Funding Your Neighbor’s Pension

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.

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E.J. Smith - Your Survival Guy

Preparing your investments and family for when disaster strikes.

E.J. Smith is the Founder of YourSurvivalGuy.com, Managing Director at Richard C. Young & Co., Ltd., a Managing Editor of Richardcyoung.com, and Editor-in-Chief of Youngresearch.com. E.J. graduated from Babson College in Wellesley, Massachusetts, with a B.S. in finance and investments. In 1995, E.J. began his investment career at Fidelity Investments in Boston before joining Richard C. Young & Co., Ltd. in 1998. E.J. has trained at Sig Sauer Academy in Epping, NH, where he completed course-work in Practical and Defensive Handgun, Conceal Carry Pistol, Shotguns, Precision Scope Rifle and Kidnapping Prevention. E.J. plays a Yamaha Recording Custom drum set with Zilldjian cymbals. His first drum set was a 5-piece Slingerland with Zilldjians. He grew-up worshiping Neil Peart of the band Rush, and loves the song Tom Sawyer—the name of his family’s boat, a Grady-White Canyon 306. He grew up in Mattapoisett, MA, an idyllic small town on the water near Cape Cod. He spends time in Newport, RI and Bartlett, NH—both as far away from Wall Street as one could mentally get. The Newport office is on a quiet, tree lined street not far from the harbor and the log cabin in Bartlett, NH, the “Live Free or Die” state, sits on the edge of the White Mountain National Forest. He enjoys spending time in Key West and Paris. Please get in touch with E.J. at ejsmith@youngresearch.com. Sign up here to receive all the best content from Richardcyoung.com each week.