To Save Defined Benefit, Unions Need to Accept Investment Realities

Editor’s Note: The president of the California Professional Firefighters union, Lou Paulson, has criticized Mayor Chuck Reed’s pension reform, stating “His idea of pension reform is, you sign up for one pension system, we’re going to change it now in mid career, and now you’re going to get something different.” But Paulson, and anyone who thinks defined benefit pensions can remain financially sustainable with only incremental adjustments, is ignoring a potential “mid-career” imposition of “something different” that could hit these funds like a seismic wave – a severe and prolonged market correction. That has already happened twice in the last 20 years, and each time, the rebound was triggered by lowering interest rates. But how much lower can interest rates go? In the following article by UnionWatch contributor Mike Shedlock, he highlights a just released forecast by GMO, a global investment management firm, that projects real rates of return for stocks and bonds stagnating at near zero levels for the next several years. What if they’re right? Shedlock’s article goes on to describe the situation with Illinois state pensions. The situation in California is scarcely better – after a bull market lasting nearly eight years, California’s state and local pension funds are still a bit shy of 80% funded, which is considered the minimum level for a healthy pension system. Saving defined benefits will require adopting much lower rate of return projections, and returning benefit formulas to pre-1999 levels. The sooner the leaders of government unions accept and support this, the more likely they will be able to save the defined benefit for all their members.

It is extremely refreshing to see a large, prominent, and historically accurate fund manager lay it on the line.

GMO does that quarter after quarter, with no-nonsense projections.

As of March 31, their 7-Year Asset Class Real Return Forecast is as follows.

GMO 7-Year Real Return Forecasts by Asset Class
2015 through 2021

Serious Question for Pension Plans

Given pension plan assumptions of 7-8% annualized returns how many of them can survive negative returns for seven years? It’s important to note that GMO is talking about “real” inflation-adjusted returns with an assumption of mean-reversion inflation to 2.2% over 15 years.

Still, that leaves US equities at zero to -1% returns and US bonds at negative 2.4% returns.

Even if GMO is wrong by say 3%, many pension plans will be in deep serious trouble at those returns.

Illinois Pension Plans

I keep harping about this issue, but it’s an important one. In the state of Illinois, and in spite of an enormous rally in the stock market since 2009, Illinois pension plans are only 39% funded.

A “Special Pension Briefing” last November, shows the Illinois State Retirement Systems are in dismal shape.

Unfunded Liabilities

  • Teachers’ Retirement System (TRS): $61.6 Billion
  • State Retirement Systems (SERS): $61.6 Billion
  • State Universities Retirement System (SURS): $21.6 Billion
  • Judicial Retirement System (JRS): $1.5 Billion
  • General Assembly Retirement System (GARS): $0.3 Billion

The above numbers show actuarial (smoothed) asset valuations.

Liability Trends – Not Smoothed

Illinois State Pension Systems Combined
Unfunded Liability History 2000 – 2014 ($=B)20150423-UW_Shedlock-2

In spite of the massive stock market rally, Illinois liabilities increased every year since 2011.

For still more details, please see Illinois Pension Plans 39% Funded; Taxpayers On the Hook for $105 Billion in Liabilities; It Will Get Worse!.

Any notion that pension shortfalls can be balanced on the backs of Illinois taxpayers needs to vanish now.

How did Illinois plans became so underfunded?

In general, by promising far more than can possibly be delivered.

Illinois State Pensions – Summary of Liabilities and Unfunded Ratios


Congratulations go to the Illinois General Assembly Retirement System (GARS) for having one of the worst, (if not the worst) pension plan in the entire nation. It is 16% funded.

No doubt, that increases the pressure of the General Assembly to put the burden of bailing out the system on the backs of Illinois taxpayers.

Fraudulent Promises

Pension promises were not made in good faith.

Rather, pension promises were the direct result of coercion by public unions on legislators, mayors, and other officials willing to accept bribes because they shared in the ill-gotten gains of backroom deals at taxpayer expense.

Illinois taxpayers cannot be held accountable for coercion of public officials by public unions. Fraudulent promises will be held “null and void” in any “non-stacked” court of law in the nation.

Given the 31% funding of the Illinois Judicial Pension Plan (JRS), the sorry state of Illinois pensions is likely headed to federal courts.

