justify financially unsustainable (and retroactive) benefit formula enhancements, and (2) basing the entire funding analysis for pension systems on rates of return that can only be achieved by relying on stock market bubbles – i.e., doomed to crash.

You can’t blame “Wall Street” for the financial challenges facing pension funds, yet demand benefits based on financial assumptions that only those you taint as Wall Street charlatans are willing to promote.

Foster ignores the fact that the stock market bubbles (2000, 2008, and 2014) were inflated then reflated by lowering interest rates and accumulating debt to stimulate the economy. But interest rates cannot go any lower. When the market corrects, and pension funds start demanding even larger annual payments to fund pensions and OPEB that now average over $100,000 per year for California’s full-career public safety retirees, Foster and his ilk are going to have a lot of explaining to do.

There is a deeper, more ominous context to Foster’s remarks, however, which is the power that government unions, especially public safety unions, wield over politicians and over public perception. The navigation bar of the website that published his essay, PubSecAlliance, is but a mild reminder of the power police organizations now have over the political process. Items such as “Intel Report,” “Pay Wars,” “Tactics,” “Tales of Triumph,” and “The Enemy” are examples of resources on this website.

When reviewing PubSecAlliance’s reports on “enemies,” notwithstanding the frightening reality of police organizations keeping lists of political enemies, were any of the people and organizations listed selected despite the fact that they were staunch supporters of law enforcement? Because pension reformers and government union reformers are not “enemies” of law enforcement, or government employees, or government programs in general. There is no connection.

Here are a few points for Jim Foster to consider, along with his leadership colleagues at the Long Beach Police Officers Association, and police union members everywhere.


(1)  Not all pension reformers want to abolish the defined benefit. Restoring the more sustainable pension benefit formulas in use prior to 1999, and adopting conservative rate-of-return assumptions would make the defined benefit financially sustainable and fair to taxpayers.

(2)  Over the long term, the real, inflation-adjusted return on investments cannot be realistically expected to exceed the rate of national and global economic growth. You are being sold a 7.0% (or more) annual rate of return because it is an excuse to keep your normal contribution artificially low, and mislead politicians into thinking pension systems are financially sound.

(3)  As noted, you can’t blame “Wall Street” for the financial challenges facing pension funds, yet demand benefits based on financial assumptions that only those you taint as Wall Street charlatans are willing to promote.

(4)  If public safety employers didn’t have to pay 50% or more of payroll into the pension funds – normal and unfunded contributions combined – there would be money to hire more public safety employees, improving their own safety and better protecting the public.

(5)  Public safety personnel are eyewitnesses every day to the destructive effects of failed social welfare programs that destroy families, ineffective public schools with unaccountable unionized teachers, and a flawed immigration policy that prioritizes the admission of millions of unskilled immigrants over those with valuable skills. They ought to stick their necks out on these political issues, instead of invariably fighting exclusively to increase their pay and benefits.

(6)  The solution to the financial challenges facing all workers, public and private, is to lower the cost of living through competitive development of land, energy, water and transportation assets. Just two examples: rolling back CEQA hindrances to build a desalination plant in Huntington Beach, or construct indirect potable water reuse assets in San Jose. Where are the police and firefighters on these critical issues? Creating inexpensive abundance through competition and development helps all workers, instead of just the anointed unionized government elite.

(7)  If pension funds were calibrated to accept 5.0% annual returns, instead of 7.0% or more, they could be invested in revenue producing infrastructure such as dams, desalination plants, sewage distillation and reuse, bridges, and port expansion, to name a few – all of which have the potential yield 5.0% per year to investors, but usually not 7.0%.

(8)  Government unions are partners with Wall Street and other crony capitalist interests. The idea that they are opposed to each other is one of the biggest frauds in American history. Government unions control local politicians, who award contracts, regulate and inspect businesses, float bond issues, and preserve financially unsustainable pension benefits. This is a gold mine to financial special interests, and to large corporate interests who know that the small businesses lack the resources to comply with excessive regulations or afford lobbyists.

(9)  Government unions elect their bosses, they wield the coercive power of the state, they favor expanded government and expanded compensation for government employees which is an intrinsic conflict of interest, and they protect incompetent (or worse) government employees. They should be abolished. Voluntary associations without collective bargaining rights would still have plenty of political influence.

