Pensions and affordability: The Demographic & Political ‘Elephant in the Room’

Illinois and Chicago unions have in many cases successfully fought for an Illinois pensions arrangements referred to as “compound cost of living adjustments.” Essentially, this means that a pension starting from a base of $10,000 dollars will increases by 3% a year so in the second year the payment is $10,300, the next year an extra 3% is added to the new, higher payment, making it $10,609, the third year would be an extra 3% on top making it $10,927 etc., etc.

Rahm Emanuel and Chuy Garcia face off next week for Chicago Mayor.

Rahm Emanuel and Chuy Garcia face off next week for Chicago Mayor.

This is a fantastic arrangement which is normally unheard of in the pension industry and seems to be specific to Illinois pensions. Financial Planners even need to work out some interesting math to get financial planning software to account for compounded cost of living adjustments. This has allowed state and local police, fire fighters and teachers to live out their retirement in comfort and without worry of inflation. In fact many would cheer on inflation as that just means a larger year over year return. Unfortunately this is clearly an unsustainable system.

In common with America as a whole, as well as other developed nations (particularly places such as Italy and Spain) the age group over-65s is growing constantly and what’s more living longer. All this means that, compared to say the 20th Century when a man or woman of retirement age might be lucky to have ten years of retirement, we are entering an age where it is not uncommon to live until 100 – making for a 35-year retirement. This would mean that someone living to 100 would end up with a final amount of approximately £28,000; nearly three times their starting pension.

The increasing percentage of people at pensionable age also means a decreasing amount of tax-paying workers to help pay for this. Elections this year have been ripe with questions posed of Bruce Rauner, Rahm Emanuel and Chuy Garcia; asking some serious questions on how to afford this presently unsustainable system without impacting on the quality of life of those who retire – clearly a conundrum with no win-win answer. None of these candidates have been particularly good at answering where the money may come from.

Two options worth exploring are as follows and unfortunately either one will upset large proportions of the population. The first, would be to take the “compound” out of the cost of living adjustment. Using the above example this would mean that the pension would increase by no more than 3% of $10,000 i.e., $300 a year. The final sum of the example 35-year pension would be only just over double the starting pension at $20,500. In this example it is important to note that with the rate set higher than CPI inflation (which is generally less than 3%), retirees would still be better off in cash terms year-on-year.

The other option would be to raise more money for the pension pot overall. This would mean higher taxes for the general population. Something that would undoubtedly cause much ire among the under-65s who may feel they are already paying more than fair share.

It is telling that, with elections looming in Chicago, neither candidate has come up with a concrete plan to deal with this demographic elephant. Quite possibly because they are, quite literally, stuck between a rock and a hard place. It is these questions that desperately need answering though and the silence on this matter is becoming quite deafening. The question to answer is which will we run out of first? Time or money?


By Adam Faust, Deep Blue Financial Founder