Though I support unions and their right to collectively bargain, I do not support the terms they have negotiated regarding retirement benefits. In localities where there are pressing funding shortfalls for those benefits, a solution must be found that is fair to both union members and tax payers who would otherwise have to make up all the difference in the funding shortfall. By 2013 the CBPP predicts a funding shortfall of around 28 percent, a deficit that has increased steadily since pensions were last fully funded in 2000. (See Figure 3: http://www.cbpp.org/cms/index.cfm?fa=view&id=3372)
The key problem is that officials on both sides of the table have assumed in past negotiations, and continue to assume today, a completely unrealistic rate of investment return of 8 percent in nominal terms (i.e., before reducing that percent by inflation).
As Figure 4 in the CBPP webpage shows, pension funds have actually achieved 8 percent returns over the past 20 years. After reducing that amount by the 2.78 percent inflation experienced during those 20 years, the real annual return enjoyed by these funds was a healthy 5.22 percent. (For inflation, see http://www.measuringworth.com/inflation/.)
Unfortunately real returns of 5.22 percent are not sustainable over the long term. Real World GDP growth seems to have a ceiling of around 4 percent per year. (http://www.economist.com/node/15127371) Quite a bit slower, annual real US GDP growth per capita between 1949 and 2007 was 2.2 percent. (http://www.measuringworth.com/usgdp/) It is worth noting that these starting and ending years help those who think 5.22 percent in real returns is obtainable annually, because I’ve removed the early post-WWII stagnation and the decline of GDP beginning in 2008. Moreover, most economists think the financial crisis has lowered America’s long-run, real potential growth rate to 1.5 percent. (http://www.economist.com/node/17493288?story_id=17493288)
As any economist will tell you, it is simply impossible for investment returns to outstrip growth of real wealth over the long term, unless the investor takes on more risk. If we can surprisingly match our post-war 2.2 percent growth rate, a portfolio that perfectly matched America’s economic profile would not exceed 2.2 percent gains. Similarly, a portfolio that perfectly matched the world’s economic profile could not exceed more than 4 percent or so of gains per year. Of course, even perfectly matched world-wide investment would entail considerably more risk than an investment targeting just the US. Investors who wish to beat the above figures will have to increase the amount of risk they are willing to take on. There is no way around that fact.
The nominal returns of 3.9 percent earned by pension funds over the last 10 years are much more reflective of what we can realistically expect heading into the future. After factoring out US average inflation of 2.35 percent over that same time period, our real return was 1.55 percent per year, which is very close to both the real growth the US realized at that time and what it can generate over the long term. (For inflation see http://www.measuringworth.com/inflation/. For Nominal return, see CBPP Figure 4.)
In short, any attempt to replicate a nominal return of 8 percent or a 5.22 real return will have to entail a lot of risk. Yet, I think everyone can agree that pension funds have a responsibility to be conservatively allocated, given that tax payers are obliged to make up for shortfalls. It is therefore remarkable that the 26 to 28 percent pension shortfalls the CBPP predicts we will suffer over the next three years require an 8 percent annual investment return. Without 8 percent returns on pension investments, this yawning gap will obviously grow and become increasingly problematic. Yet, since investment returns cannot possibly exceed real wealth creation over the long term, without taking on extra risk, expecting an 8 percent return over the long term is total fantasy.
Let’s run the numbers for two Maryland workers as generously as possible, but without irresponsibly assuming we can beat the total real growth of American GDP. If you wish to check my figures, I use a compound interest calculator that can compound annually and monthly (http://www.webmath.com/compinterest.html) and the resources at Measuring Worth (http://measuringworth.com/graphs/indexan.php).
1) In 2011, the starting salary for a Maryland govt analyst with a BA is $40,291. A skilled state auto mechanic starts at $29,855. Let’s set a retirement goal for both of them at a quite low $20,000 per year in 2011 dollars, for 30 years, and assume 30 years of work. (http://www.dbm.maryland.gov/jobseekers/Pages/JobSearch.aspx) Since all the growth rates are “real”—i.e., they already filter our inflation—our $20K retirement goal, current and future salaries, and investment returns will remain in 2011 dollars.
2) The average annual wage gain enjoyed by the bottom 90 percent of wage earners from 1949-2007 was $266.76 per year or 1.73 percent in real average salary increases per year. I’m going to apply this same rate of real salary gain to both our workers, a fact that helps unions out, because over the last 40 years none of the increases in real wages have accrued to the bottom 90 percent, and there is no reason to think this trend will reverse in the short and mid terms. Also, as I noted earlier, the years I selected are generous to unions. (http://www.stateofworkingamerica.org/pages/interactive?%2F%3Fstart=1997&end=2008#/?start=1947&end=2007)
3) Applying our generous 1.73 percent real salary increase, compounded annually for 30 years, results in a final year salary for the analyst of $67,403 and for the mechanic of $49,945. The analyst therefore makes an average career salary of $53,847, while the mechanic makes an average of $39,000. These are the salaries we will work with to approximate the ease with which these workers can meet their retirement contribution.
4) Applying a monthly compounded real US GDP growth rate of 2.2 percent (annualized)—a safe rate of real return—means that our analyst will have to set aside $10,411 per year, or 19.3 percent of his average pretax salary to retire on $20k per year. Our mechanic would have to invest 26.7 percent of his pretax salary to enjoy the same retirement. If unions wish to earn a higher rate of return, they will have to take on additional risk on their investments.
Conclusion: These 20K per year retirements would be very uncomfortable, especially until social security kicked in at some point in our workers’ late 60s. Moreover, the required rates of employee contributions are draconian. It is completely unrealistic to think that Americans can successfully save 19.3 to 26.7 percent of their pretax earnings—ie., before they contribute even to Social Security or Medicare. Unless tax payers are willing to underwrite extra investment risk for pension funds, there is no way that state workers can retire for 30 years after working for 30 years. The math only works if they work longer and/or retire for a shorter period of time.
Incidentally, assuming 5.22 percent real returns means that our mechanic would have to contribute $4,346, or 11.1 percent of his average salary. This should be achievable, although he would still have a fairly miserable retirement. But only if we imagine the impossible—i.e., that our investment returns can outpace real US GDP growth by 240 percent over the long term and do so safely; that real salaries of workers in the lower 90 percent will rise by 1.73 percent per year despite not rising in the past 40 years; and that our average gain in real GDP will equal the 2.2 of our generously selected years of 1949 to 2007, despite the financial crisis—can we assume what supporters of state workers take for granted. It's a total pipe dream.
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