(10)  Expectations of security have risen, the value of life has risen, the complexity of law enforcement challenges has risen, and the premium law enforcement officers should receive as a result has also risen. But unaffordable pensions, along with the consequent excessive payments of overtime, have priced public safety compensation well beyond what qualified people are willing to accept. Saying this does not make us your “The Enemy.”

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Ed Ring is the executive director of the California Policy Center.


Pension Reform is BAD for Wall Street, and GOOD for California, April 14, 2015

Desalination Plants vs. Bullet Trains and Pensions, April 7, 2015

The Glass Jaw of Pension Funds is Asset Bubbles, February 24, 2015

Police Unions in America, December 9, 2014

How Police Unions and Arbitrators Keep Abusive Cops on the StreetAtlantic Monthly, December 2014

More Taxes and Tuition Buy Time for the Pension Bubble, November 25, 2014

The Amazing, Obscure, Complicated and Gigantic Pension Loophole, November 18, 2014

Estimating America’s Total Unfunded State and Local Government Pension Liability, September 9, 2014

Two Tales of a City – How Detroit Transcended Ideology to Reform Pensions, July 22, 2014

Government Employee Unions – The Root Cause of California’s Challenges, June 3, 2014

California’s Green Bantustans, May 21, 2014

Conservative Politicians and Public Safety Unions, May 13, 2014

The Unholy Trinity of Public Sector Unions, Environmentalists, and Wall Street, May 6, 2014

Public Pension Solvency Requires Asset Bubbles, April 29, 2014

Add ALL Public Workers to Social Security, March 25, 2014

How Much Does Professionalism Cost?, March 11, 2014  (The Kelly Thomas Story)

Pension Funds and the “Asset” Economy, February 18, 2014

Middle Class Private Sector Workers Are NOT “Ripping Off the Next Generation”, December 17, 2013

Unions and Bankers Work Together to Protect Unsustainable Defined Benefits, November 26, 2013

A Member of the Unionized Government Elite Attacks the CPC, November 19, 2013

How Public Sector Unions Skew America’s Public Safety and National Security Agenda, June 18, 2013

Estimating America's Total Unfunded State and Local Government Pension Liability

Summary:  The total state and local government pensions in the United States at the end of 2013 had an estimated $3.6 trillion in assets. They were 74% funded, with liabilities totaling an estimated $4.86 trillion, and an unfunded liability of $1.26 trillion. These funds, in aggregate, project annual returns of 7.75%. If you apply a 6.2% average annual return to recalculate the liability, using formulas provided by Moody’s Investor Services, the liability increases to $5.87 trillion and the unfunded liability increases to $2.27 trillion. Using the 4.33% discount rate recommended by Moody’s for valuing pension liabilities, the Citibank Pension Liability Index for July 2014, increases the estimated liability to $7.39 trillion and the unfunded liability to $3.79 trillion. That is, if America’s state and local pension funds were to no longer make aggressive market investments but were to return to relatively risk free investments, the payment required just to return these funds to solvency would be more than $12,000 per American.

This study concludes with four recommendations to ensure the ongoing solvency of public sector pensions. Based on the principals governing Social Security benefits, they are (1) Increase employee contributions, (2) Lower benefit formulas, (3) Increase the age of eligibility, (4) Calculate the benefit based on lifetime average earnings instead of the final few years, and (5) Structure progressive formulas so the more participants make, the lower their actual return on investment is in the form of a pension benefit. Finally, the study recommends all active public employees immediately be enrolled in Social Security, which would not only improve the financial health of the Social Security System, but would begin to realign public and private workers so they share the same sets of incentives and formulas when earning government administered retirement benefits.

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Introduction and Methodology:

This study relies on the most recent data compiled by the U.S. Census Bureau, combined with recent analysis performed by Wilshire Associates, an investment advisory firm, to estimate America’s total state and local government pension fund assets, liabilities, earnings, contributions and payments to retirees. This study then applies formulas provided by Moody’s Investor Services to estimate how much the unfunded liability deviates from the Census Bureau’s estimate, based on using lower rate of return projections. This study is limited to state and local government pension funds and does not include analysis of the federal retirement pension systems. In most cases, instead of footnotes, citations and links to sources are included within the text. This report concludes with some recommendations intended to stimulate discussion and debate.

