Saturday, March 5, 2011

Pensions and Taxes - Take 2

So I had a discussion tonight with some friends about the Wisconsin situation, government pensions, and pensions in general. I can't say I am much more swayed in either direction. But the one thing I did realize is the issue with pensions in general is an individual doesn't really have to think about it - which is a scary thought. Do we really know what the costs and implications of pension plans are?

I ran a quick calculation. There are some great calculators at this Financial Calculators website. I started with a worker making $32,000 today. I assumed a 2% COLA adjustment and a 2% step adjustment every year for 30 years. At retirement, that worker is making just about $101,000/year. That totals about $1.8 million of total pay over 30 years (this number is important in a minute) Taking the "high five" of that same worker and starting at a 90% of the high five average, that worker will start making about $93,000 in retirement, and assuming a 30-year retirement with a 2% COLA adjustment would end at $169,000 and will have drawn $3.95 million in retirement. If the pension did not exist, to draw that kind of wage in retirement would require about $1.9 million in an annuity making a 5% return. To save $1.9 million, a person would have to save $1,500 per month and get a rate of return of 7.43% annually. So to pay for this person's pension, the company or government has to set aside an extra $18,000/year and get a pretty high rate of return in order to fund this person's retirement. So just in pay and retirement benefits, this person is getting an effective wage of $50,000 the very first year and is getting a guaranteed return of over 7% on investment. This doesn't include any other benefits such as health care.


I thought of 1 other interesting statistic to run today. Using the example of the above worker making $32,000 in the first year would require $18,000 per year deposited into an account making over 7% annual return, I thought I should see what that would add to the benefits as an average percentage. It comes out to about 32% of salary per year towards retirement benefits. The best retirement matching I ever had was 10% of my salary, and I had to be at that job 5 years before that took effect. I also didn't make $32,000 / year.

I also thought I should point out a couple of articles. This USA Today article is a summary of federal pay versus private sector pay (it does not include benefits). Here's one that takes into account education levels. And probably the best one is this one showing the comparison in each state of private and public compensation. I felt it was important to show the counter-point to those that claim government workers take lower pay now for the deferred compensation later. As I argue here, I think individuals should be responsible for their compensation later in life, and in exchange get paid what is appropriate now. It keeps things fair AND prevents long-term, unknown liabilities.

What does this all mean? I know for sure that in regards to the Wisconsin situation and government pensions in general, things have to change. This is an unsustainable model in the world of lengthening life-spans and increasing aging population. As I said in a previous post, the scariest part of the whole situation is we are at risk of leaving our parents and grandparents with nothing. People my age that continue to demand these type of benefits at this rate will eventually run everyone out of money. So what do we do?

A simple fix would be to start to immediately raise the retirement age. Now I am not saying this applies to everyone, but a nice steep graduation such that for every year you are away from retirement we add in the neighborhood of 1/3 to 1/2 a year to your retirement age. This would put pensions more in line with how they were intended - a 75% accumulation time to a 25% distribution time ratio. This would also go for social security and similar programs to keep them solvent as well.

A more dramatic fix would be to take pensions completely out of the realm of the employer. Pensions should be run by an association of participants or a similar organization. By leaving them with the employer, it subjects them to unknown liability. We end up with situations like GM or Chrysler where we all pay for those pensions through bailouts or a Wisconsin situation where the budget is beginning to be weighed down by retiree benefits. Instead, the pension fund would be funded with a finite negotiated dollar amount from the employer, and the association of employees would be responsible to keep it solvent and set the benefit levels. The other option is to leave individuals in charge of their funds, by having 401(k) or 403(b) accounts where an employer can match funds deposited, but again absolves the employer of long-term liability. Current pension participants could choose to either move their pensions to a group pension outside of the employer or move to individual plans and have a lump sum initial contribution made to their plan based on years of service.

The second option seems to work from an initial glance because employees and employers generally don't have contracts that span the entire length of an employee's tenure. Thus the pension, once implemented, becomes nearly impossible for an employer to change because of the long-term impact to the employee. This is one of the main reasons why airlines, car manufacturers, LTV steel and other mining operations, and other companies have all gone bankrupt. This leaves those employees without the benefits they were expecting. The only difference with government pensions is governments either can't or have a harder time filing bankruptcy (depending on the level of government), thus the taxpayers end up on the hook.

To focus again briefly on Wisconsin, I don't think the the Republicans or Democrats have handled themselves in a good way. Gov. Walker did indeed create the remaining shortfall for 2011 by cutting a few corporate taxes. However, those tax breaks only account for about 2% of 2012's shortfall in Wisconsin. I do think both sides should have met, made their case, and perhaps compromise or come up with an entirely new solution (see my solutions above).

Update 2

Just thought I should briefly comment on the "rights" to collectively bargain.  This certainly is a right as in the right to assembly, but then the employer also has a right not to associate with your association - meaning at the end of a CBA, they can choose not to renew it and hire other workers.  So this works both ways.  Let's make sure we have perspective.

Also, government unions have a conflict of interest.  Unions were the largest contributors to the last 2 elections.  Elections in turn are the choosing of the very boss/people they will later be negotiating with.  Imagine you are sitting across from the table from the person you just helped hire and will also have a say in rehiring a few years down the road.  Do you think that person would have an interest in giving in to whatever you want?  Of course.  This is why there needs to be a change with either unions involvement in elections or their involvement in government.

FDR, one of the pioneers of modern progressive policy was against public sector unions. Even the unions themselves thought this was absurd and beyond the scope of the purpose of unions.

I think as a general rule, we need to get the federal government and each state government to work together to create long-term tax stability. Basically, let's leave the rates alone and work our budgets around the dollars being collected. Then, as the economy grows, so to should the dollars flowing into government since most taxes are collected as a percentage. Tax stability is very important for business development and investment decision-making. The economy will have ups and downs, but its stability is further eroded by tax uncertainty.

Finally, a small word on government budgets and tax rates. They both need to be cut. But even before cutting taxes, we need to start with balancing the federal budget. This year we are expected to have a deficit of $1.6 trillion. Some justify it and saying we need it to stimulate the economy. Here's the thing... that money would end up in the economy anyway. If government borrows money, the people or countries doing the borrowing treat it as an investment. Let's just say the government balanced the budget right now. Those people with the $1.6 trillion still need a place for their money. So they put it in savings (which in turn can be borrowed to start new businesses, buy shares, etc), they buy stocks, they buy real it still stimulates the economy. There is only so much money that can fit under the mattress. Why does China borrow so much money to the US? Because we buy so much of their stuff. Think of it this way - when we buy stuff from China, we buy it in dollars (yes, it might get exchanged, but the reality is somehow they need to convert that money). So China needs to do something with those dollars - invest in American companies, buy American goods - or they can borrow it to us. If we stopped borrowing, they would have to find another place to put that money - which would be those very businesses that would stimulate the economy. We need a balanced budget and tax stability now.

I am really hopeful that people in America are starting to see we've over-promised and it's time we get back to the American way of hard work and reducing the entitlement mentality. I also hope we are starting to move away from this political elite class and we can get some real problem solvers in. I think everyone can be on board with that.

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