The key to understanding the public pension mess is the expected rate of return—a guarantee at the local and municipal level of 8% or higher.
How many of you in the private sector are earning 8% risk free? The five-year Treasury, for example, yields a shade over 1%.
Here’s the public pension trick—the higher the expected future return, the less needs to be saved today. Cities and towns have overpromised and overspent. The hope is that the stock market will come to the rescue.
Think about this from the private-sector viewpoint. Let’s say you retire with a $1-million portfolio. You draw 4% a year, a reasonable draw. That’s 1% per quarter. If you can maintain the balance every quarter, then you draw $40,000 in a year.
Let’s say you retire from the public sector. Using an expected rate of return of 8%, the payout is still $40,000, as in my example above. But the amount that needs to be invested is much lower. Only $500,000 has to be invested, rather than $1 million.
That’s how states and municipalities get away with saving about half of what they should. The assumptions they use for future returns are overly optimistic. The day of reckoning is pushed out beyond most politicians’ careers, and allows them to spend more on pet projects today.
The returns in Rhode Island over the past 10 years have been closer to 2%. Does the retiree make up that difference? No. Do the employees contribute more to the fund? Not much. Taxpayers are responsible for funding the gap.
Imagine how high the real liabilities of public-sector pensions are if the actual rate of return of around 2% is used? If it takes $500,000 at 8% to generate $40,000, and $1 million at 4%, then it will take $2 million at 2% to achieve the same payout. That’s four times $500,000.
Once you start using realistic expected rates of return, you see how truly ugly this pension mess is—and how underfunded these plans really are.