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Total Assets – All U.S. State and Local Government Pension Systems:

The most recent compilation of total assets, contributions and payments for America’s state and local government pension funds is the “Summary of the Quarterly Survey of Public Pensions for 2014: Q1,” released on June 26, 2014 by the U.S. Census Bureau. It provides data for the quarter ended March 31, 2014.

In the introduction, the report states “total holdings and investments of major public pension systems increased to over $3.2 trillion, reaching the highest level since the survey began in 1968.” In the footnotes, the report provides clarification that they are only referring to state and local pension systems. They also estimate these “major public pension systems” to only represent 89.4% of all state/local pension system assets, which allows the means to reasonably extrapolate an estimate representing 100% of the total state/local pension system assets, contributions, and payments. They write:

“This summary is based on the Quarterly Survey of Public Pensions, which consists of a panel of the 100 largest state and local government pension systems, as determined by their total cash and security holdings reported in the 2007 Census of Governments. These 100 systems comprised 89.4% of financial activity among such entities, based on the 2007 Census of Governments.”

In table 1, below, the total pension assets are determined by taking the Census Bureau’s reported $3.218 trillion representing the 100 largest state/local pension funds, and dividing by 89.4%, yielding an estimated total assets for all state/local pension systems in the United States of $3.6 trillion.

Similarly, in table 1, using Census Bureau data, the most recent reported quarterly total employer and employee contributions for the 100 largest state/local pension funds are multiplied by four, with the product then divided by 89.4%. The resulting estimates are that during the 12 month period through March 31, 2014, $163.8 billion was contributed into these funds by employers and employees, and $251.6 billion was paid out to state and local government retirees. Presumably the cash flow deficit, $87.8 billion, was covered by investment returns.

Table 1 – State/Local Pension Systems as of 3-31-2014
Estimated Assets, Contributions, and Payments ($=B)

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Official Funding Status  – All U.S. State and Local Government Pension Systems:

At face value, it would appear that the funding status of these pension systems is quite healthy, since the deficit implied by payments to retirees exceeding contributions by employers and employees, $87.8 billion, represents only 2.4% of the estimated $3.6 trillion in assets. It isn’t nearly so simple, however.

The funding status of a pension system is determined by comparing the value of the invested assets to the present value of the estimated future payments to retirees. These future payments include estimates for people who have not yet retired. Since most state and local government employee participants in their pension systems are still working, the fact that current investment returns easily cover the deficit between contributions and payments to retirees is irrelevant. For a pension system to be 100% funded, payments into the fund, combined with investment returns earned by the fund, need to ensure that the total assets invested by the fund are equal to the present value of the liability. More on this later.

Wilshire Associates, a global investment advisory firm, performs in-depth analysis of America’s public employee pension systems through research papers that are updated annually. Their most recent reports are a “2014 Report on State Retirement Systems,” which primarily discusses data for the fiscal year ended 6-30-2013, and a “2013 Report on City and County Retirement Systems,” which primarily discusses data for the fiscal year ended 6-30-2012. Taking into account the improvement in the investment markets between June 2012 and June 2013, the weighted average funding ratio of the state and city/county pension systems combined, in accordance with the estimates provided by Wilshire Associates, at the end of June 2013 was 74%.

As previously discussed, the estimated total assets for all state/local pension systems in the United States is $3.6 trillion. Assuming that $3.6 trillion in assets represents 74% of the total pension liability carried by these same pension systems, then the estimated total liabilities for all state/local pension systems in the United States is $4.86 trillion. This means the total unfunded liability for these systems is estimated to be $1.26 trillion.

