401K's for Illinois Public Employees?

I was recently having a conversation on the topic of Illinois Public Pensions (specifically with regard to police officers and fire fighters) with a Chief Economist for one of the major investment banks – I am attaching my part of 3 conversations we had that some of you might find of interest. 

Conversation # 1

In response to the recent Illinois Supreme Court ruling on pension restructuring, you offered the suggestion that all state workers be laid off and rehired under new contracts that had 401K provisions in lieu of the current pension system. I am not sure if that is your own view based on your own perspectives or if you were quoting from the May 11, 2015 Chicago Tribune article that offered the identical solution (http://www.chicagotribune.com/news/opinion/commentary/ct-illinois-pension-reform-workforce-perspec-0512-20150511-story.html), but I would appreciate if you would read my perspective on this idea:

I don't disagree that the pension system needs an overhaul, but unfortunately I think a larger issue preventing resolution is that most people in the pension system do not understand the basics of investing and most people in the financial industry do not apply their own knowledge to this issue.

Let's say you went to Investment Bank X at 25 years old & asked to buy an annuity that would provide you lifetime income of y dollars starting at age 55 (let's just assume that this product/vehicle exists and that someone can pay regularly towards its purchase until such time as the agreed sum has been arrived at). The investment advisor said that if you contributed 7.5% of your gross earnings per year for the next 30 years, you would be able to purchase the annuity (that the annuity would be sufficiently funded at that time).

Now let's say at age 55 you go to Investment Bank X & tell them you are ready for the annuity to start paying out; the investment advisor says, "Here's the thing - over the last 30 years, we used some of the money that you gave us for the annuity we were selling you & put that towards some other investments that weren't doing so well - we thought we'd get a good return, but we didn't; while we were planning on paying your annuity back, we cannot. Hey - you don't really need that annuity, I mean most people don't have one..." - even if Investment Bank X offered to return all of the client's money, the time-value of the money over 30 years invested is still a substantial loss. Obviously the client would not be pleased and make a complaint.

At some point, the Security & Exchange Commission (SEC) would likely step in, investigate, prosecute, force sales of assets & make investors whole (as much as possible) since what this person essentially bought into was a Ponzi scheme.

In the private sector, running a Ponzi scheme is illegal, however, it apparently - as cited in Conversation # 3 - is not when the government does it. A pension is an annuity product - it is just sold by the government as opposed to private equity. As such - in my opinion - the SEC should have authority over its management to prevent & penalize mismanagement of the funds. Certainly in the private sector, if there was even a hint that annuity investors be required to take a hit based on mismanagement of the investor funds, future annuity sales would be hard to make to say the least. But the government has one-upped the private sector again since the employee has to (as a condition of employment) buy the annuity!

I understand why the "401K" seems like a good solution, but 401K's are an untested retirement system as of yet. They have been tested on the sales side: people have bought them, however, how valuable they are has yet to be seen.  They are touted as the pension solution in the Tribune article (and in your presentation), but we don't really know if the solution actually works. Employees who have 401K's today, according to many surveys, fear outliving their capital. 

When the 401K was first introduced, it was a means for management in the private sector to invest in addition to their pension. The return on equity in pension investments, at that time, seemed boring compared to the return provided by the stock market at that time (returning to your point between correlation and causation; the market was in a bull market phase - fueled by employees putting retirement money into the market - even do-it-yourself investors and not-so-smart money managers were making good returns; many assumed causation - as in they must know what they are doing, but as many are discovering now, their success only existed in the short term)  - said differently, while a pension offered security, the 401K looked like it could make you rich. And no one wants security if you can get rich...until you realize you have neither riches nor security.

Companies offered more & more employees the 401K in lieu of pensions (some of that was due to companies seeing the opportunity to remove long term pension debt obligations from their balance sheets, but a lot of it was due to the demand from newer employees - who did not think "long term" - that believed that a 401K would make them "financially free" in a short time) & slowly phased pensions out.

The next few years will reveal the effectiveness of the 401K experiment (remember, they were never designed to be a substitute for the pensions that companies provided); as people make their withdrawals & attempt to make their capital last longer than their lives, we might see the tax payer being asked to shore up the public aide, Medicare, Medicade, & social security systems that are burdened with people who cannot live off their 401K. The 401K looks like an attractive option to the pension system until you realize that, in the United States, we do not just "kill someone" when they run out of money - we have a social safety net that is tax payer supported. Whether we should have this safety net or not is another topic, however, putting people into a 401K may not actually absolve the tax payer from paying for them...

