A quick-and-dirty analysis:
35 years of 11% contributions based on $60k/yr salary, compounded at a 5% real return, comes to:
=FV(0.05/12,35*12,5000*0.11) = $625k

25 years of 80% payout, compounded at a 8% nominal return, requires funding of: =PV(0.08/12,20*12,4000) = $518k.

The major errors in the above:
(1) Teaching salaries escalate rapidly over the first ten years of employment (typically adding $20k between the bottom and top of the scale), so those valuable EARLY years contribute less to the pension fund.

(2) A portion of the pension is indexed for inflation, significantly increasing the cost.

Still, both of those simplifying assumptions pale in significance next to the assumed 8% annual returns, 5% real returns (calculating real return as nominal return less wage escalation). If you knock the assumed real return down to 3% (partly to take salary escalation into account) then the employee contributions fund only 80% of the pension.

Still cheaper for the schools than paying Social Security would be. As long as the school/state contribution to the pension is less than 6.2% annually (36% of the value of the pension), it saves the taxpayers money. This is why they prefer “pension reform” to abandoning the pension system entirely.

The pension system works out quite nicely for a teacher who starts in their mid 20s and never does anything else. It is a good deal for the taxpayers, who don’t have to contribute to Social Security. It is a very bad deal for anybody who teaches for a decade and then leaves (contributions are returned, NOT investment growth) or for anybody who spends a decade in private industry (contributing to Social Security) before entering teaching.

The ultimate effect of this is to suppress career mobility in teaching. The longer you’ve taught, the greater the cost to leave (even if your heart is no longer in it). Nor is it a recommended “second career” for anybody coming from business, since they are still required to contribute the same 11% to the system but at sharply less favorable terms. (Among other things, their paid-for Social Security benefits will get “clawed back”.)

It continues to puzzle me how people can complain about public school teachers and teaching, yet work SO hard to make the job unattractive to people with professional qualifications and experience.

Then the pension is wholly paid for. A teacher might start at $40k and work up to $60k, contributing an average of $8k per year over the first fifteen years (double what you describe). Moreover, at a 5% real rate of return the money doubles every 14.5 years, so those initial contributions compound substantially before retirement. Finally, your annuity payout assumes industry standards that are based on a *3%* rate of return. If you assume an 8% rate of return on the payout, you get a much higher income stream.

As always, the devil is in the details. In this case, the key detail is the assumed rate of return. Massachusetts assumes investment returns of 8.25% on their portfolio. If they can achieve that, they’ll be fine. But I fear that is a political fiction in this investment environment.

In the private sector where accounting rules and funding requirments are actually tougher, nearly all companies have converted to defined contribution rather than defined benifit plans. The risks of underperforming investments has been entirely shifted to workers.

In the U.S. the law requires payment in full of the benifits that have been acrued by workers. The problem with pension math is that the teacher you used in your example has not actually invested all that much… in the ballpark of 60k assuming 4000 annually. Even if you add the compunding at 8% (a fantastic return over the last 15 years) that only gets you to 100k.

Now 100k is a lot of money… for a 40 year old to have saved up for retirement… but it’s still not anywhere what the pension will be worth.

If you are willing to assume that the average teacher retires today at 60years old with a final salary of $60,000 what will it cost to replace 80% of that income?

Well to buy an immediate annuity paying $4000/month costs $692,401 according to http://www.immediateannuities.com

So there’s the problem… the teacher you used in the example has worked 42% of there carreer and has amassed about about 1/7th of what they need to retire.

I’ll also point out that the pension scheme you noted in Mass is actually pretty reasonable compared with many. Many allow 100% income replacement rather than 80%. Many allow for inflation ajustment… that one imminently fair and seemingly small change increases the cost of a pension by nearly 1/3rd.

A MA teacher born in 1971, hired in 1996 at the age of 25, contributes 11% of their salary annually to the pension fund. In return they can retire at the age of 60 (after 35 years of service) to an 80% pension. If you assume an 8% annual return, the employee contributions fund roughly 80% of the value of their pension. The state obligation is minimal.

Your “solution” slashes the value of that pension (which they paid for 80% out of their own pocket) by a third. The state promised to fund 20% of the pension. Instead, they’ll contribute NOTHING — instead confiscating a portion of the employee contributions to pay off past debts.

Sounds like “getting the shaft” to me… Especially since you don’t offer them any positive alternative. They can quit their job (in which case they get back just 2% annual interest on their contributions, leaving the remainder in the fund) or they can accept that they’ll get back less than they put in.

Any HONEST pension reform would take one of two alternative paths:
(1) It would wholly honor existing obligations and terms, applying only to new hires.

-or-

(2) It would offer current employees the right to withdraw their pension contributions from the system along with the 8% rate of return implied by the pension assumptions.

The former could easily cost MA alone hundreds of billions, especially if future investment returns fail to keep up with the 8.25% target rate.

The latter would result in roughly a $20B obligation (if everybody were to cash out of the system) but would protect the state from additional losses down the road.

Hopefully the MA Supreme Court will strike down any attempts to otherwise renege on the implied debts.

In 5 years time this problem will be mostly behind us and the public retirement ages will be pegged at the same age as Social Security using exactly the same discounting forumla for early retirement. You want to retire at 62 you get 66% of your full penison.

The problem now is that some municipalities truely do have old General Motors style pensions retire with FULL INCOMRE REPLACEMENT at 60. That is a staggeringly expensive benifit considering the life expentancy of a 60 year old is something like 26 years. (And probably a bit higher if you consider that the 60 year olds in question are well educated citizens with good health care!)