Table 2 – State/Local Pension Systems as of 3-31-2014
Estimated Assets, Liabilities, and Unfunded Liability ($=B)

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Funding Status Scenarios – All U.S. State and Local Government Pension Systems:

As part of their analysis of America’s state/local pension systems, Wilshire Associates compiles a “median actuarial interest rate assumption,” representing both the average annual rate of return these systems expect to earn over the next 20-30 years, as well as the discount rate they use to derive a present value for the estimated stream of payments they expect to make to current and future retirees. For both state and local systems, in their “Summary of Findings” in both of their reports, Wilshire Associates estimates this median interest rate assumption to be 7.75%.

As alluded to earlier, to be 100% funded, a pension plan must have invested assets equal to the present value of all future pension payments. For every participating employee, whether they are active or retired, actuaries estimate their salary growth, their year of retirement, their initial pension, their subsequent pension payouts based on COLAs, and their life expectancy. The present value of all these future payments is how much a fully funded pension plan’s assets must be worth.

The rate at which these future payments are discounted per year must be equivalent to whatever rate the pension fund managers believe they will earn interest, on average, over the life of the fund. The theory is that if no future work were performed, and therefore no additional future pension benefits were earned and no additional money was contributed to the fund, the assets currently invested in a fully funded plan would earn enough interest to support every future pension payment until the last participant died of old age.

Since the amount of assets in a pension plan is a known, objective quantity, the debate over how much unfunded liability a plan may have centers on what assumptions are used to estimate the present value of the future payments, i.e., the “Actuarial accrued liability (AAL),” which, as discussed and noted on table 2, is estimated as of 6-30-2013 at $4.86 trillion. In order to assess whether or not that amount is overstated or understated, we can use a short-cut formulated by Moody’s Investor Services in their July 2012 proposal, “Moody’s Adjustments to US State and Local Government Reported Pension Data.”

In order to revalue a pension fund’s liabilities without having access to every actuarial calculation from every fund, what Moody’s does is estimate the midpoint of the future payments stream. They select 13 years into the future, which is quite conservative. Using a longer duration than 13 years will greatly increase the sensitivity of the liability to changes in the projected rate-of-return. As discussed in their July 2012 proposal, here is their rationale:

“To implement the discount rate adjustment, we propose using a common 13-year duration estimate for all plans. This is a measure of the time-weighted average life of benefit payments. Each plan’s reported actuarial accrued liability (“AAL”) is projected forward for 13 years at the plan’s reported discount rate, and then discounted back at 5.5%. This calculation results in an increase in AAL of roughly 13% for each one percentage point difference between 5.5% and the plan’s discount rate. For example, a plan with a $10 billion reported AAL based on a discount rate of 8% would have an adjusted AAL of $13.56 billion, or 35.6% greater than reported.

We recognize this duration estimate may be higher than warranted for some plans and lower than warranted for others. Each pension plan has a unique benefit structure and demographic profile that affects the time-weighted profile (duration) of future benefit payment liabilities. However, plan durations are not reported, and calculating duration individually for each plan is not feasible. Our proposed 13-year duration is the median calculated from a sample of pension plans whose durations ranged from about 10 to 17 years. Plans with shorter durations usually are closed or have a preponderance of older or retired members.”

Here is the formula that governs this recalculation of the present value of the liability (“PV”):

Adj PV = [ PV x ( 1 + official %i ) ^ years ] / ( 1 + adjusted %i ) ^ years

As made explicit in the above formula, along with duration (years), the other key variable in order to use Moody’s formula to evaluate funding status scenarios, of course, is the “%i,” the discount rate, which is also the rate of return projection. It is worth noting that the discount rate and the rate of return projection don’t have to be the same number. In private sector pension plans, the discount rate is required to differ from the rate of return projection. Private sector pension plans are required to use a lower, more conservative discount rate in order to calculate the present value of their future liabilities in order to avoid understating the present value of the liability. Public sector pension plans have not yet been subjected to this reform regulation, and the rate used to project interest is invariably the same as the rate used to discount future liabilities. This puts enormous pressure on these funds to adopt an aggressively high rate of return projection.

Here are explanations for the various alternative rate of return projections applied in Table 3.