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About the Author:  Mike Shedlock is the editor of the top-rated global economics blog Mish’s Global Economic Trend Analysis, offering insightful commentary every day of the week. He is also a contributing “professor” on Minyanville, a community site focused on economic and financial education, and a senior fellow with the Illinois Policy Institute.

Why Middle Class Private Sector Workers Are NOT “Ripping Off the Next Generation”

A few months ago we published an editorial entitled “Social Security is Healthy Compared to Public Sector Pensions.” The highlights offer compelling evidence of two very distinct categories of “middle class workers” in America:

“According to the U.S. Census Bureau, in 2030, when Social Security will be supposedly approaching insolvency, there will be 99.4 million citizens over 58 years old, and 59.5 million citizens over 68 years old. This means that by 2030 (assuming no public employees also participate in Social Security – which many of them do) there will be 19.9 million government retirees collecting pensions that average $60,000 per year, and there will be 47.6 million private sector retirees collecting Social Security benefits that average $20,000 per year. Using these assumptions, the total pension payouts to government retirees, who were only 20% of the workforce, will be $1.2 trillion, more than the total Social Security payouts to private sector retirees, which will be $952 billion.

As for solvency, assuming government’s share of the workforce remains at around 20%, in 2030 we will have 247 million citizens over the age of 25. On a pay-as-you-go basis, to pay $1.2 trillion annually to 19.9 million government pensioners, 29.6 million active government workers would each require $40,343 per year withheld from their paychecks; to pay $952 billion annually to 47.6 million retired Social Security recipients, 150 million private sector workers would require $6,337 per year withheld from their paychecks – one sixth as much.”

These facts, stupefying all by themselves, don’t go far enough to counter what has become an irritating meme: That the baby boomers, to fund their retirement security, are passing massive debts onto the younger generation.

That really depends on which baby boomers you are referring to. The remainder of this post will illustrate exactly why middle class private sector workers are not stealing anything from the next generation, and if anything, are making noble financial sacrifices for their fellow citizens.

The chart below compiles benefit data for three hypothetical retirees, one who receives Social Security, one who has a Defined Contribution plan, and one who has a Defined Benefit plan. To make the examples consistent, each participant begins working at age 25, works 43 years, and retires at age 68. All three of them retire at a final salary of $70,000 per year. Using the Social Security Administration’s “Quick Calc,” it is simple enough with these assumptions to determine the annual Social Security benefit due – $25,824 per year, as noted in the “Retirement Benefit” row in column 1, “Social Security.”

And with this data, using a declining balance annuity spreadsheet (to see detailed calculations, download here), determining the imputed annual rate of return for the Social Security participant’s 12.5% of total earnings contribution each year is simple and precise; these middle-income workers earn exactly 2.68% per year on their retirement investment. Hardly a gargantuan ripoff.

Comparing Social Security, Defined Contribution, and Defined Benefit Plans

SS-DC-DB_comparison_chart-4In order to fully appreciate the comparison between Social Security (column 1) and a Defined Benefit (column 3), refer to the row “Pension Formula” to see the imputed annual pension accrual (all imputed numbers are highlighted in yellow). For a Social Security recipient who retires at age 68 earning a final salary of $70,000, their pension formula – to provide an “apples to apples” comparison – is “0.85% at 68.” Not exactly “2.5% at 55,” or “3.0% at 50,” is it?

The information in column 3, “Defined Benefit” is fairly straightforward, although ridiculously conservative in order to maintain the “apples to apples” comparison. Ridiculous, because very few people spend 43 years in public service and wait until age 68 to retire. And few of them have a pension accrual that is only 2.0% per year. But let’s suppose they do. This would mean their “pension formula” is “2.0% at 68,” and even under these hideously crammed down terms they earn a pension of $60,200 per year, 2.5x more than they would have gotten through Social Security.

The point of this post isn’t to attack the defined benefit, by the way. Column 2 clearly illustrates the problem with defined contribution plans as the sole source of retirement security – refer to the row “Max Life Expectancy.” As can be seen, the defined contribution participant has an individual account, which means they need to make sure they have money to live on if they have a longer than average lifespan. Hence, in order to not be broke if they make it to age 90, they have to contribute 11.1% of payroll for their entire lives, instead of 7.3% if they were in a defined contribution. That’s a lot more money. And if you think this example is ludicrous, go talk to an 87 year old in reasonably good health who planned for their 401K to sustain them for ten years beyond an average lifespan, and ask them how they sleep at night.

