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Wednesday, November 14, 2012

PSPRS members: How I learned to stop worrrying and love my pension

The previous post showed how much it would cost to purchase a lifetime annuity that paid the same benefits as a PSPRS member who retires after 25 years with an average high three-year annual salary of $67,000.  In this post we will see how much a PSPRS member pays to achieve his benefits.

There are several assumptions necessary to make these calculations, but for simplicity we will assume the member earns $67,000 annual salary over his entire career.  We will use the high member contribution rate of 11.65% that will begin July 1, 2013.  The member contribution rate is currently 9.55%.   Over a 25 year career, this member will have paid a total of $195,138 ($67,000 X 25 years X 0.1165) or about $300 biweekly ($7,805 per year) into PSPRS in order to receive a benefit of $41,875 per year.  In order to receive the same benefit from a lifetime annuity it would cost a male PSPRS member $801,000.

So how does this compare to an employee with a defined contribution retirement plan like a 401(k), 403(b), or 457(b)?  Among the assumptions we will make is that this employee earns the same salary and works the same number of years as the PSPRS member.  With no matching by an employer and a 5% annual interest rate, compounded monthly, the employee would need to contribute about $16,100 per year or $619 biweekly for 25 years to be able to purchase the $801,00 annuity.  Using the PSPRS assumed rate of return of 7.85%, compounded monthly, the employee would need to contribute about $10,300 annually or $397 biweekly to achieve the same annuity amount.  If the employer was especially generous and matched contributions up to 10% of an employee's salary, the amounts would drop.  In this case, a 10% matching would mean that the employer would match the employee contribution up to a maximum of $6,700 (10% of the $67,000 annual salary).  At the 5% rate, the member would only have to contribute $9,400 annually or about $362 biweekly.  At 7.85%, the member would only have to contribute $5,150 annually or about $198 biweekly.

This would make it seem that the private sector employee's potential retirement savings match up well with the PSPRS member.  However, this is illusory for one simple reason: the PSPRS member's contributions have no bearing on his ultimate retirement benefits.  The $195,138 paid by the PSPRS member guarantees him a $41,875 per year retirement benefit, regardless of the return his contributions earn.  The retirement benefit is also based on the average of his high three-years salary, so the PSPRS member will not pay the $195,138, yet receive benefits as if he did.  If he increases his high three years with overtime and sick leave sellback, this will further distort the cost-benefit discrepancy.  The difference will, of course, have to be made up by taxpayers when the required rates of return are not achieved. 

Compared to our less fortunate private sector employee, his contributions have everything to do with his retirement benefits.  He must start contributions early and at a very high level to take advantage of compounding over his working life.  He will bear all the market risk of his investments and must invest in such a way as to achieve above average returns.  The ability to save $800,000 over a 25-year career at a $67,000 annual salary would require a monastic frugality and/or incredible investing acumen.

The preceding examples were unrealistic because no employee earns the same salary his whole working life.  Futhermore, we utilized the most optimistic conditions for the private sector employee and the most pessimistic conditions for the PSPRS member.  Changing the conditions for either will only further show how much better the PSPRS member fares versus the private sector employee.  The PSPRS member ostensibly has a worry-free situation where he pays his contributions and need not concern himself with how that money performs.  The private sector employee will not only have to contribute more during his working life but also worry about his money until the day he dies.

Note: Bankrate.com Compound Savings Calculator was used to calculate returns.

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