If you’re not into economics or following our pension crisis, this is a primer on one key matter.
An interesting, short analysis published this week by The Economic Policy Institute discusses the difference between a guaranteed benefit and one that’s merely hoped for. The difference is enormous, and understanding that is key to understanding our pension problems.
The main finding of the study, if true, may surprise: Social Security is a pretty good investment. The key conclusion is that a young worker today with average career earnings will receive Social Security retirement benefits equivalent to total employer and employee retirement contributions plus a 5.7 percent annual rate of return. It depends, however, on how old you are and how much you are making.
The reason that indeed would be a good investment is because Social Security benefits are very low risk compared to what you can expect in the stock market or a 401(k), where you get only hoped for returns. I know, I know, Social Security benefits may get adjusted and the system has problems, but short of an annuity secured by treasury bills, it’s pretty much the least risky form of retirement benefit. It’s part investment and part “insurance plan,” as the authors put it.
How does this relate to public pensions? Pension contributions are calculated as if the benefit obligations are only hoped for, which means low contributions to purchase relatively small, high earning assets. Pension benefits, however, are guaranteed, which should require huge contributions to buy lots of low risk, low return treasury bonds and the like.
That makes all the difference in the world, and it’s why you hear so often about the rate of return pensions assume on the contributions they take in. Most pension report their unfunded liabilities assuming their assets will earn 6.5 to 7.5%, which is a hoped for return, and that means official national total unfunded liabilities are usually reported as $1 to $2 trillion.
But if you really wanted to guaranty pensions’ ability to meet their promises you’d need to have them invested in low return bonds — and have far more investments on hand. That’s what takes other measurements of national total unfunded liabilities to $6 trillion or more.
Getting back to Social Security, it’s a different system. Though it has severe problems, the federal government has far more capacity to deal with shortfalls than do states and municipalities, which is what makes that 5.7% return on Social Security attractive.
States and municipalities, however, are trying to have their cake and eat it too. They, and workers, fund public pensions as if the benefits are just hoped for, when in fact they are guarantied. It’s a fundamental design flaw.
Who is really bearing the cost of that guaranty?
Taxpayers, unless they flee.
By the way, I am not vouching for the accuracy of that 5.7% return number on Social Security. However, I did bounce it off one actuary who thought it looked “plausible.”
-Mark Glennon is founder and Executive Editor of Wirepoints.