Continued from Part 1
John Mauldin published an article yesterday in Forbes about the coming public pension crisis. Many states and local governments do not have enough funds to pay future benefits, let alone current benefits, and spending on education and public works is being curtailed due to these shortfalls.
In Florida, the pension crisis is not much of an issue because the Florida Retirement System (FRS) is 84% funded based on actuarial projections ($161 billion of assets) and offers a separate, paltry monthly stipend for medical expenses rather than the generous health benefits offered by many other states. In 2011, the FRS also devalued the program in the following ways:
- New 3.0% payroll deduction (formerly none)
- State contributes 3.3% to DC plan (formerly 9.0%)
- DB vesting period: 5 -> 8 years
- DB salary lookback period: 5 -> 8 years
- Full DB benefits 33 years / Age 65 (formerly 30 / 62)
- DB inflation adjustment removed (formerly 3.0% / year)
- Deferred Retirement Option Program (DROP) participants earn only 1.3% instead of 6.5% APY on deferred benefits
These 2011 changes continue today despite booming stock market returns. Although they did not affect employees who retired before July 1, 2011, employees who started after this date are fully affected by all of the above, and existing employees are still affected by the inflation adjustment removal for work credits earned after July 1, 2011, as well as having to contribute 3% of salary. There are 643,333 working members in FRS as of June 30, 2018, and 1,210,795 total members including retirees and terminated members who can expect benefits in retirement. These include teachers and other public employees such as police officers, city and county workers, higher education, et cetera, although school districts are the largest component of active membership with 314,001 members (49%). (Source: Comprehensive Annual Financial Reports)
There was a time before the Great Recession where the FRS was more than 100% funded even with the previous, more generous benefits. For it to be 84% funded now is quite good compared with pension systems in other states, but still wanting considering we are potentially at the apex of a 10-year economic expansion. As with most pension plans, the majority of FRS assets (80%) are in high-risk assets such as stocks, real estate, and private equity. Although these risky assets are advisable to invest in as growth will be higher in the long run as compared with safe assets like U.S. Treasury bonds, near-term risks are high. If there is another recession the FRS pension trust fund might go from 84% to 60% funded. The 2011 devaluation was used as an opportunity for the state to contribute less—if they would have kept up their contribution levels the trust fund would be over 100% funded now. For example, the 3% payroll deduction was taken as an opportunity for state and local governments to reduce their contribution rates.
Like life insurance, a pension plan puts a metaphorical bounty on members’ heads. Financially, the best thing that can happen to a life insurance company is for all policyholders to outlive their policies’ end dates; the best thing that can happen to a pension fund is for everyone to die off before receiving benefits. With a defined-contribution retirement account like a 401(k), assets pass to a spouse or children at death, but pension benefits do not generally function like this (although survivor benefits may be offered, they are usually small in comparison). Of course, the state is not going to go on a killing spree to save on pension costs, but conceptually the perverse incentives created by a lifetime payment scheme are entertaining to ponder.
With Social Security benefits, Americans are directly presented with a macabre choice—deciding whether to receive benefits at 62, 67, or 70. Waiting until 67 or 70 results in higher total payouts if one lives to about 83 or older. Of course, someone who is delaying to 70 who ends up dying at 69 would have been better served by starting the payouts at age 62. This is basically the vesting problem in reverse. The FRS, like many pension plans, requires workers to attain eight years of service to get a pension benefit; otherwise, the employee’s contributions (3% of salary) are refunded with no interest and the pension fund retains the employer portion of contributions. However, the FRS is unusual for offering a choice between a 401(k)-like plan and a pension, which must be selected within the first few months of employment. The 401(k)-like plan, called the FRS investment plan, vests the employer’s 3.3% salary contribution after only one year instead of eight. Predicting how long one will work for the State of Florida is not easy, and not fully in the employee’s control—what if they are fired with cause or terminated due to a recession?
In the private sector, we see the bounty effect result in employer malfeasance in smaller ways. The employer match to a 401(k) plan typically takes a few years to vest; employers are incentivized to terminate employees before reaching this milestone in order to claw back the benefits. Other benefits, such as vacation time and health insurance, are only offered after one year of service at many employers, with employee turnover serving to make these benefits useful to only a small percentage of hires, and rationales for firing employees mysteriously spike as they close in on attaining costly perks. Indeed, the customer-facing space is no exception; consider my continuing crusade against Amazon, a company that encourages customers to pre-pay purchases by attaining a gift card balance, perversely incentivizing the company to ban customers and steal gift card balances to maximize free cash flow. The larger your Amazon account’s gift card balance, the higher the probability of you being banned. This happens with credit card reward programs, frequent flyer miles, hotel points, and in many other areas, both via theft or forfeiture, hoops to jump through to redeem one’s benefits, and by devaluation of existing balances.
Devaluations of benefits occur within the broader context of fiat currencies. The U.S. dollar loses value continuously, with the Federal Reserve aiming for a 2% increase in consumer prices each year. Anyone with substantial debts, particularly if they are locked into a low interest rate such as a fixed-rate mortgage, should cheer inflation as it reduces their debts in real terms. With the 2011 removal of a 3% annual inflation adjustment from FRS benefits, current members must consider the U.S. dollar’s performance if they seek to forecast purchasing power in and during retirement. We could have several decades of 2% inflation per year, or there could be years like 1979–1981 which had more than 10% inflation per year. If high inflation occurs, FRS members’ benefits decline substantially in real terms, although they remain flat in nominal dollars. Even during retirement, this has large costs.
Many people misconceptualize retirement as a singular moment where one cashes in their poker chips and leaves the casino, but in fact it is a long slog with unknowable costs and pitfalls (many of them health related), and a need for risk-taking. Target-date retirement funds don’t go to 0% stock allocation when one retires; they typically stay around 40–50% for continued potential for portfolio growth as retirement could last 30 years or even longer. Another large unknown that may appear unrelated, but in fact is intensely relevant, is climate change. Planet-wide, humans are continuing their suicide mission to boil themselves alive. We have no idea whether risky assets such as corporate stocks and real estate will continue their growth trajectories as the climate crisis worsens, and this will be coupled with personal costs unrelated to one’s retirement portfolio.
This concludes my two-part series on the FRS and retirement saving, but expect more writing from me on similar topics in the months to come.