Understanding the “Entitlement Crisis” – The Problem – The Solution

We are always so pleased to be able to share with you articles from Charles DuBois, an incredibly talented and tremendously experienced research analyst and fund manager, with whom I had the distinct pleasure to work with and learn from during my tenure at Invesco.  I’m very pleased to say that I continue to learn so much from him on a regular basis.  Chuck’s focus today is on the “entitlement crisis”.

We hear and read, it seems on a daily basis, about the dangers of the Federal public debt.  We are reminded about the looming fiscal crisis.   We are told we are broke, that we are “leaving a burden to our grandchildren” and that we could even become the next Greece.  These views are widely believed not only because of their constant repetition but also because they appear to reflect straightforward accounting as well as our common sense. 

The primary culprit for these concerns is the projected growth of “entitlement spending” as, according to projections, such spending will be consuming an ever increasing share of federal outlays.  With the baby boomers now retiring, this “threat” is now upon us and the situation is usually described as “unsustainable”. Should we worry?

Please click on this link for the balance of Chuck’s excellent article.

Cut Spending by $3.6 Trillion??

“The White House is seeking to slash federal spending by $3.6 trillion over the next decade through steep cuts across most agencies and tough new restrictions on aid to the poor — a dramatic rethinking of the role of government in the American economy”, wrote Ylan Mui, CNBC Corespondent.

The goal of the White House’s 2018 budget is to slash the deficit, but what are the ramifications to the U.S. economy should these budget cuts become reality?

If you are a disciple of MMT (Modern Monetary Theory) you scoff at the suggestion that a draconian reduction in government spending will be a springboard for economic activity.  Charles DuBois, a former colleague of mine while at Invesco, would tell you that “a reduction in the deficit will dramatically reduce private sector income”. Unfortunately, most people think that a reduction in private sector spending “frees up” private sector resources, but, according to Chuck, ” they don’t explain how that exactly works. Worse, no one asks!”

Michael Norman wrote in MMT Trader Update, that the proposed budget is “ridiculous if this is true”. He further explained, “that’s 2% subtracted from GDP each year for 10 years COMPOUNDED!! Do the math…that could be like a 40% contraction in the economy.”

We already have an economy working on only half its cylinders.  How would dramatically reducing government spending, especially in light of the fact that the private sector isn’t reinvesting in new plants, equipment, and/or inventory, be an economic catalyst?

Another recession/depression would crush the stock market, and potentially be the final nail in the coffin of defined benefit plans that cannot afford a significant hit to the asset side of their asset/liability equation.

Americans Doing Better? The Sequel!

As a follow up to our recent blog post on the current financial state of the American worker, we want to share the following information that was provided by Keith Jurow, a wonderful real estate analyst whose insights we’ve shared before.  According to Keith and the NY State Department of Financial Services, the number of pre-foreclosure notices (since 2010) sent out by mortgage servicers to residents in NYC and Long Island has exceeded the one million mark and greater than 2 million state-wide. UGH!

This, of course, is occurring in an NYC real estate market that is ridiculously priced. According to The Elliman Report: Manhattan Sales, the number of resales in Manhattan rose 7.7 percent from last year to 2,429, while the median sales price of resale apartments remained unchanged at $950,000.

In addition, the median sales price for luxury listings—listings priced over $4 million—hit a record of $6,975,006 and median sales prices on new development increased 4.9 percent to $2,734,510.

Lastly, “for all renters who feel left out, Apartment List happened to release its monthly rent report. No big surprises there, as NYC remains one of the most expensive cities for renters in the country, with a two-bedroom boasting a median rent of $4,100 and one bedrooms costing $3,200. Chelsea was the most expensive neighborhood for renters over the past month, with a two-bedroom costing $6,500 and a one-bedroom at $4,400. The West Village experienced the fastest-growing rents, at a 3.1 percent increase over last year. There, the median rent for a one-bedroom was $3,800.”

