Pension Reform and Why You Should Care
It seems we are all aware of how sluggish our economic recovery has been. Each day we hear about economic indicators that are simply lackluster. There is uncertainty regarding our future tax policy, uncertainty about the implications of financial regulation and uncertainty about the true costs of our new health care system.
Indicative of this uncertainty, a majority of Americans currently believe they will be earning less in six months than more. While the government is hopeful that exports will help stimulate the economy, little progress has been made on any of the pending trade agreements (perhaps a devaluation of the dollar is what the administration is hoping for to stimulate export growth). The majority of Americans believe that current legislators are anti-business; consumer spending remains below trend; the price of oil continues to increase; and gross domestic product growth continues its malaise, at less than 2 percent on an annualized basis. The housing market continues to limp along, and the all-important jobs market is not creating nearly the number of jobs we need for our recovery to gain strong traction.
Recently, the Federal Reserve’s $600 billion “QE2” was implemented in the hopes of keeping long-term interest rates low. It appears that QE2 is nothing more than the proverbial “pushing on a string,” as long-term rates have actually increased by about 10 percent since this program was announced. Clearly, the market’s interpretation is that the $600 billion makes higher inflation more probable in the future, which has investors nervous and is diverting capital from the long-term bond market. This weakening of demand has driven bond prices down, thus increasing their yield. It also appears that this new government initiative is creating a major distortion in the allocation of capital. You could say it is nothing more than a Band-Aid to cover up some very bad public policy.
On a federal level, the administration will push its platform as it sees fit. However, it is important to realize that individual states have significant powers and rights. Each state is a sovereign entity, with the power to tax and set spending levels. Simply put, states have the ability to straighten out their own affairs. The overwhelming majority of states are projecting massive fiscal deficits, putting them in positions where they will need to decide to raise taxes, cut spending or utilize a combination of both. With taxes at burdensome levels, controlling spending must be a focal point for legislators.
However, few have had the political will, thus far, to do so.
MANY STATES LIKE like California, New Jersey and New York already have significantly high tax rates, and sensible politicians are reluctant to raise taxes to bridge budget gaps, as this could potentially drive businesses and job-creating individuals out of their states. For many facing large budget deficits, the only method of survival will be to cut spending in a meaningful way. This, unfortunately, means inevitable tough battles against public-sector unions, which have been granted unsustainable collective bargaining arrangements and pensions systems that are driving municipalities into balance sheet insolvency.
Recently, the first of approximately 80 million baby boomers have begun to retire. This fact is placing a magnifying glass on the increasingly apparent fact that the United States is up against a pension crisis of unprecedented magnitude. Almost all state and local government pension plans are significantly underfunded; many large corporate pension plans have collapsed or are near insolvency; the Social Security system is a time bomb waiting to explode; and nearly half of all Americans have managed to save just about zero upon which to live during their golden years.
In order to make it through this potentially devastating problem, we must realize that we need to change almost everything we know about retirement. It is simply impossible to keep all of the financial promises that we have made to an entire generation of Americans, as we have promised to provide more than can be delivered to future retirees. This is particularly true when it comes to public-sector unions, which have negotiated packages that are oblivious to economic reality.
So at this point, you may be asking why a real estate guy cares so much about pension obligations. In this case, the dots are fairly easy to connect. To the extent pension obligations cannot be reformed and controlled, property taxes will increase. If property taxes increase disproportionately to other expenses, property value falls. If property values fall, history has shown us that transaction volume will fall. Any market participant that relies on transaction volume within the real estate industry for their livelihood clearly understands the relationship between transaction volume and their relative level of professional happiness.
The pension issue is one that must be dealt with and must be dealt with soon. On Capitol Hill, you know questions will be asked as to whether the federal government will bail out states and municipalities facing budget problems caused particularly by their overly generous and significantly underfunded pension plans. The options for the government, include (1) doing nothing, which will likely create emergency cost-cutting and increases in taxes, which will drive away businesses and jobs; (2) yielding to pressure from politicians and organized labor for condition-free funding; or (3) motivating states to straighten out their own affairs by providing resources that have restrictive conditions attached to them.
The catch with these scenarios is that even the possibility of a federal bailout will stop politicians from making the tough decisions that need to be made in dealing with these very real problems. Reforming pension systems is not an easy task and requires tremendous political will. Public-sector-union pension funds require fundamental reform, which is unlikely to come if potential bailouts are on the horizon. The current administration could take great strides in resolving this problem by simply stating that they will not provide the assistance that so many municipalities are praying for.
One of the most significant methods of reforming these pension systems is to switch from the current “defined-benefit” plans to “defined-contribution” plans such as 401(k)s for new employees. The current defined-benefit scenario is tantamount to a Ponzi-style system, where contributions from workers today are funneled to benefit retired recipients.
Recent published reports have indicated that in New York, we are doing relatively well compared with the rest of the country, as our pension obligations are “funded” at 107 percent, an amount that sounds more than adequate. However, this number, and all funding obligation percentages, are derived using hocus-pocus accounting. One of the major contributors to this fantasy is the assumption of a 7.5 percent annual compounded rate of return within the funds. This expected return percentage was recently lowered in New York from 8 percent, which is the national average.
Notwithstanding this lowered expectation, does anyone really believe that a 7.5 percent return is achievable given market conditions?