How do we value a pension for a public employee? We think it is fair and reasonable to compare the value of that pension by using the dollar amount needed to purchase a pre-paid annuity from a financial institution. In our example we use Vanguard Mutual Fund Company, the lowest cost option we could find.
A teachers pension is an annuity. How do I know that? Because the words and are used over 20 times in the Teachers Retirement System (TRS) Comprehensive Annual Financial Report for 2006. Therefore it makes sense to use an annuity value to compare it to a private sector pension. Apples to apples so to speak.
When it comes to funding an employee annuity, there are only two possible sources – the employee and the employer. So if we know the value of the employee contribution including the assumed accrued investment return (in this case 8.5%) then we know the balance of the cost of funding the annuity is the employer. There is no other source.
The accompanying spreadsheet shows the calculations. The math is simple: we know that in order for a private sector retiree to have a pension of $83,775 at age 56 indexed for inflation he would need $1.9 million dollars up front to buy a prepaid annuity guaranteeing that annual pension for life regardless of how long he lived. So we use the $1.9 million dollar figure a private sector worker would need as the fair value of the teachers retirement benefit. Again, apples to apples.
We also know the teacher contributes 8.4% per year so the difference is what the employer (taxpayers) has to pay. The teachers actually contribute 9.4% but 1% is for survivor benefits which are excluded from the annuity calculation on the spreadsheet in order to make the teacher to private sector comparison apples-apples.
An annuity including survivor benefits is even more costly than the example shown. The actual breakdown of the teacher 8.4% contribution is this: 7.5% for annuity, .5% to fund 3%/year increases and .4% for ERO (Early Retirement Option).
The ERO portion is refundable to the teacher if he doesn’t use it but we will include it anyway. Also note in our example the teacher began his career in 1971 when the teacher contribution was 6%. Again, in order to be extraordinarily fair we use the 8.4% contribution rate beginning in 1971 thus over calculating the teachers actual contribution by more than a third for most of his career.
We have also used the 8.5% investment rate-of-return assumed by the TRS even though we argue here why we don’t think that will happen. Warren Buffet thinks 6.5% is the rate to be used going forward. If Buffet is right then the employer rate jumps to 46%. See 2nd spreadsheet.
Another problem is the way the TRS calculates future obligations. The problem with this is: what if they do not earn 8.5% and in fact earn less than the long-term return of 6.5%?
What if there is a depression? During the last depression in the 1930 the stock market fell by over 80%. It is certainly within the realm of possibility that could happen again ($100 oil, terrorist attacks, etc.). If this happens the taxpayer makes up the difference. The taxpayer is liable for all shortages in the rate of return-estimate used by the TRS.
The teachers are guaranteed by the Illinois constitution to get every penny of their pension no matter how bad the economy is. And in a depression that could only be accomplished by an enormous increase in taxes exactly at the time most taxpayers could least afford to pay them.
Another costly assumption is the Life Expectancy tables used by TRS. If TRS Life Expectancy estimates are low then taxpayers are stuck with more taxes to pay for people living longer than initially expected. I would argue the TRS assumptions for life expectancy and salary increases are too low and represent more risk to the taxpayer than is prudent.
And those arguments proved to be true in 2006. In the TRS Comprehensive Annual Financial Report for 2006 the state actuaries report a trifecta of bad assumptions: average rate of return over the last 5 years was 7.9% not 8.5% (page 56), retirees are living longer than expected (page 87) and teachers salaries went up by $68 million more than assumed (page 86). If those trends continue, taxpayers are in for a huge triple whammy of tax increases.
Another complaint we hear about is our calculations are not using investment income from the assets currently in the pension trust funds. The problem with that is that money is also the taxpayers money not the teachers. The retirement systems are not pay, and teachers contributions have never covered the retirement benefits paid out meaning whatever is left was contributed by the employer i.e. the taxpayers of Illinois. For example in 2006 teachers contributed $800 million but benefits were almost 4 times that amount at $2.9 billion.
And there is another huge tax liability on the horizon that is not included in any of our numbers. That is retirement health benefits for public employees including teachers. According to the Illinois State Comprehensive Financial Report for 2006 (page 114) that amount was $700 million growing at 18% per year (compared to 2003). If that cost continues growing at say 9%/yr for the next 40 years then taxpayer liability for retirement benefits will more than double i.e. health benefits in 2046 would be greater than the current actuarial estimate for pension benefits. That means about $40 billion taxpayer dollars for public employee retirement benefits for the one year 2046. That will, of course, be impossible to pay.
What the teachers have in terms of retirement benefits is unavailable in the private sector where most taxpayers work and retire from. Consider that the teacher shown in the spreadsheets will receive a larger pension in his 15th year of retirement (and every subsequent year for his remaining lifetime) than he contributed over his entire career! His total take if he lives the normal life expectancy will be $3.7 million. And these excessive payments come from all taxpayers rich and poor alike. Thats because 28% of state income comes from the sales taxes, utility taxes and fuel taxes everyone pays.
Remember that when a single mother with 3 kids drives to the carry out to buy a gallon of milk the sales tax on that milk and the fuel and sales tax on the gasoline and the utility tax used to run her refrigerator all go to help pay for these multi-million dollar pensions. Only in a Blue state could a wealth transfer from the poorest citizens to wealthy retired public employees be considered enlightened public policy.
The only answer is social security and 401K for all public employees. Otherwise the state and its citizens will go broke funding retirement benefits for public employees.
The question comes down to this: why should public employees have a better retirement plan than their employers the taxpayers of Illinois?
Bill Zettler is a free-lance writer and consultant specializing in public sector compensation. He can be contacted at this email address..