With ponzi schemes, the golden rule to avoiding them is: “if it sounds too good to be true, then it is too good to be true”.

Current investors funds are used to provide remarkable returns to the early investors, so there’s a credible track record. It needs to keep growing to keep paying. As soon as there aren’t enough new investors, the scheme sensationally fails. People who’ve invested discover too late that the money just isn’t there.

And so it is with the pensions of public servants.

The contributions are based on the salary earned at the time. The pensions are calculated on the salary in the last few years. The calculation of the amount that expected to be paid at retirement is based on the life expectancy, and that’s gone up. So where does the missing money come from: current contributions.

Pension schemes are supposed to calculate their liability to make sure that they have funding. The pension payments are in the future. A payment in the future is not the same as a payment today. One hundred dollars today is worth more than one hundred dollars in 10 years time. Accountants and actuaries calculate today’s value of the future payments using a discount.

An amount of $100 in 10 years time at a discount rate of 10% is worth $38.55 today. At a rate of 1%, it’s worth $90.53. The rate makes a big difference, and if it’s wrong, the value can be badly out. The rate used should be a reasonable estimate of the expected return that could be earned on the current investments. With the current climate, and a very low risk free interest rate, the expected return can only be low. The figure of 8% that the funds are using bears no relation to reality.

Because of this, a number of towns and cities have started to declare bankruptcy. Stockton is the biggest so far.

The OECD has done an exercise predicting the picture for member states in 2060. They estimare that by then four countries will have a shortfall amounting to more than 10% of GDP. The worst offender – Greece.

One solution is to up the retirement age. So, one wonders what arithmetical miracle France’s President François Hollande will have to perform to reduce the retirement age to 60.

The cheque is in the mail.

More at:

OECD Pensions Outlook 2012

OECD Shortfall in pension

Stockton’s bankruptcy

Fun with pensions

Ooops, the coffers are empty

The road to risk

Promise now, bill your children