I don't have a crystal ball to see how well 401K's will work in application, but I do know that 20 years ago you did not see retirement age Americans working as greeters in retail chains or in fast food establishments. Time will tell the wisdom of the 401K, but as long as the pension system has no oversight, it will continue to be the biggest Ponzi scheme in history.

My last point in this conversation relates directly to the issue of price elasticity (supply and demand): the total cost to the tax payer of a teacher, police officer, or fire fighter includes the benefit package.  If you were to restructure the salary/benefits, you would likely see a shift in the types of applicants; that may or may not be a bad thing, however, consider that, in our country, the ability to make middle class income and manage one's own retirement can be found in many venues where one is not risking life/limb (in the case of police/fire service), subject to odd hours, etc; without the benefit package, you might see the price go up (to get people to risk life/limb, work odd hours, etc - remember this is not the Soviet Union where we can order people to do these jobs) or, more probably, you would see people with ulterior motives move into the industries at the current or reduced prices (people who want access to young children going into education, people who want to hurt other people becoming police officers, people who want to have blanket access to businesses during their closed-hours becoming fire fighters - as we know, there is a black market economy to every legitimate economy). 

Just to give you one simple analogy, there is a difference between the type of person who is a career bouncer in a strip club and the type of person who is a career police officer - while the the job functions may have some narrow lap, they are different enough that the individual who is working for $10/hour cash at the strip club may not be type of person you want working as a police officer; if the supply of candidates who are attracted to to the police job diminishes as a result of diminished benefit packages, you may have that bouncer, who is willing to work for $10/hr without benefits in a strip club, fill the police job for 3-4 times the pay; however the individual's motivation to do the work could prove problematic in the long term since his likely motivators are looking a girls, drinking booze, and hurting people (not that he thinks $10/hour is really great money!).

Conversation # 2

In our original conversation, you many have intuited that there is concern on my part when educated, capable, and well credentialed persons who epitomize success, such as yourself, advocate the 401k system as a solution to "the pension crisis". (I put the pension crisis in quotes since any time contributions are insufficient and rates of return are insufficient to meet expected returns, we would call that a risk of investment as opposed to a crisis. If however, one had automatic deposits made into a checking account and the bank was re-routing the incoming funds into some account other than customer checking accounts, we could call that a criminal action as opposed to a "checking account crisis".) The 401k system seems to have issues that are far more severe, due to the magnitude of the number of persons affected, than the government pension crisis; the 401k crisis is simply slower in showing itself and, as mentioned previously, the vast majority of Americans have poor financial literacy. Therefore people are unaware that this threat is on the horizon.

Being a leader in the financial industry, you likely have access to better information than I do on this issue, however, most open source data suggests that the average 401k is between $25,000 and $100,000 in balance. In a Forbes article on the issue, the author cites 4 indicators that will show symptoms of the 401k system's shortcoming: 1) Retirees will return to the workforce; 2) Workers will delay full retirement; 3) Full retirement will become unachievable, and 4) People will financially "drown". Here is a link to that article - and I am fully aware that gloom and doom articles sell publications, so I do not blindly accept what is written in these: 

 http://www.forbes.com/sites/edwardsiedle/2013/03/20/the-greatest-retirement-crisis-in-american-history/

Here is another article from NBC News in which the average 401k savings is estimated to be $18,433. Obviously this "average" likely includes new workers who have just started 401k's and bring the average down, however, even if the upper end of the the 401k's were 10-20 times the average amount, they would be $184,330 - $368,660; with healthcare costs rising, housing costs rising, etc, I doubt that any responsible financial advisor would put these up as target numbers for clients' retirement goals. It is also highly unlikely, just mathematically, that there are many 401k's at 100-200 times the average. Here is a link to the NBC News article: 

 http://www.nbcnews.com/business/retirement/great-401-k-experiment-has-failed-many-americans-n327321

Please do not misunderstand me - I am not coming down on you or the financial industry. I am merely pointing out that 401k's did not "solve" corporate pension issues (although I am unsure that corporations were struggling with financial issues when the 401k was developed - I believe is was developed as something in addition to a small, but secure pension; when employees demanded 401k's over pensions, corporations simply gave them what they wanted), but rather have shifted those issues from corporations to the individual and in the future, ultimately, to the tax payer. 

