The Pension Time Bomb

In recent years, there have been intense political battles regarding pension systems, and these arguments will persist and only worsen.  Many readers of this website will have sharply divergent views from one another on this topic, so I will do my best to present this in a rational economic construct.

Governments on the federal, state, and municipal levels have completely and systematically overpromised pension benefits to current and retired employees.  The mid-to-late 1990s witnessed significant economic growth and stock market appreciation, which is unquestionably a good thing, but unfortunately this outperformance set unrealistically high expectations for future investment growth rates.  Many politicians, who receive significant campaign contributions and electoral support from public sector unions, were incentivized to make pension plans more and more generous.

Unfortunately, investment returns over the past 13 years have been quite paltry.  Crucially, for the past four years and going forward for at least the next couple, we have been in a protracted low interest rate environment.  This drives bond yields lower, thereby making it exceedingly difficult for pension funds to achieve investment targets without taking undue risks.

Source:  http://www.freeworldmaps.net/printable/us/us_political2.gif

Nearly every state now finds itself having promised way more in benefits than it can possibly deliver.  As we have witnessed in California and other high-tax states, trying to tax your way out of this problem ends up being largely counterproductive, as businesses and higher-income earners end up relocating to states like Texas and Florida which are relative tax havens.  In this still-depressed economic environment, states may be able to raise some revenue without suffering a significant exodus, but not nearly enough to make up for the pension shortfall.

This leaves us with an uncomfortable realization, but a realization nonetheless.  Pension reform isn’t a choice, it’s a necessity.  And the sooner states adopt pension reforms, mathematics proves that comparatively small short-term sacrifices will be far preferable than having a bankrupted system that cannot afford to make any payments to retirees.

The next article below provides the math to back up this statement.

Pension Math and Investment Returns

While the private sector primarily utilizes a defined contribution scheme, where employers will contribute funds to a 401(k) account that an employee is in charge of managing, the public sector predominantly has a defined benefit pension system where fixed dollar amounts are promised during retirement.

To illustrate these concepts, let us consider the case of a 40-year-old who opts to retire at age 65, and then receives a defined benefit amount for the rest of his/her life.  For simplicity, looking at a single payment illustrates how projected investment returns considerably influence how much money needs to be contributed now.

Money contributed in 2013  è  Compounds for 25 years  è  Money for retirement in 2038

Suppose that upon retirement in 2038, the worker is supposed to receive a payment for $100,000.  State and local governments must contribute money now, in 2013, to ensure the retiree will receive $100,000 in 25 years.  The compound interest rate (also called the discount rate) reflects the state’s estimate of annual investment returns over the next 10-20 years.  You can also think about the discount rate as the expected rate of return (which in theory should be achievable with the asset mix the pension fund uses).  For example, if you believe that investing in stocks and bonds will generate a 6% annual return over time, then 6% would be the appropriate discount rate.

A high discount rate allows for smaller contributions now in the hope that significant appreciation will grow the amount to $100,000.  A low discount rate means that larger contributions must be made now.

Given that states are struggling to balance their budgets, many are using more aggressive assumptions in order to save cash now.  However, if actual investment returns fall short of these targets, states will have to contribute substantially more money in the future to compensate for this shortfall.  Despite lower interest rates and investment returns, many public pension plans have never adjusted the discount rate, exposing these plans to grave risk.

Let’s look at the difference between compounded returns of 8.25% vs. 6.50%.  Many state governments are using figures around 8.25%, while corporations are (by law) using a much more conservative 6.50%.

? contributed in 2013  è  25 years @ 8.25%  è  $100,000 in 2038       vs.

? contributed in 2013  è  25 years @ 6.50%  è  $100,000 in 2038

Required contribution using 8.25% rate:  $100,000 / (1.0825) ^25 = $13,782                                                           vs.

Required contribution using 6.50% rate:  $100,000 / (1.0650) ^25 = $20,714

Reducing the discount rate by 1.75% (from 8.25% à 6.50%) necessitates contributing a staggering 50% more money now.  It’s no wonder that states have generally opted to use a significantly higher discount rate, but in this “new normal” rate environment, they are likely deluding themselves.  Yet even at the high discount rates, states have promised far more in benefits than they will be able to pay, resulting in massive projected shortfalls.

For instance, New Jersey, only the 11^th most populous state, has unfunded pension liabilities of $55,000 million at an aggressively high discount rate.  Applying a more conservative discount rate, this number increases to around $100 billion, fundamentally compromising the state’s capability to provide any other desired services (e.g., education, human services, transportation, etc.).

Source:  http://www.policyprospectus.com/2012/08/a-primer-on-pensions.html

In order to shore up the pension system, state governments will need to adopt a combination of these politically unpopular, yet economically necessary, approaches to stave off a true fiscal crisis where everybody will lose out (defaulting on debt, huge cuts to state budgets, and not having cash to pay retirees):

1)  Employees contributing more to their pension plan to ensure its sustainability

2)  Gradually migrating from a defined benefit to a defined contribution system

Unfortunately, politicians who care about their self-interest above all else have “kicked the can” on pensions and other issues for years, and it takes statesmen to address difficult fiscal issues now in order to stave off financial ruin later.  When offering constructive ideas, the debate is often poisoned by public sector unions claiming that teachers, police officers, firefighters, clerical workers, etc. are being attacked, when in fact pension reforms are necessary to ensure the solvency of the very system they are relying on for retirement.

For any helpful discourse, it is paramount that both sides separate the individual from the union they are required to join.  The default response from certain interest groups has been to demonize the messenger without offering any meaningful proposals, but it is critical for people to see through that shallowness.  Hopefully these mathematical concepts and their applications were illuminating.