Case 1, 6.2%  –  here is the rationale for this rate-of-return, excerpted from the report “Pension Math: How California’s Retirement Spending is Squeezing The State Budget” authored by Joe Nation, a Ph.D., Stanford Institute for Economic Policy Research, and former California Democratic assemblyman: “This 6.0 to 6.5 percent figure is based on the performance of a hypothetical fund containing 80 percent equity and 20 percent income instruments between 1900 and 1999. It assumes an equity rate based on the 20th-century Dow Jones industrial annual average of 5.3 percent, plus 2 percent in dividends, less 0.5 percent in fees. Combined with income instruments with a net rate of return of 4.5 percent, this hypothetical fund would have earned an average annual rate of 6.2 percent.”

Case 2, 4.33%  –  the rationale for this rate-of-return comes from Moody’s Investor Services “Moody’s Revised New Approach to Adjusting Reported State and Local Government Pension Data,” released in April 2013: “For adjustments to pension data, Moody’s will use the Citibank Pension Liability Index (Index) posted on the date of the valuation instead of its original proposal to apply a single rate for all plans each year.” Citigroup Pension Discount rate as posted by the Society of Actuaries in July 2014 was 4.33%.

Table 3, below, shows how much the unfunded liability for all of America’s state/local pension systems will increase based on various alternative rate-of-return projections, all of which are lower than the official composite rate of 7.75% currently used by America’s state/local pension funds. As can be seen, if a rate of 6.20% is used, reflecting the historical performance of U.S. equities, the total liability for America’s state/local pension systems rises from $4.86 trillion to $5.87 trillion; the unfunded liability rises from $1.26 trillion to $2.27 trillion; the funding status declines from 74% to 61%.

If the relatively risk-free rate of 4.33% is used, reflecting Moody’s recommendation to adhere to the Citibank pension liability index rate, the total liability for America’s state/local pension systems rises from $4.86 trillion to $7.39 trillion; the unfunded liability rises from $1.26 trillion to $3.79 trillion; the funding status declines from 74% to 49%.

Table 3 – State/Local Pension Systems as of 3-31-2014
Estimated Unfunded Liability Using Various Discount Rate Projections ($=T)

Please note the above table can be downloaded here [1]. It is a useful tool for quickly estimating how much the unfunded liability may increase for any pension fund if the projected rate of return is lowered from the official rate. In this table, and on the spreadsheet, the yellow highlighted cells represent assumptions, and require input from the user. The green highlighted cells depict key results from the calculations.

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Observations and Recommendations

The data gathered for this study, combined with reasonable assumptions, allows one to estimate the pension fund assets for the total state and local government pension systems, combined, to equal $3.6 trillion, with an attendant liability of $4.86 trillion. In turn this means the total unfunded liability for these pension systems is estimated at $1.26 trillion. Using formulas provided by Moody’s investor services, one may apply lower rate-of-return assumptions to the official total liability estimate, and calculate how much the liability – and unfunded liability – will increase based on lower projected returns. While none of these various estimates can be considered precise and indisputable, the credibility of the source data and formulas strongly suggest they are reasonably accurate.

Not beyond serious debate, however, are financial questions and policy issues relating to pensions that are of critical importance to the solvency of America’s state and local governments. For example, even if the 74% funded ratio is accurate, it is a best case scenario that still raises troubling questions. Because the $183 billion in reported annual contributions must include not only the “normal contribution,” representing the present value of future pensions earned by workers in the most recent fiscal year, but also the “unfunded contribution,” the catch-up payment designed to pay down the unfunded liability. Even if the total unfunded liability for all of America’s state/local government pension systems is only $1.26 trillion, to eliminate the underfunding over 20 years at 7.75% interest would require annual payments of $126 billion per year. That would leave only $63 billion to cover the normal payment.

Although consolidated contribution data that breaks out the normal and unfunded contributions separately is not readily available for America’s state/local government pension systems, it is possible to impute the normal contribution – an exercise that leaves wide latitude for interpretation. Nonetheless, in a 2013 study, “A Method to Estimate the Pension Contribution and Pension Liability for Your City or County,” the California Policy Center did just that. The worksheet showing the assumptions and formulas can be downloaded here, ref. the tab “normal contribution (imputed).” As it is, assuming 16 million full-time equivalent active state/local government workers, accruing pension benefits at an aggregate rate of 2.0% of final payroll per year worked – keeping the rate-of-return assumption at 20 years, the imputed normal contribution is $120 billion per year. [2] By this logic, the total contribution of $183 billion is inadequate. The normal contribution of $120 billion plus the unfunded contribution of $126 billion suggests an adequate contribution should be $246 billion per year.

