Why California Is Going Broke

There’s a piece on Bloomberg that talks about pension spiking by educators in California.

In his final full year of nine as superintendent of the 3,500-student system 25 miles (40 kilometers) south of San Francisco, Bayless got a $61,000 raise. When he retired in 2007 at 56, his annual pension topped $154,600 — exceeding his salary before the 45 percent increase, retirement system records show. After its review, the fund cut the payment by 26 percent last year to just under $114,600.

Abuse of course is rampant, but what is even more shocking is the part not discussed, which is the future solvency of the California pension system.

So this poor guy got his pension reduced to $114,600 or so. Let’s assume for a moment that he’s going to live to 90 – remember, on top of the inflation-adjusted pension he has free healthcare for the rest of his life. If we use John Hussman’s return model, we can assess the return on investment for the pension fund at maybe 3.5% or so, with an inflation rate running around 3% we end up with a real return of 1.5% or so. We further assume the healthcare adds 20% or so to his pension, so we’re looking at $137,500 in constand dollars over 34 years. My trusty HP-12C says the fund better set aside $3.6 million to pay this guy. But in fact they’re assuming more like 7.5% return so they would claim they’re fully funded at about $1.7 million. But in fact they’re 69 percent funded according to the article, which translates into $1.16 million. The real truth is that they’re more like 33% funded, with the taxpayer certain to be called on to make up the shortfall.

This is such abuse. Retiring at 56? With $3.6 million? This guy ran a 3,500 student system. So he gets $1,000 per student when he retires? And he is just one person on the staff of that system. Do the math. California is doomed by the greed of the public sector unions.

Of course, it isn’t just California. Illinois, our President’s home turf, is pretty much bankrupt already.

The teachers’ fund is one of the country’s worst-financed statewide pension systems, reporting that it is only 47 percent funded. And that’s if you buy the system’s rosy accounting assumptions, including that it will achieve 8.5 percent annual returns on its assets. This level is tied for the most aggressive investment assumption among state pension funds in the country, and the fund has had to get creative in an effort to meet it. Pensions & Investments magazine says it has the fourth-riskiest pension investment portfolio in the U.S., with less than 17 percent of its investments in fixed income and cash.

So in the real world it is probably more like 15% funded. If that. The proximate problem for all these funds is that the long-term assumption – either theirs or Hussman’s – doesn’t include the problem of making payments when there is a drawdown.

Let’s say we take the California guy who is getting the $137,500 and let’s even say that they’ve got the $1.16 million for him. Even if they end up getting 7.5% over thirty years, what happens if returns are zero – as they have been for the last 10 years – for the next four years? He gets $550,000 over that time. Now it is four years later and there’s only $600,000. To make the 7.5% average correct, they would get 8.5% over the remaining thirty years. The problem is, 8.5% on $600,000 only pays $56,000 or 41% of what is due. That’s the drawdown problem. By the way, it’s a huge risk for retirees in general, of course, who are investing in retirement.

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  • Tyro  On April 12, 2012 at 3:10 pm

    I’m saddened that the “cut” didn’t even take his pension back in line with the pre-spike level. I think pension spiking sounds like a great idea for those involved but it’s criminally stupid when other people have to foot the bill in the end. If the pension plan contributions are based on current pay while working, it’s a nice way to ensure that the plan will be underfunded out of the gate. This is especially important when considering the drawdown you mention next…
    I think it should be noted that there’s a limit on what you can set aside for retirement tax free, which is a set total and doesn’t scale with pay… (http://benefitsattorney.com/modules.php?name=415)

    • reality  On April 12, 2012 at 3:45 pm

      The real problem is that the defined benefit pension model only works with stable returns, such as from bonds maturing contemporaneously with the actuarial commitment of the funds. This is how pensions worked in the distant past. But then Wall Street decided that it could make more money by convincing pension funds to invest in stocks, which they did. However, the volatility of stock returns effectively doomed the defined benefit model because of the drawdown problem. The funds then compound the problem by reaching for riskier assets (riskier = more volatile) in an effort to make up the losses.

      The spiking issue is just icing on the cake, really. The situation would be unworkable anyway, because the over-contribution required to offset the drawdown problem would drive the costs out of sight.


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