Are Government Pensions a Scam?

2010 October 23

by Wesley M. Brown

Our dear, dear, Editor and I had a raging disagreement recently about the
New York Pension System. Not being any sort of math wizard, I found it
nearly impossible to believe that after 30 years in the system, a New York
State retiree’s pension would be calculated on the basis of 80% of their (3)
highest-salary/wage years, as opposed to some sort of average between their
starting salary/wages and their pay when they retired. In my very limited
and naive view, if a worker spent 27 years earning $50,000.00 (constant
dollars), but then was promoted to a $75,000.00 job for the last three
years, pension benefits would equal 80% of three years at $75,000.00.  Or,
the worker could also spend 27 years at a job earning $25,000.00 (constant
dollars), and then get promoted to a job earning $100,000.00 for three
years. The pension would thus be calculated at 80% of the worker’s last
three years at $100,000.00. So, while the latter scenario is likely rare,
this imaginary worker could conceivably earn more in pension benefits when
retired than he/she ever did in salary/wages while working the first 27
years in the system.

The answer, the Editor assured me, was the magic of compound interest. Funds
sent to the Pension System by the various governments were invested and
multiplied considerably by compound interest over a career working. Over 30
years, it was easy to see how a small number of dollars, invested in safe
things, and earning compound interest, could grow enough to be sufficient to
pay a retiree until their death.

Not satisfied with our Editor’s answer, I did some calculations myself using
a simple online compound interest calculator:

Assumptions

Employee makes $100,000.00 yearly for 30 years in constant dollars.

80% of $100,000.00 is $80,000.00, or roughly $6666.00 in monthly pension
benefits when retired in constant dollars.

Government employer contributes 5% of salary ($5000.00) to the Pension for
30 years

Government pension invests in safe things so the interest rate is 5%

Calculations

$5000.00 yearly x 30 years @ 5% interest compounded once yearly =
$348,803.95

$348,803.95 divided by $6666.00 (monthly pension benefit) = 52 months
By this simple formula the retiree only has about 4 ¼ years to draw upon the
pension until it is exhausted.

Now, I realize that some other factors may come into play, namely (1) the
remaining funds on the declining balance are earning compound interest as
the retiree is drawing on those funds (2) the pension fund may be earning
more than 5% compound interest (3) some retirees will contribute to the fund
for 30 years, retire, and promptly die, leaving their funds in the system.

But, even if I double the final pension balance to take into account those
factors, the retiree then only has 8.5 years at that rate before the pension
funds are exhausted.

Therefore, for all of you out there who understand this math far better than
I, are governmental pensions more of a Ponzi scheme (like social security)
than a pension investment fund? In other words, are government pension plans
actually relying on the contributions of current workers to pay some part of
benefits for retirees?

I invite all of you to respond.

One Response leave one →
  1. Dan permalink
    October 25, 2010

    I’m not certain that my state pension works the same way as social security, but since you mentioned SS, this link is worth looking at: http://pol.moveon.org/ssmyths/index.html

    It’s also worth mentioning that the ultra-wealthy do not pay anything at all toward social security. That doesn’t address anything in your point, but it’s still worth mentioning.

    Anyway, let’s clear up a few terms before I fully respond. What you’ve described is essentially a defined benefit plan (in simplest terms, a plan where your benefits are based on something other than contributions, like years of service). By comparison, a traditional defined contribution plan is like your 401(k) – your benefits are based entirely on your (and possibly your employer’s) contributions (plus interest due to investment).

    But most state pension plans are a little more complicated than just a straight-forward defined benefit plan. The basics of New York’s plan, as you’ve described them, sound similar to my pension plan in Texas. However, a few key points make it less of a ponzi scheme than you seem to think it is.

    First, at least in Texas, the employee contributes to his own pension annuity, in addition to the state. I (must) contribute 6.5% of my salary, and the state contributes 6.95% of my salary; so 13.45% of my salary goes into the annuity.

    Second, retirement is based on two factors: age and length of service. In Texas, you can retire at age 60 with at least 5 years of service, OR with a combination of age + service that equals 80. E.g., if you began working for the state at 20, you could retire at 50 (30 years of service plus 50 years old = 80). So you can’t swoop in and reap a pension salary without having paid in. You could, however, pay into the system for years and die before retiring (your survivors may be entitled to some of the annuity, but that involves even more convoluted calculation).

    Third, my monthly benefit payment is not based solely on my salary while employed. I actually only receive a percentage of my salary, and the percentage is calculated based on time of service. New York seems to be different, but in Texas, they take your years of service multiplied by 2.3 to arrive at the percentage of your salary you’ll receive (called service percentage). E.g., if you worked for 20 years and 3 months (20.25 years) your service percentage is 46.575. So, similar to what you described above, you would have to calculate your average salary from the 48 months prior to retiring, then multiply your avg. salary by your service percentage.

    E.g. Using your examples above, $100,000 for 30 years, in Texas you would be entitled to 69% of your avg. salary from your last 4 years. You’ve put in $195,000 to the fund (6.5% x $100K x 30 years), and the state has put in $208,500 (6.95% x $100K x 30 years) for a total of $403,500. Using your formula, $6500 + $6950 = $13,450 per year in contributions; at 5% compounded annually, the end result is a fund holding $938,282. Now, for ease of math, let’s say you retire and immediately get your first annual payment of $69,000 (69% of your avg. salary), leaving roughly $870,000 in the fund. At the end of the year it has earned $43,500 in interest (at 5%), bringing the principle back up to $913,500. The formula for calculating an annuity pay out (in this case, paying out $69,000 per year and earning 5% interest per year) gets a little complicated, and is made worse once you factor the timing of the payout vis a vis the timing of the compounding interest. Essentially, I’ve come up with a bottom line of 21 years (rounded up).

    So between higher contributions and lower pay-out percentages, I’ve given you two and a half times the number of years you originally calculated. And assuming you retire at 70, giving you payments until you’re 91 years old is probably going to cover the rest of your life.

    But, all of this is a little bit of smoke and mirrors to some extent. The ultimate truth is that compound interest will never equal your employment contributions, which means your retirement annuity fund will always be operating at a loss in this simplified model. So juicing the numbers (raise contributions and lower pay-out, like Texas does) only buys you more time until the money runs out. The hope is that it buys you enough time to cover the remainder of your life.

    But all similar pension systems rely on current workers. That does not make it a pyramid (A.K.A. ponzi) scheme. I’ve misplaced the link with exact data, but Texas has roughly twice as many state employees as state retirees. Much hoo-hah has been made about the Baby Boomer generation being larger than the one following it, but (1) that’s a statistical anomaly, and (2) it’s not bigger than the 3 or 4 combined generations following it, all of which will be working while the Boomers are retired. In normal years the number of new retirees minus the number of retirees who die minus the number of new workers contributing to the system all balance out. This is actually true of Social Security even. In the case of the Texas state pension system, we’re operating at a surplus because of these factors I’ve described.

    The average retirement age is 62, and the average age of death for a retiree is a little over 80. Which means we just need the system to cover you for 18-19 years. The one in Texas is designed to cover you for about 21. For the folks who make it past that time-frame, we have an ever-growing state workforce to contribute to the trust fund.

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