To summarize the immediately preceding paragraphs, if one continues to assume these funds will earn 7.75% per year, annual contributions were $67 billion short of the $246 billion total necessary to pay not only the normal contribution, but enough of a catch-up “unfunded contribution” to restore 100% funded status within 20 years. Aspiring to at least do this much is crucial, because the 7.75% rate-of-return projection may not be achieved. As already shown, the amount of a pension system’s liability is highly sensitive to the assumed rate of return. So are the normal and unfunded contributions. Here is the impact of lower rates of return on those payment estimates:

On Table 3, above, the impact of a 6.2% rate-of-return projection is shown to increase the unfunded liability from $1.26 trillion to $2.27 trillion, and lower the funded ratio from 74% to 61%. Using the tools and assumptions summarized in the preceding paragraphs, the impact of a 6.2% rate of return – representing the historical performance of U.S. equities over the past 60 years – on the unfunded contribution is to increase it from $126 billion to $201 billion; the normal contribution increases from $120 billion to $176 billion. Put another way, if realistic repayment terms are adopted for the unfunded liability, at a rate-of-return of 6.2% the total required contribution for America’s state/local government pension systems could rise from the current $183 billion to $377 billion.

Similarly, at a hopefully risk-free rate-of-return of 4.33% (the July 2014 Citibank Pension Liability Index Rate recommended by Moody’s), the normal contribution estimate rises to $281 billion and the unfunded contribution estimate rises to $287 billion – a total of $586 billion vs. $183 billion being actually contributed today.

These figures are not outlandishly inflated. They merely indicate how extraordinarily sensitive pension fund solvency is to rate-of-return projections, and how perilously dependent pension funds are on investment returns.

This, again, brings up the most salient question of all: What rate of return is truly achievable over the next 2-3 decades?

To at least recap this economic debate is necessary because this one assumption is central to policy decisions of extraordinary significance. If the optimists are right, rates-of-return will rise into the high single-digits and stay there, rendering pensions financially sustainable. The states and locales who offer them can therefore keep their contributions flat and allow a few more good years in the market to wipe out their unfunded liabilities. If the pessimists are correct, rates-of-return are going to shrink into the low single digits and stay there, making aggressive paydowns of a swollen unfunded liability a mandatory proposition. Required contributions will rise to untenable levels, crowding out other government services, causing taxpayer revolts, union lawsuits, and a string of bankruptcies.

The case for pessimism – or realism – is strong. Economic growth over the past 30 years has been fueled by debt accumulation; economic growth creates profits, profits create stock appreciation. Debt accumulation stimulates consumption, low interest rates stimulate purchases of real estate and durable goods, driving prices up. Debt accumulation and easy credit causes an asset bubble, and asset bubbles create collateral for additional debt. Total market debt in the U.S. is now higher than it was in 1929, immediately before the great depression. We are at the point now where there is no precedent in economic history that enables us to assume we can continue to use debt to stimulate economic growth.

The other economic headwind facing investments is the aging population. In 1980, 11% of the U.S. population was over 65. By 2030, over 22% of the U.S. population will be over 65. This means that compared to 1980, when America’s current era of of debt accumulation began, by 2030 there will be twice as many people, as a percentage of the U.S. population, selling assets to finance their retirements. The impact of so many sellers in the markets, combined with interest rates having now fallen to near zero – meaning a primary method to stimulate debt formation has been exhausted – will at the very least take the growth out of asset bubbles, if not cause their collapse. The state/local pension funds, based on current data as presented here, are already net sellers in the markets. All of this augers poorly for returns-on-investment. And while, as noted in the next paragraph, America’s economy remains extraordinarily resilient, especially compared to the rest of the world, a collapse of collateral values would trigger a global financial meltdown, and that would take America down with it.