The problems in MA are likely pretty typical. Formal debt around $80B, with a public pension that is underfunded by $20B. Seems pretty manageable for a state with a $400B GDP, no?

It isn’t that easy, though. First, the state revenues are only $30B, so the debt is more than 3x the annual money available to pay it. Second, the $20B pension shortfall assumes an 8.25% annual return on the $50B pension fund. Anybody seriously think they can achieve that target?!? (Nor can this be “inflated away”, since pensions are tied to wages and partially indexed to inflation.) Their actual pension obligation could run to the hundreds of billions when all is said and done.

This isn’t “breaking contracts with unions”, however. The pension system may have been originally negotiated with unions, but it is an obligation to the INDIVIDUAL. Teachers hired in the last fifteen years pay 11% of their salary into the pension fund, in theory enough to pay for their full pension (albeit with optimistic return assumptions). After decades of collecting their contributions (and using them to pay benefits to retirees) you’re going to turn around and tell them their pension is worthless?!? Bernie Madoff went to jail for precisely that fraud.

I was at one point a teacher in Massachusetts, forced to contribute to the retirement system. Under state law this is NOT optional (I asked when I was hired), likely because it exempts the state from paying into Social Security. When I left the public schools after a decade, I withdrew my contributions from the system (along with 2% annual interest that they so graciously were willing to pay me for the use of my money), which is a big part of why I’m financially sound today.

But my ex-colleagues are still contributing their 11%, still hoping that they will receive SOMETHING when they retire. They won’t get Social Security, even if they’ve paid their 40 quarters (state law prohibits that). They won’t get anything like their full pensions if the state is allowed to declare bankruptcy. I sure hope they have something else to live on!

The pension system is evil in so many ways, but if states are allowed to steal pension funds and then declare bankruptcy, it becomes a pure fraud, perpetrated by the taxpayers against the public school teachers and employees.

It is highly likely that there are any number of hedge funds and possibly investment banks who believe that the next “big short” is in munis. One of the few ways to short munis is to buy credit default swaps on the big, heavily traded issuers, which tend to be the large states, most of which are facing fiscal troubles. And these are no longer just the ususal suspects of Ca, Il and NJ. You can now add Az, Fl, Mi, NY, Pa and Tx just for starters.

So what better way to send the value of those CDS’s through the roof than to abolish the prohibition on state bankruptcies. If you could follow the money from those who stand to benefit from this trade to members of Congress behind this legislation, you might just find another example of the wicked folly of the Citizens United decision.

“The sound and true rule is that if the contract, when made, was valid by the laws of the state as then expounded by all departments of the government, and administered in its courts of justice, its validity and obligation cannot be impaired by any subsequent action of legislation, or decision of its courts altering the construction of the law.. We shall never immolate truth, justice, and the law because a state tribunal has erected the altar and decreed the sacrifice.”

1. “The Tenth Amendment doesn’t say send power from Washington to Austin. The Tenth Amendment says ‘The States and the people thereof’ and so the trick is to get the power through Austin back home.”

From http://www.uscourts.gov/FederalCourts/Ba nkruptcy/BankruptcyBasics/Chapter9.aspx

“The first municipal bankruptcy legislation was enacted in 1934 during the Great Depression … Although Congress took care to draft the legislation so as not to interfere with the sovereign powers of the states guaranteed by the Tenth Amendment to the Constitution, the Supreme Court held the 1934 Act unconstitutional as an improper interference with the sovereignty of the states.”

2. “States like California and New York and Illinois that think they’re going to come to Washington for money can be told, you know, you need to sit down with all your government employee unions and look at their health plans and their pension plans and frankly if they don’t want to change, our recommendation is you go into bankruptcy court and let the bankruptcy judge change it, and I would make the federal bankruptcy law prohibit tax increases as part of the solution, so no bankruptcy judge could impose a tax increase on the people of the states.”

Ah … a two tier system:

1) Bankruptcy judges making decisions on behalf of states such as “California and New York and Illinois.” Gee, whom do they usually vote for?

2) For Texas, state sovereignty, even though Texas is “$27 billion short of what we need to write a budget that funds what the state is doing now.” http://www.cppp.org/research.php?aid=102 8

Fair and balanced.

Pure gold Felix… poetry.

Now explain to this investor how California is going to do that.

Their top income tax rate is 10%
They charge state and local sales taxes of up to 10%
They charge the highest gas tax in the nation almost 50 cents a gallon.

These taxes do not bring in nearly enough rev to cover the cost of the goverment they have created.

I know you hate making any comment that could remotely be construed as investment advice but broadly do you think the current ytm of roughly 4.5% on a 10 year California State GO bond adaquatly compensates an investor for both interest rate risk and credit risk?

At current yields I think you’re better off looking at the weak Euro-states than Cali.

I seem to remember not too long ago that GM insisted that it could not declare bankruptcy, as it was a self-fulfilling prophecy and no one would buy a car from a bankrupt auto company. And besides, even if it did survive, credit would become prohibitively expensive. Yet it managed to get done, with some important Federal intervention.

Now, I understand that GM is not Illinois, but can we not conceive of one or more scenarios that would enable a state to restructure debts and perhaps mend their fiscal ways? I think we probably can.

Felix, when will you admit that a lot of this misinformation can be laid at the feet of the Peter Peterson Foundation?