Why do I say the burden has been shifted ultimately to the tax payer? Our society is not a society that is based on true rugged individualism, personal responsibility, or self-reliance anymore (and we can debate the merits or downfalls of that at another time); when your home is burning, you don't put out the flames yourself; if someone is breaking into vehicles in your neighborhood, the neighbors do not organize a militia to protect life and property; most people do not build their own homes, educate their own children, grow their own food, etc. We are a transactional society where we transact through the medium of money.

Under true self-reliance, if your home burned down and, providing you escaped on your own, no one gave you shelter, or helped you build another one, and the weather was harsh or you had not thought to store resources at another location, you would probably die. And under true self reliance, nobody would care if you died that way since people would believe that you should have planned for that potential outcome. As humans, however, we exist in tribes and societies. Ideally, we try to bear our-burden-and-then-some in the event someone else needs assistance that we can provide - and selfishly, in hopes that, through the law of reciprocation, if we need assistance one day, someone from our tribe or society will provide for us. Obviously that is an emotion that can, and has, been abused and, at its extremes, leads to entitlement mindedness. However, is there not an ethical difference between one who cannot work any longer and needs the tribes' assistance and one who can work, but chooses not to and demands the tribes' assistance? If you agree that there is a difference between those two individuals abilities and values, then you will see that just because someone runs out of money in their 401k, it does not mean that our society will abandon them. And the cost of basic resources of food, shelter, and medicine will be carried by the tax payers if the individual cannot provide for their own.

Any system is unsustainable once there are more resources leaving than coming in; therefore unless something changes in market returns and/or people's 401k contributions going forward, this will be a crisis that affects the tax payers. And if that is true, the idea of "laying off government workers on pension programs and rehiring them under a 401k system" is akin to treating cancer by promoting heart disease - at least you won't die from cancer! You mentioned that after the Illinois Supreme Court decision, you wrote down the value of your home as a taxpayer; is your home value any different if you are bailing out the 401k system through some sort of aid or supplemental program? How much more sustainable is the 401k system than the pension system if, ultimately, taxpayers will have to foot the bill?

I understand that that your organization is very successful and you are at the top end of your field. I applaud that because that is a great example for others to follow - you have worked hard and surrounded yourself with people who have similar qualities and aspirations. I would offer this analogy as counterpoint to keeping perspective: in academics, top university professors who teach gifted students with great work ethics in difficult subjects such as math, science, engineering, etc sometimes lose their perspective that their group of students is not representative of students as a whole. There are a series of barriers that must be crossed and standards that must be met in order for students to find themselves in front of that professor; your teaching perspective can get skewed when you only teach to the A+ students with genius IQ's!

Similarly, when financial advisors only deal with clients who have minimum net-worth's, they are managing money for the "A students'' so to speak; there is nothing wrong with that, however, we have to remember that the entire student body makes up a school, as the analogy goes. Therefore, at your level, you may not see people with low balances in 401k assets, however, they likely exist in larger quantities than high net-worth individuals based on the average 401K's values cited.

One final point on 401k's for government employees - and this may take a bit of understanding of government psychology to understand the point - there is a reason that the government itself does not want 401k's for its employees: the only thing the government values more than money is control. Currently, a pension is the "carrot" that keeps government employees in place to accept the "stick" (that can be a number of things including the previously mentioned hours, risking life/limb, etc); a 401k, since it moves with the employee, frees the employee to leave organizations if a better opportunity comes their way (I think that is easy to understand) or may be promoting corrupt practices (think about how many Illinois governors have been indicted). If these employees leave with their benefit package, they are free to speak out about issues that may be below the public's radar, and work from their conscience. Imagine this scenario: a mayor decides that he is going to generate revenue by putting in red light cameras and speed cameras to catch and fine traffic violators; in addition, he wants parking enforcement, and all officers to write 5 tickets a day. Lets say the officers do not want to work like that - they see their work as a public service and and in in their opinion, they see this new mandate as making them an unofficial taxing body exerting usury taxes on the working public. So they leave with their 401k's - some go to the private sector (hey, being a cop in my 20's was great, but now I want to do something else) and others go to nearby police agencies that have lower crime, nicer citizens, and pay competitively. 

The mayor still has a revenue gap which he was trying to meet with fines, but now he has a significant safety issue as well as a potential public relations issue compounding the situation. The now private-sector-former-cops may decide to speak openly about the purpose of the fines and what the revenue was going towards (public relations issue). In order to close the safety gap, the mayor will have to hire more cops, but they will need to be trained. The state requires them to go to the police academy and with all the hiring and training costs, each body hired is a minimum of $100,000 investment before you get a single day's work from them. And they can leave at any time...