The only thing wrong with defined benefits – and yes, this is our understatement of the year – is they make no provision to adjust benefits downwards when returns fail to meet expectations. Perhaps, to turn the tables in a most representative way, we shall permit private sector workers to invest their individual 401K contributions with the pension funds, and if those 7.5% returns falter, tax public sector pensioners to make up the difference! Would the public sector unions, to keep this topical, support such a magnanimous gesture? Would it be “constitutionally protected?”

The older generation is indeed passing on troubling levels of debt and unfunded liabilities to younger Americans. But don’t blame middle-income Social Security participants. To do so is not merely inaccurate, it is scurrilous, demagogic, opportunistic drivel.

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

Union Controlled Illinois Politicians Consider Tax Increases to Fund Pensions

Editor’s Note:  This post by regular UnionWatch contributor Mike Shedlock documents the latest bad news for the Illinois Teachers Retirement System. And of course, union-controlled Illinois politicians have a solution: More taxes in one of the most overtaxed states in America. Like many if not most pension reformers, Shedlock advocates a scrapping of defined benefit plans, presumably in favor of defined contribution plans. But it doesn’t have to be that way. An adjustable defined benefit plan could work, eliminating the mortality risk and much of the market risk that make 401K plans undesirable for many individuals. To convert defined benefits to adjustable defined benefits, you would have to (1) use lower rate of return assumptions, (2) lower benefits across the board – to retirees, existing workers, and new employees – on a pro-rata basis, to levels that would restore solvency to the funds. Floors for workers in low-paying jobs with modest pensions could be established, along with ceilings for beneficiaries whose pensions are, say, more than twice the maximum social security benefit. If unions representing public sector workers would accept these tough reforms, they could keep their defined benefits.

In spite of a 12.8% annual return, with an 8% return assumption, the Illinois Teachers Retirement System (TRS) fell another $3.5 billion in the hole. TRS pension underfunding grew to $55.73 billion as of June 30, 2013.

Via email, the Illinois Policy Institute explains the growing liability.

 First, TRS only has $0.40 in the bank for every dollar it should have today to make necessary pension payouts in the future. That means the high investment returns in 2013 were earned on less than half of the assets that TRS should have

TRS acknowledged this in a recent press release:

“Despite these strong returns, TRS cannot invest its way out of the funding hole we are in,” Ingram added. “This increase in the System’s unfunded liability, even with good investment results, is another wake-up call to state officials and our members that TRS long-term finances continue to head in the wrong direction.”

“Without changes to the pension code to ensure sustained and adequate funding, TRS faces the very real possibility that in a few decades the System will not have enough money to pay benefits to retirees. We cannot guarantee that TRS will have enough money to pay the pensions promised to every member in the System.”

Second, the inherent flaws of the state’s defined benefit pension system have driven up the shortfall significantly. According to the Commission on Government Forecasting and Accountability, the state’s pension shortfall grew by $41 billion from 1996 to 2012.

Of that amount, nearly $23 billion came from some form of missed “assumption” that continually plagues defined benefit pension plans:

  • The investment returns for the state’s five pension funds were lower than their assumed 8% expectation. Cost to taxpayers: $9.5 billion.
  • Unplanned benefit increases for employees. Cost to taxpayers: $1.1 billion.
  • Changes in actuarial assumptions. Cost to taxpayers: $4.9 billion.
  • “Other” actuarial factors. Cost to taxpayers: $7.2 billion.

TRS fails to acknowledge the failures of the defined benefits plan and instead chooses to blame taxpayers for not contributing enough to the system.

Who is to Blame for Shortfalls?

Please consider the Illinois Policy Center report State pension contributions: Taxpayers bear the brunt of increasing pension costs

 A common refrain sounded by public sector unions is that government workers have consistently “paid their share” into Illinois’ pension systems and the state has not. However, the facts tell a different story.

While government worker contributions to Illinois’ five pension systems have increased by 75 percent since 1998, taxpayer contributions have increased by 427 percent over the same period. In 2012 alone, Illinois taxpayers contributed $3.5 billion more to the pension systems than state workers did.

Government workers’ share, as a percentage of total contributions, has continued to decline when compared to taxpayers’ contributions. In 1998, government workers paid for 47 percent of the state’s total pension contribution; today, they only pay 21 percent. By 2045, government workers will be expected to pay only 17 percent of total pension contributions.

