When John Galt read one of my posts concerning labor unions, he suggested perhaps it was time to write another article.  I readily agreed, but thought I would be clever and write one on pensions instead.  Once again, the old adage, “No good deed goes unpunished,” has come true.  While I had some idea there was a problem looming on the horizon, what I discovered stunned me.

To begin with, a little background on pensions in the US.  The first private pension plan was created by the American Express Company in 1875.  By 1930, most large companies offered pension plans and most survived the Great Depression.  The ones that failed were the ones funded under a pay as you go system, where benefits were paid out of current earnings rather than funded reserves.  The Social Security Act of 1932 began the growth of state and local government pension programs.  Pension plans expanded with the Wage and Salary Act of 1942, which was instituted to freeze wages in an effort to curb inflation.  Pension benefits were added as an incentive to attract workers when wages could not be increased.

The type of retirement plan primarily utilized by the public (government) sector and unions is the defined benefit plan (DBP).  Like the 401(k) and other defined contribution plans which are now more common in the private sector, DBP’s are typically funded by employee and employer contributions.  The disadvantages of a DBP are that the funds cannot be moved between employers and you have no control over how the money is invested, which is controlled by a system administrator.  The major advantage of a DBP is that the benefits are pre-defined based upon pay and years of service and cannot be reduced.

In the 1960s, the Studebaker Corporation failed, leaving the pension fund with less than 20% of the funds needed to pay promised benefits.  This gave birth to the Employee Retirement Income Security Act (ERISA) in 1974.  ERISA lead to the establishment of the Pension Benefit Guaranty Corporation (PBGC), which was designed to increase DBPs and to insure private sector plans like Studebaker’s from failure.  As of 2005, approximately 44 million private sector employees were covered.

Just how are the benefit levels determined in these defined benefit plans?  In California, the Public Employee Retirement System (PERS) uses what is called the 2-55 rule.  Under this rule, years of service are multiplied by 2%, with the result applied against your highest salary year, with a minimum retirement age of 55.  For example, an employee whose high salary was $60,000 and who worked for the state for 30 years would have an annual pension benefit of $36,000 (30 x 2% x $60,000).  This does not include retiree medical benefits. 

However, there is also a certain amount of “gaming” which goes on in the system.  The state allows an employee to “sell back” unused amounts of “banked” vacation pay for a lump sum payment.  If the employee in the example above were to bank two days of vacation each year, he would receive a lump sum vacation payout of $13,800 in his last year of service, likely also making that his highest salary period.  This would increase his annual pension benefit by over $8,000, or 23%!  This is just one way to game the system.  There are others used with similar results – larger annual benefits and greater taxpayer expense!

Unfortunately this pales in comparison to the increased cost which results when investment performance falls short of what is projected in funding the plan.  Last year in California, the PERS lost approximately $1 billion!  Since the benefits paid to plan participants are cast in stone (by the courts), these lost funds have to be replaced, by the taxpayers!  There are many states in the same situation as California, some with pension shortfalls larger than their annual state budgets!  With baby boomers now reaching retirement age, the costs will be staggering! 

It has been estimated that the US has over $100 TRILLION  in unfunded obligations, including public pensions, social security, Medicare and debt service.  It’s enough to give you heartburn.  Bon Appetite!

Gregg: The Public Employee Pension Tax

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