Since most of us aren’t following the real estate market to the extent that Keith is we are likely shocked to read about the massive pre-foreclosure data, especially since all we hear about is the current state of the “exciting” NYC real estate markets. Although it often appears that we are trying to touch the heavens with the height of our buildings, I can assure you that prices cannot continue to skyrocket for too long, while outpacing wage growth!  We’ve seen this story before, and the ending was pretty gruesome!

Americans Doing Better Says The U.S. Federal Reserve – Really?

Do you agree that you are “doing better” financially? In a WSJ article, titled “Americans Doing Better Financially, Except For Non-college Educated”, 70% of 6,643 respondents indicated that they were “living comfortably” or “doing okay”. Really?

How is it possible that 70% are okay or better when 44% of the survey participants responded that they couldn’t meet a $400 emergency medical or car expense without borrowing or selling something.  They clearly aren’t doing okay!

Furthermore, according to the article, the median out-of-pocket medical expense is about $1,000, and 24 million Americans currently have a medical debt as a result of an expense in the last year alone.  By how much would the 44% grow if they were asked about the $1,000 expense, as opposed to the $400, which seems somewhat arbitrary.

In addition, roughly 28% said that they hadn’t saved anything for retirement. In many cases, these are current workers that have no access to a pension plan. We also know that the median defined contribution balance is <$10,000.

Can we please have surveys conducted and results presented that actually ask appropriate questions related to the current economic status of the American worker? Someone living paycheck to paycheck is not okay economically.  Americans that have no pension or retirement savings are not okay, especially if they are age 40 or older.

The social and economic consequences of our collective failure to provide quality jobs, living wages, and adequate retirement benefits will be devastating. I often repeat myself, but I will not apologize.  We have a crisis unfolding in our country, and neither kicking the can down the road nor burying our heads in the sand is an appropriate response at this time.


How Do They Know?

It was recently reported in the Hartford Courant Community that Hartford, CT, was beginning to solicit law firms for a possible bankruptcy.  It has been reported that Hartford is facing a $14 million deficit this year while projecting a $65 million deficit in 2018.  Contributing significantly to this underfunding is the $40+ million contribution for the defined benefit plan this year and a slightly larger forecasted amount for next.

We would suggest that they really don’t know what that DB contribution should be.  Why? First, because of GASB, plans can use the return on asset assumption (ROA) to discount their liabilities.  As everyone knows, liabilities and assets don’t grow at the same rate.  Furthermore, because public pension plans and multi-employer plans have been allowed to engage in this activity, they have annually underfunded their plans.

In addition, the ROA is not a calculated number.  It is an exercise in guessing what a combination of assets will do in some defined future period that if achieved will “ensure” that the plan is well funded.  Is that so?  As we’ve highlighted before, there are myriad examples of public plans generating annual returns far in excess of the ROA, yet their funded status is incredibly weak.

Ultimately, we need to get rid of GASB accounting standards and have every plan in the U.S. at least adopt FASB (if not IASB accounting standards).  The discount rate used will still not be a market rate, but it will be substantially more accurate than the fairy tale rate currently being used.  However, I’m not holding my breath while we wait for this to happen.

In the meantime, plan sponsors need to stop being afraid of the truth.  We need all plans to get a more accurate and complete picture of their liabilities by having a custom liability index (CLI) created.  This index can use multiple discount rates, including the ROA, and incorporate future contributions, too.  Next, plans need to have an asset exhaustion test run.  This examination will absolutely determine the true ROA necessary to keep the fund solvent while providing every last promised benefit.

We’ve recently completed a review of one of the poorest funded plans in the country, and our analysis calculated the true ROA at only 6.4%.  We did not alter the anticipated contributions nor the future benefits (no haircuts), and still, this plan had enough in future assets to meet all its obligations. Skeptical? Shocked? Don’t be.  Unlike the ridiculous exercise of guessing what a ROA should be, allow us to build for you a CLI and prepare an asset exhaustion test. Not knowing the truth is far scarier than having to deal with the reality.