Illinois’ Five Pension Systems

Illinois has five state pension systems, and all of them are seriously underfunded:

  1. The Teachers’ Retirement System, or TRS, manages pensions for teachers across Illinois (excluding Chicago).With more than 130,000 active members and nearly 95,000 retirees, TRS is the largest pension system in the state. Unfortunately, TRS also has the highest unfunded liability of the state’s pension systems. In 2012, TRS was only 40.6 percent funded and officially had more than $53.51 billion in unfunded liabilities. TRS members contribute 9.4 percent of their salary to the pension system.
  2. The State Employees’ Retirement System, or SERS, manages pensions for state-level employees across Illinois. It has 62,000 active members and 50,000 retirees. In 2012, SERS was only 33.1 percent funded and had officially $22.13 billion in unfunded liabilities. Under its regular pension formula, SERS members covered by Social Security contribute 4 percent of their salary, and those not covered by Social Security contribute 8 percent of their salary to the pension system.
  3. The State Universities Retirement System, or SURS, manages pensions for employees working at state universities. It has 71,000 active members and more than 45,500 retirees. In 2012, SURS was only 41.3 percent funded and had officially $19.46 billion in unfunded liabilities. SURS members contribute 8 percent of their salary to the pension system.
  4. The Judges’ Retirement System, or JRS, manages pensions for judges throughout the state. It is one of the two smaller pension systems, with only 968 active members and 725 retirees. Despite its small size, in 2012 JRS was only 28.6 percent funded and officially had $1.44 billion in unfunded liabilities. JRS members contribute 11 percent of their salary to the pension system.
  5. The General Assembly Retirement System, or GARS, manages pensions for members of the Illinois General Assembly. Despite having only 176 active members and 294 retirees, GARS has the dubious honor of being the worst-funded pension system in the state. In 2012, GARS was only 17.4 percent funded and officially had $251 million in unfunded liabilities. GARS members contribute 11.5 percent of their salary to the pension system.

All Five Systems Bankrupt 

TRS, SERS,SURS, JRS, and GARS are all insolvent. None of them can possibly meet their pension obligations. With 10-year treasuries yielding a scant 2.5%, plan assumptions of 8% are preposterously high on a sustained basis.

Yet, TRS went another $3.5 billion in the hole in spite of a 12.8% annual return.

What the hell is TRS going to do in the face of a stock market plunge, a bond market plunge, or both?

GARS, the General Assembly Retirement System is only 17.4% funded. Is it any wonder that state legislators are pressing for more tax hikes?

Beware Tax Hikes!

On October 18, I reported Illinoisans Beware: “Progressives” Seek Massive Tax Hike Again; Fight the Hike!

Pension shortfalls are the reason for the proposed hikes.

A few people commented the “progressive” tax was not as much as they pay. Here is Rep Naomi Jakobsson’s proposed scheme.

Shedlock_IllinoisProperty Taxes

What I failed to point out previously is that I pay $14,000 annually in property taxes on a home I can sell for $400K or so.

Sales Taxes

My sales tax rate is  7.75%. But hey, that could be worse. Cicero tops the state with a 9.5% tax. In Chicago, the sales tax is 9.25%.

In spite of all these massive taxes, the entire state is bankrupt!

The Solution

Raising taxes for the benefit of legislators and seriously undeserving public unions is certainly not the answer. The solution is twofold:

  1. Immediately kill all Illinois public defined-benefit pension plans
  2. Drastically lower existing pension plan expectations, via default if necessary

Nothing else can possibly work, and the numbers prove it. 

About the Author:  Mike Shedlock is the editor of the top-rated global economics blog Mish’s Global Economic Trend Analysis, offering insightful commentary every day of the week. He is also a contributing “professor” on Minyanville, a community site focused on economic and financial education. Every Thursday he does a podcast on HoweStreet and on an ad hoc basis he contributes to many other websites, including UnionWatch.

Saving Pensions Will Require Unions To Face Reality

“Not surprisingly, within moments of news of Detroit’s bankruptcy, pension scare mongers took to their pedestals to place all the blame on pensions. California, Los Angeles, and other governments would surely follow Detroit’s footsteps in short order, they cried. It’s simply not true, like most of the claims made by the anti-pension soldiers who have been trying for years to take away the retirement security of firefighters, teachers, police officers and other public servants.”

