PERS misery

No one in Government wants to face ugly truths.

This blog post is no fun.

State legislators are facing the grim reality that their pensions are underfunded.  People want to cross their fingers and hope for a magical solution.

Some truths are just too painful to think hard about.   The Oregon legislature (along with almost every other state legislature) is dealing with the problem of pension underfunding.  Oregon Public Employee Retirement System--PERS--assumed that some 70% of the money needed to pay pensions would come from earnings by the portfolio of saved and invested pension contributions.   It was a wonderful idea.  Free money, through the magic of investing, rather than taxing people.

The idea was so enticing and investment gains seemed so easy that beneficiaries of the system were guaranteed an 8%--now 7.5% net--investment return on a fixed income portfolio and, even more unrealistic, a rate of return from investments during the annuity  phase (the payout period after retirement) of 8%.  Typically an insurance company or other institution in the annuity payout business would invest that money in very safe, reliable investments since their obligation is known and relentless: a check a month.  Currently treasury bonds of 10 year maturity pay about 2%, not 8%.  A mix of almost-safe fixed income investments might boost the yield a little, but in a world in which the ten year treasury is 2%, investments that are safe enough to be in that portfolio don't pay a lot more than that baseline.  An interest return of 3.5% is ambitious, and a bill--#560--is under consideration which would make future calculations on annuity payouts to be based on that 3.5%, not 8%, plus some other changes.  

It doesn't fix past problems but it will lesson future underfunding.  People will not like this.  Labor leaders called it "outrageous", considering it too much of a cut.  Moreover, it would cause an immediate avalanche of people retiring which would itself further stress the system.   Picture it from the point of view of a long time employee in her late 50s or early 60s, and there are a lot of them.   If they immediately retire they get, say, $4,000 a month.   If they wait until next year or a couple of years, they get $2,500 a month because new rules would be in effect.  You can bet a great many of them will retire right now, while the old rules are in effect.

Click Here for the Story

There is a disaster facing the Oregon PERS and it is unpleasant for everyone:PERS promised--contracted for--benefits that go far beyond what they can pay without substantial new taxes to make up for what the investment returns almost certainly can not provide.  They promised 7.5% and 8% returns in a world of 3% investment returns.

I am confident most readers have a sense of the difference a return of 8% versus 2 or 3% in the build-up of a retirement account.  Most readers have experience here, watching their own accounts.  And many readers are comfortable with the "rule of 72", a lovely shorthand way of thinking about investment growth.   Divide an assumed investment return into 72.  The product is the years it takes for an investment to double.   

Example:  If there it a pool of $100,000 and the investment return is 8% then 72 divided by 8 is 9, and therefore the $100,000 grows to $200,000 in 9 years and to $400,000 in 18 years and $800,000 in 27 years.  Those early contributions of an employee with a 30 year career really grow.

In a 3% investment world, calculate that 3 goes into 72 exactly 24 times.   So $100,000 grows to $200,000 in 24 years and adds another $20,000 by the 27th year, for a total of $220,000 versus the $800,000.   The difference is huge.

But the consequences are equally bad on the payout side and readers may be less familiar with how this works and its implications.   Assume that the brand new retiree, a long time employee now age 64 has, thanks to investment returns and taxpayer deposits, created an pool of $500,000 to pay for her retirement which would be, on average 20 years, the approximate life expectancy for a 64 year old woman.   PERS would calculate that that pool would be paid down to zero over the next 20 years.  They would have reserved the money to pay her retirement, just the way the system is supposed to work.   

Imagine if the pool earned no yield at all, zero.  It could pay out $25,000 a year (20 times 25,000) and the money would run out exactly as predicted in 20 years.  Perfect.  If PERS had made no promises about returns other than a return of that principal over her lifetime then the system would be sound on the payout side,and they would pay her some $2,100 a month for the rest of her life.   But that is not the promise they made.

Instead, PERS promised that they would calculate the internal rate of return of that pool of $500,000 as if it earned 8% and would calculate the guaranteed payout for the rest of her life accordingly.  So when figuring how much her payout would be they came up with a much, much higher figure than the $2,100 a month they would pay out if they were simply withdrawing the principle.  After all, the $500,000 would earn $40,000 per year, not zero, in that first year, and almost that much the second year, and so on,  so as they paid down the amount the amount still left in the account would be earning that 8%.  They therefore could--and did figuring an 8% investment return--guarantee a monthly payment of  $4,182, or just over $50,000 a year.  That is what a $500,000 pool would allow if in fact it earned 8% per year as it slowly paid out over 20 years.

Unfortunately, 8% investment returns are simply not realistic.  So taxpayers need to step in to replace the money that investment returns cannot likely earn.  How much? At 3.5% internal returns during the payout phase, an ambitious but sensible number, the investments earn enough to pay out some $2,900/month, or $34,800 a year for the 20 year life expectancy.   Investment returns are about $15,000 short of what was promised.  Every year.

It gets worse.  The PERS people promised cost-of-living adjustments on top of the unrealistic payouts.  Inflation does not solve the PERS problem.  It continues it.

Click here for the Oregonian article

The Oregon legislature is looking at bills which will, if passed, reduce some of the gap, but none of the solutions are pleasant for public employees.   One proposal is the increase from 3 years to 5 the years under consideration for the final salary.   Many employees seek overtime and other pay adjustments in their final years in order to boost the salary which is multiplied by the number of years for pension calculations.  Another proposal is to raise the retirement age from 65 to 67.  It would mean payments are for fewer years.  

Each of these things help but the real solution is that taxpayers must pay more.

Oregon State Senator Alan DeBoer talked to me about a bill under consideration that would add a surcharge of another 1.5% on incomes of $250,000 per year or greater.  This would move the marginal tax bracket for high earners from 10% to 11.5%. The extra money would be dedicated to boosting PERS, he said. There are risks. Prosperous people are the ones who write campaign checks and Oregon is testing the boundaries of how high a state income tax can be.   It makes Washington and Nevada, two neighboring states with zero income tax, more and more enticing to prosperous retirees free to move their tax home elsewhere.  But most taxpayers do not earn $250,000 a year.  It may be popular enough to pass.  

The other solution, which is inevitable, is that school districts and other public bodies simply budget more money raised to go to retirees and cut the services for their current mission.   Fewer teachers in the classroom and school programs get cut  longer lines at the DMV, fewer caseworkers for foster children.  That is the reality.  Government services will get worse and taxes will go up, both.   

Why?   The State of Oregon made a deal that turned out to be a very, very expensive one, and now we are beginning to pay for that mistake.