Wouldn’t it be great if it was determined that Hartford didn’t need to contribute $40+ million to their plan this year or next? It could be what keeps them from filing for bankruptcy!



Houston Voters Back Plan to Issue POBs

53% of Houston voters back a tentative plan to issue Pension Obligation Bonds (POBs) to support the city’s foundering pension system.  Does this make sense? As we’ve discussed many times before, the history of POBs hasn’t been pretty.

The idea of issuing a bond to close the funding gap makes sense, but both the timing and implementation have left a lot to be desired.  It would be great if plans could borrow at 4% and earn 8% on their investment.  That potential arbitrage is what intrigues plan sponsors in the first place.  However, most often we’ve seen interest in doing this at the peak of a market cycle, and not at the bottom.

Furthermore, subjecting the principal from the bond to the volatility of a traditional asset allocation (chasing an ROA of 7.5%) doesn’t make sense.  We would highly recommend that plans engaging in this activity use the proceeds from the bond to immunize or cash match the plan’s retired lives as far out as they can.  This will allow future contributions and the plan’s current assets to have an extended investing time horizon that will permit the portfolio’s less liquid assets to actually capture their liquidity premium.

We don’t know when the next equity market correction will occur, but we are a lot closer to a peak than a bottom at this time.  Would the 53% of Houston voters supporting this idea continue to support it if they knew that these assets were going to be subject to potentially significant market risk?  What would they say if they were on the hook for 100% of the principal and interest and then had to make additional contributions when the assets declined 20% or more? It has happened before and there is no guarantee it couldn’t happen again. Caveat emptor!

Another One-two Punch!

As expected, the U.S. Senate has passed legislation to effectively reverse an Obama-era DOL ruling that would have permitted employees to fund their retirements through an employer’s payroll system, and have those contributions managed in a state-sponsored system. Several states have already passed legislation to permit this action. The reversal of this ruling is likely to significantly reduce future consideration.

The DOL promulgated its rule, Savings Arrangements Established by States for Non-Governmental Employees, last year. It encouraged states to establish automatic enrollment, payroll deduction individual retirement accounts, known as auto-IRAs, for private-sector workers not covered by a workplace retirement plan.

There are roughly 55 million private sector employees (aged 16-64) that don’t have access to an employer-sponsored retirement plan.  The demise of the traditional defined benefit plan is bad enough, but compounding this issue is the lack of access to any retirement vehicle outside of an individual IRA, which restricts the owner of the IRA with a very modest annual contribution limit.

Couple the lack of access to an employer-sponsored retirement program with the growing dependence on Social Security, and it becomes easy to see the retirement crisis unfolding.  Nearly 60 million Americans are now collecting Social Security and for the fifth year in a row, the beneficiaries have had to settle for historically low increases.  In fact, the average recipient saw a $4 per month increase in their benefits for 2017.

Meanwhile, a new survey by The Senior Citizens League (TSCL) reveals that household budgets for older Americans were stretched by significantly rising medical and food costs. According to Mary Johnson, TSCL’s medical analyst stated, “over any retirement, our needs change. We require more medical services and prescription drugs, our need for different housing and supports like transportation services grow, and life events, like caregiving, or the death of a spouse, have a big impact on spending.”

According to the survey, the average monthly increase in expenditures dwarfed the annual increase in benefit growth by a factor of roughly 10 to 1. Unfortunately, the government continues to use the CPI for Urban Wage Earners and Clerical Workers (CPI-W), and not the CPI for the Elderly (CPI-E), which weights medical and food expenditures to a greater extent than the traditional CPI-W.

It is bad enough that our retirement system is failing the average American, but do we really need to exacerbate the situation by rendering life-saving Social Security benefits less effective? We can, and must, do better.