The case for optimism is not unfounded. To stave off recession, or worse, the U.S. has pursued a policy in recent years of injecting trillions of dollars of new money into the system through massive Federal Reserve Bank intervention. But the only way this impetuous gambit can backfire is via a global loss of confidence in the U.S. currency. Despite wails of panic from predictable quarters, that isn’t likely, since every other central bank in the world is playing the same game, with less success. The largest currency group apart from the U.S. dollar is the Euro, and the Eurozone, unlike the U.S., faces a demographic crisis that is genuinely alarming, and their debt burden combined with their level of structural entitlements is much worse than in the U.S. China’s economy is far more dependent on trade, they face a demographic crisis similar to Europe’s, their society is the most likely among the major economies to experience social upheaval in the future, their real estate bubble is worse than in the U.S., and despite the opacity of their banking system, their debt burden is quite likely more severe than in the U.S. Japan is still reeling from a generation of deflation and crippling debt. No other currencies are supported by economies that are big enough to matter. Especially since the energy boom began in the U.S., no other country has anywhere near America’s capacity to domestically source raw materials and manufactured goods for export. The U.S. is basically daring the world to depreciate the dollar, because currency depreciation might actually help the U.S. economy more than it would hurt.

And so the debate over realistic rates of return rages on.

There is another question, however, which considers not the economic issues, but the issue of equity and fairness. A recently published book “Capital in the Twenty-First Century,” by Thomas Piketty, has become a favorite among leftist intellectuals who provide thought leadership for, among others, the public sector unions who control most public sector pension fund boards and who advocate tenaciously for keeping pension benefits as they are. Piketty makes the following claim:

“The rate of capital return in developed countries is persistently greater than the rate of economic growth, and that this will cause wealth inequality to increase in the future.”

Piketty is certainly correct that the rate of capital return exceeds the rate of economic growth. But his moral arguments fail when it comes to public sector pensions. Because public sector pensions have provided the means whereby public sector employees are granted immunity from the very forces that Piketty is arguing have empowered the oligarchy at the expense of ordinary workers. Public sector pensions have essentially creating a common cause between government workers and the oligarchy they allege is exploiting ordinary workers. This point cannot be emphasized enough. Government workers, through their pension funds, benefit from all policies designed to elevate asset values, including bubble levels of asset appreciation, because that is essential to the solvency of their funds. Their interests are aligned with those of central bankers, international corporations, and individual billionaires, whose self-interests impel them to support policies to keep interest rates artificially low, heap additional levels of debt onto the economy despite diminishing returns, and push asset values to even higher, more unsustainable levels. Because to stop doing that will crash these pension funds.

Is it equitable for government sponsored investment entities to control over $3.6 trillion in market investments, investments made in an economic environment which, if successful, perpetuates the gains of productivity flowing disproportionately to the wealthy elite, yet which, when unsuccessful, hits up taxpayers to cover the losses?

When considering solutions to both the financial challenges and issues of equity and fairness surrounding public sector pensions, it is important to understand that even if these systems are able to recover fully funded status based on surprisingly good and sustained market performance, it does not follow that their performance is something that can be extended to the entire population, because if so, instead of 20% of the retired population funding their retirement income through selling assets on the markets, 100% of the retirement population would be doing so, exerting far more downward pressure on asset values.

A relevant question to ask is therefore whether or not pension systems that are funded by taxpayers and bailed out by taxpayers should be investing in the market at all – why aren’t government employee pensions funded through a combination of low risk investments such as T-Bills and contributions from current workers?

The example of Social Security provides several instructive points which should be considered in any discussions of pension reform, or the larger question of what the government’s role should be in providing financially sustainable retirement security to Americans. Social Security, unlike state/local government worker pensions, has a positive cash flow. As seen here from this table on their website “Fiscal Year Trust Fund Operations,” during 2013 Social Security collected $851 billion from active workers and paid out $813 billion, primarily to retirees. The so-called Social Security “Trust Fund” had a balance at the end of 2013 of $2.76 billion.

If public sector pensions are indeed facing serious, potentially fatal financial challenges, they should consider adopting five elements from Social Security:

(1) Make it possible to increase employee contributions – Social Security withholding can be increased or decreased at the option of the federal government. If collections into public employee pension funds are inadequate, increase the withholding from employee paychecks – not only for the normal contribution, but also to help pay the unfunded contribution.