The reason that government employees do not have a transferable retirement systems (even from police agency to police agency) has nothing to do with the financial industry or money, but it is the only means by which the government can maintain control over its workforce.And it values that control more than money (especially if it's not their money). Think of the turn over of employees who work night shits, get married, have children, expand their educational/work options, develop an injury, find an agency paying more competitively, etc...the pension is the primary retention tool which the government would give up in a 401k system. 

I understand your perspective on the issue and, again, agree that the pension system needs to be changed. It is unsustainable, but 401k's are not the answer as we can see from private sector 401k's; a system where the government does not get to control the actions and behavior of its employees will also likely not receive government support.

Conversation # 3

Returning again to your comment of "writing down the value of your house when the Illinois Supreme Court struck down the suggested pension reforms as being unconstitutional", I have a section of the pension code for your reading which shows that we should have all written down our property values well before that case decision:

(40 ILCS 5/1-107) (from Ch. 108 1/2, par. 1-107) 

Sec. 1-107. Indemnification of trustees, consultants and employees of retirement systems and pension funds. Every retirement system, pension fund or other system or fund established under this Code may indemnify and protect the trustees, staff and consultants against all damage claims and suits, including defense thereof, when damages are sought for negligent or wrongful acts alleged to have been committed in the scope of employment or under the direction of the trustees. However, the trustees, staff and consultants shall not be indemnified for willful misconduct and gross negligence. Each board is authorized to insure against loss or liability of the trustees, staff and consultants which may result from these damage claims. This insurance shall be carried in a company which is licensed to write such coverage in this State.
(Source: P.A. 80-1364.)

What this section of Illinois' pension law means to me is that there is a level of protection offered to the fiduciaries of Illinois' public pensions that is not offered to private sector fiduciaries. The ramifications of that are immense in both ethics and finances as we can see; if we used a medical analogy, the pension crisis is a symptom of the underlying disease of corruption promoted through a lack of accountability.

We both agree that the current pension system is unsustainable. Fiscally it may, in fact, have to be eliminated altogether through a bankruptcy process - after all, when there is no more money, there is no more money. That is just part of life. If that is what must happen for the greater good, the men and women who, on any given day, would lay down their own lives in order that others might live will understand. That does not mean, however, they will not fight against losing a retirement that they have contributed to, both as employees and tax payers, if the basis for the loss is corruption on the part of the fiduciary.  

Where we seem to disagree is the why's of the crisis - and the why is important if we are going to avoid the next problem. A lack of government/fiduciary accountability has promoted behavior such as failing to pay into the pension fund (despite collecting both the employee contributions to the fund as well as the tax payer/government contributions to the fund); the pension code indemnifies the fiduciaries from ramifications arising from that. I am not against changing the law that the Illinois Supreme Court cited in their recent decision, but do advocate changing it in a meaningful way so as to promote accountability of fund management if we are going to have public pensions.

If we are going to move to a 401K system for public employees, let us prepare for what that might entail when a significant number of people outlive their finances (and are also not able to remain in the workforce at a level that sustains them); their living expenses will be shifted to public/social programs.Those programs are tax payer funded as well and will have the equal impact on the value of "all of our houses". In addition, we should plan for either shortages of government employees or higher salaries to retain those employees if they are provided a transferable retirement system such as the 401K.

Memorial Day provides the opportunity to reflect on our freedom itself. We tend to think about "freedom from" as Americans: freedom from being told what to say, think, do, etc. Freedom from the government searching your home or belongings. But, since our society is currently relatively safe, we tend to forget about our "freedom to's" and take them for granted: we have the freedom to go to the store without being robbed by highway bandits; we have the freedom to walk down the street without gangs coming into our homes and removing our belongings while we are away. This also is a type of freedom that is not as available in many other societies. 

If enough people lose their "hope" for the future - hope that is significantly influenced by their finances - there may be more at stake than just our asset values. Our very freedom could be lost. The 401K system does provide tremendous opportunity for those who use it, financially literate, sophisticated investors, and use it wisely (as does the Roth/IRA system); however, financial data reveals to us that a significant number of people are not likely going to be supported by their own retirement plans simply based on their asset values, age, and current/future cost of living. If enough people fall into this category, not just our quality of life, but our very way of life, could be at risk. As DC (Defined Contribution) retirements are found to be underfunded, as most of the financial data suggests, this risk continues to grow just under our general level of awareness.