Reformed Public Pensions Can Still Be Generous

As documented in a September 18, 2016 story in the L.A. Times, the problem of California’s unfunded public pensions has reached crisis proportions. The state controller’s office estimates that the total unfunded liabilities of the state and local public pension systems are $241.3 billion. But this assumes an annual return on investments of 7.5 percent per year. Stanford professor Joe Nation, using a lower 4 percent annual return, shows the unfunded liabilities could approach $1 trillion.

For perspective, Nation’s estimates indicate that the unfunded liabilities of California’s public pension system could be larger than the entire economy of Indonesia (the 16th largest economy in the world) and nearly as big as the entire economy of Mexico. Clearly, reforms are necessary.

A potential obstacle to reform is the impact on the retirement income of public employees. In reality, current public pensions are very generous relative to the retirement income private sector workers can expect to receive.

This discrepancy creates an easy reform opportunity.

So, how big is the gap? Andrew Biggs from the American Enterprise Institute estimated the combined state public pensions benefits as a percent of the final salary for career state government employees across the country. In California, the retirement benefits equaled 102 percent of the final salary.

Biggs’ results are consistent with the findings from my recent study, California’s Pension Crowd-Out, which compared the potential retirement income of two teachers with the same lifetime earning profiles — a public sector teacher and a private sector teacher.

The public sector teacher’s pension income was estimated based on the current CalSTRS 2@62 retirement benefit program — the current retirement program available to public school teachers in California.

The private sector teacher’s retirement income was based on the typical benefit available in the private sector. Typically, private sector workers are enrolled into a defined contribution retirement plan where the employer and employee both contribute money into a 401(k) plan that will partially fund the worker’s retirement.

To ensure that the calculations did not understate potential contributions, I assumed that the private sector teacher followed the suggestions of financial advisors and saved 10 percent of his or her salary for retirement, and the employer contributed the average match currently offered in the private sector ($0.50 for every dollar of salary up to the first 6 percent of the employee’s salary). Since the private sector teacher will have to devote more of his or her income toward retirement throughout his or her working career, his or her income after retirement savings have been deducted will actually be lower than the public sector teacher’s.

Both people were assumed to begin working at age 25 and earning the average starting salary for a teacher ($39,972). Adjusted for inflation, the salaries of both teachers grew 2 percent annually each year until they both retire at age 67 — the Social Security retirement age for people born 1960 and after. By the time both workers retire, they would have worked for 43 years and their final salary, adjusted for inflation, would be $91,825.

The results from this comparison are striking.

Even though the teachers both have the exact same lifetime earning profile, the public school teacher would receive an annual pension worth $92,918 at retirement or 101 percent of the teacher’s final salary. This pension is then eligible for inflation and benefit adjustments.

Including Social Security benefits and the nest egg that the private sector teacher was able to accumulate, the private sector teacher is able to create a retirement income worth $60,827 a year, or 66 percent of his final salary. Such a pension income would meet the current retirement income rule of thumb once the lower expenses of retirement is included. Generally speaking, the rule of thumb is to replace between 55 percent and 85 percent of a private sector worker’s pre-retirement income once all income sources, including Social Security, are included.

Although the retirement income of the private sector worker is within the suggested range, the income pales in comparison to the public sector teacher. And this comparison does not account for the different retirement risk profiles. At the assumed expenditure rate, the nest egg that the private sector teacher accumulated over his or her entire working life would only last for about 19 years.

Therefore, should the private sector teacher live past 86, his entire nest egg would be depleted. The public sector teacher does not face such risks.

Of course, there are many assumptions necessary in order to make these comparisons, and changes in the assumptions will change the exact numbers. However, reasonable changes to these assumptions do not change the wide discrepancy in potential retirement incomes between otherwise identical workers – the important illustration of this comparison.

With respect to California’s unfunded pension liabilities, the lesson from this comparison is clear. Not only can the unfunded public pensions liabilities be significantly reduced by adjusting the current overly-generous pension benefits, the reformed benefit levels provide comfortable (and comparable) public pensions benefit for public sector workers.

Nothing contained in this blog is to be construed as necessarily reflecting the views of the Pacific Research Institute or as an attempt to thwart or aid the passage of any legislation.

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