(2) Make it possible to decrease benefits – nothing in Social Security is guaranteed. Benefits can be cut at any time to preserve solvency. Decreasing benefits may be the only way to preserve defined benefit pensions. Equitable ways to do this must be spread over as many participant classes as possible. For example, the reform passed by voters in San Jose (tied up in court by the unions) called for suspending cost-of-living increases for retirees, and prospectively lowering the annual rates of benefit accruals for existing workers.

(3) Increase the retirement age. This has already been done several times with Social Security. Pension reforms to-date have also increased the age of eligibility for benefits.

(4) Calculate benefits based on lifetime earnings. Social Security calculates a participant’s benefit based on the 35 years during which they made the most. Public sector pensions, inexplicably, apply benefit formulas to the final year of earnings, or the final few years. These pension benefits should be calculated based on lifetime earnings.

(5) Make the benefit progressive. The more you make and contribute into Social Security, the less you get back. At the least, applying a ceiling to pension benefits should be considered. But it would serve both the goals of solvency and social justice to implement a comprehensive system of tiers whereby highly compensated public servants, who make enough to save themselves for retirement, get progressively less back in the form of a pension depending on how much they make.

These suggested reforms are meant to be taken to evolve defined benefit pensions into a plan that provides a minimal level of retirement security. The government should not be in the business of providing retirement benefits to anyone, private or within government, that go beyond providing a minimal safety net. The government certainly shouldn’t be in the business of providing pensions to government employees that are many times better than what they provide to private citizens in the form of Social Security. And the government, or government employees through their union controlled pension funds, should not be playing the market with $3.6 trillion of taxpayer sourced dollars, then forcing taxpayers to bail out these funds when they don’t meet projections.

A unique and elegant way to provide equitable, minimal, government administered and financially sustainable retirement security to all American’s would be to immediately require all active government workers to join Social Security. These workers, and retirees, would keep whatever pension benefits they’d qualified for so far, subject to reductions per the five options just noted in order to preserve solvency for the fund. They would begin to pay into the Social Security system, with the employer contribution into their pension funds proportionally reduced to make it an expense-neutral proposition. Since government workers are relatively highly compensated compared to private sector workers, the participation, for example, of 16 million active state/local government workers would immediately improve the solvency of the Social Security Fund. The five options available to preserve Social Security, as noted above, would be far less onerous in their implementation over the coming decades if tens of millions of highly compensated government workers were to participate. And since their unions purportedly speak for the common man, they should have no objection to the highly compensated among them getting less back in retirement than those less fortunate.

Who knows, maybe the much vaunted, potentially real Social Security “Trust Fund” assets could be used to purchase Treasury Bills. Such a policy would have the twin virtues of taking pressure off the federal reserve, and augmenting Social Security collections with modest investment returns.

Ed Ring is the executive director of the California Policy Center.

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(1) The tables in this study are all found on this spreadsheet, State-and-Local-Pension-Liability.xlsx. The spreadsheet also contains additional notes on the assumptions used, as well as links to the source data.

(2)  To estimate a fund’s required normal pension contribution using the Impact-of-Returns-and-Amortization-Assumptions-on-Pension-Contributions.xlsx spreadsheet, “normal contribution (imputed)” spreadsheet, the assumptions used and referenced above were as follows:
–  Average Salary = $70,000
–  % cola growth/yr = 2.0%
–  % merit growth/yr = 1.0%
–  avg years till retire = 17
–  proj % discount (fund’s assumed annual rate of return) = 7.75%
–  base year 2000+ = 11
–  avg years retired = 20
–  pension formula/yr = 2.00%
–  pension cola % = 2.0%
–  elig # workers = 16,000,000
Please note this spreadsheet does not default to these values. They have to be entered in the yellow highlighted input cells. The spreadsheet is designed to calculate results for whatever set of assumptions the user wishes to enter. This spreadsheet also contains tabs, similarly highlighted with yellow to denote cells to input user assumptions, to recalculate estimates for the unfunded liability and the unfunded contribution. On this spreadsheet, as noted above, there are tools to recalculate the normal contribution based on having that information, or imputing it if that information is not available.