Ralph Miller, President, LA County Probation Officers’ Union, AFSCME, Fox & Hounds, August 20th, 2013

Miller has a point. California is not Detroit. California’s population has not imploded, nor will it. Detroit’s economy was reliant on one industry, California’s huge economy is diverse and relatively healthy. Turning California around, while daunting, is going to be a lot easier than turning around Detroit. And, yes, it was a collapsing industrial base and an imploding population that did as much or more than unsustainable pay and pensions to destroy the city of Detroit’s finances. Fair enough.

Where Miller goes off the rails is when he then infers that equally bogus are “most of the claims made by the anti-pension soldiers who have been trying for years to take away the retirement security of firefighters, teachers, police officers and other public servants.”

Few, if any pension reformers want to take away anyone’s retirement security. But as a nation, we are currently on track to pay more money each year in pensions to retired government workers than we pay in Social Security to everyone else. The average pension for a recently retired government worker in California who logged at least 30 years of full-time service is about $65,000 per year. The average Social Security benefit for a private sector retiree who logged 40 years or more of full-time work is $15,000 per year.

This is not a valid social contract. Government workers, through these pensions, are no longer required to endure the economic challenges facing the taxpayers they serve. And despite rhetoric and reporting that confuses these issues, Social Security is a relatively healthy system that can remain solvent with minor adjustments to withholding and benefit formulas, whereas public sector pensions are going to catastrophically collapse the very next time there’s a bear market.

There are really two primary issues that ought to be the focus of debate: (1) What is a realistic rate of return, after adjusting for inflation, for pension funds over the next 30 years? (2) If you don’t believe that pension funds are going to continue to deliver 7% returns, 4% real returns after inflation, year after year for the next three decades, do you fix the system by converting participants to an adjustable defined benefit, or by converting participants to a 401K?

To the first question, if you truly believe real rates of return are going to hover somewhere north of 4% per year, forever, then you should have no trouble agreeing to an adjustable defined benefit. This would simply be a modification of pension formulas, whereby pension benefits would be reduced by a uniform percentage, applied to everyone – new hires, active employees, and retirees – by as much as necessary to maintain an adequate funding ratio. By applying this formula to everyone equally, the amount of sacrifice for any given participant is minimized.

The alternative, should markets turn downwards, is to intensify attempts to protect veteran employees and retirees at the expense of new entrants to the public workforce. The fatal problem with this method is that new entrants have lower rates of pay and a very long wait until they retire, both factors that minimize any benefit to the fund’s solvency by reducing their pension formulas.

The other alternative, which many pension reformers have determined is inevitable given the intransigence of public sector unions to even consider options such as an across-the-board adjustable defined benefit, is to go to a 401K defined contribution plan. That would force every individual to hope they successfully pick the best investments, subjecting them to the caprice of a highly volatile, highly manipulated global market. It would also force every individual to hope they die before they run out of money. It is not a preferable option. It is as brutal as it is whimsical.

What government union leaders and their members must realize is they have set themselves apart from the rest of the American people during a unique period in our nation’s history. Between 1980 and 2030 the percentage of Americans over age 65 is projected to double, from 11% to 22%. At the same time, the costs of healthcare march relentlessly upwards – partly because medicine can do so much more to improve the length and quality of life. Moreover, we are entering the terminal phase of a global debt bubble that has been inflating at least since 1980. It’s about to pop. Passive investment funds are not going to be coining money like they used to.

Government unions can continue to demonize wealthy people, hoping enough voters will be duped by this scapegoating, but they must understand that “wealthy people” is becoming synonymous with “old people.” Their rhetoric, therefore, will foment discord between generations. Yet the reality is quite different. If things continue the way they are today, the discord, and the wealth disparity, will not be between old and young, but between old government workers (and the super rich, of course), and everyone else – young and old private sector workers, as well as newly hired government workers.

Ensuring that every American can enjoy sufficient retirement security to allow them to live their final years with some measure of dignity is not going to be easy. The solution is to lower defined benefits for all government workers to financially sustainable levels, as needed, and more generally, to move towards applying the same set of taxpayer funded benefit formulas and incentives to all American workers equally, for them to earn regardless of whether or not they work for the government.

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Ed Ring is the executive director of the California Public Policy Center and the editor of