Double Taxation of Capital Gains and Dividends

At 35%, the United States has the second highest corporate tax rate in the industrialized world.  Through their ownership, shareholders receive capital gains and dividends from these corporations.  Instead of the taxation ending at the corporate level, however, individuals also pay federal, state, and local taxes on these distributions.

Policymakers continually debate about what the optimal capital gains and dividend tax rates should be.  In fact, nearly every president since Gerald Ford has presided over a change to the long-term capital gains rate.  While interest income gets taxed as ordinary income, capital gains from investments held for over one year typically receive preferential tax treatment.

On January 1, 2013, capital gains and dividend rates increased for higher-income earners as depicted here:

Source:  http://www.forbes.com/sites/beltway/2012/01/24/capital-gains-taxes-are-going-up/

With this background, we can illustrate the effects of double taxation.  For simplicity, let’s assume:

·         100 people purchase all shares of a company for $1,000 each; the company is therefore worth $100,000

·         Over the next year, the company earns $20,000 pre-tax

·         35% corporate tax rate is applied à the company earns $13,000 after-tax

·         Each shareholder risked $1,000 of capital by investing in the company, and is entitled to fractional ownership of the company’s profits

·         An individual owns 1/100 of the firm, and would therefore receive (1/100) * $13,000 = $130 of profits through stock price appreciation or dividends

Because of double taxation, however, more deductions need to be calculated.  Most people need to add a 15% federal rate, plus state and local rate, to the tax burden.  This issue becomes even more acute for higher-income earners, where the effective federal tax is now about 25%.

If the (Federal + State + Local) tax rates on capital gains and dividends amounts to 30%, then the shareholder only receives $130 * 70% = $91.

Stocks are inherently risky to invest in because the firm’s creditors are entitled to cash before shareholders.  In this example, the company did well by earning $20,000 for its shareholders.  As a 1/100 owner of the company, you would be entitled to $200 pre-tax.

However, the corporate tax lowers this to $130, and then the capital gains and dividend taxes lower it further to $91.  The $91 represents merely 45.5% of what the company actually earned on a pre-tax basis, meaning that as an owner, you are subjected to an effective 54.5% tax rate.

Political discourse will continue about these issues, and hopefully this provides some helpful background material about corporate and individual tax rates. 

Source:  http://www.invigorlaw.com/choosing-a-business-entity-double-taxation-v-pass-through-taxation/

Personal Story from 1960s Cuba

Americans are quite fortunate to live in a society where we can freely vote, worship, express ideas, and maintain personal property without fear of reprisal by an authoritarian government.  These rights seem so natural to us that they are sometimes taken for granted.  This would be a terrible mistake, as billions worldwide regrettably lack one or more of these fundamental rights.

An important part of the American fabric has been woven by Cubans immigrating to the United States.  From the perspective of Americans and especially younger people, it is one thing to know that the Castro regime has spanned since 1959.  Internalizing the incredible ordeal Cubans have gone through is quite another.  Following the revolution that swept Castro to power:

-Religious schools were disbanded

-Personal property was confiscated

-Compulsory education was used to glorify Castro and communism

-Speaking out against the government resulted in persecution

At great risk, many Cubans opted to leave behind family, friends, property, and financial assets to ensure a better life for their children.  Immigrating to the United States was an extremely arduous, and at times dangerous, process that required tremendous sacrifice.

My friend’s father grew up in Havana and was 9 years old when the problems of the communist regime became apparent.  Before long, his family made the incredibly difficult decision to leave their homeland and start a new life in the United States.

Source:  http://www.cubanosinwisconsin.com/#!home/c104h

In his book, Cubanos in Wisconsin, Silvio Canto Jr. documented these experiences in Cuba and the tribulations the family went through in leaving, which took them to multiple countries over a long period before reaching American soil.  This is a powerful read that sheds light into the Cuban experience, and many of these principles can be applied to everyone living behind the Iron Curtain, trapped within a morally bankrupt society.  On the flip side, it also ventures into the greatness of humanity and how the kind acts of so many helped the Canto family get established in their new country.

If you’re looking for an enlightening and inspirational read, consider Silvio’s book:

http://www.amazon.com/Cubanos-Wisconsin-Silvio-Canto-Jr/dp/0615714994

Economics of the PGA Tour

Compared to the “Big Four” professional sports in America, golf has a decidedly smaller fan base, and tournament venues lack the infrastructure that can be found at stadiums and arenas.  Consequently, the Professional Golfers Association (PGA) Tour is especially reliant on volunteers and title sponsors to make tournaments operational.

In a typical tournament, golfers will share a $6-8 million purse based on their performance that week, with a title sponsor contributing 40% of the purse.  Additionally, the sponsor will pay $4-5 million to cover a television advertising commitment and fees to both the PGA Tour and the local tournament organizing committee.  The PGA Tour is also unique in that these tournament committees are structured as nonprofit entities, whose primary mission is to charitably contribute to the local region.  Despite its much smaller scale compared to the major professional sports, PGA tournaments raise over $100 million annually for charity.

Tiger Woods’ dominance from 1997 through 2009 drove significant excitement in professional golf, and prize money astoundingly increased five-fold since Tim Finchem became commissioner in 1994.  The Great Recession of 2008-09 was very problematic for recreational and professional golf, however.  The golf industry – primarily consisting of golf courses and equipment manufacturers – was devastated from shrinking disposable income, and remains years from regaining its vitality from the mid-2000s.  In 2009, the PGA Tour found itself at a crossroads because many title sponsorships were up for renewal in 2010.  Unfortunately, many sponsors were automobile and financial services companies that experienced major economic and public relations difficulties during the crisis.

Another low point came in November 2009 when Tiger Woods crashed his Cadillac Escalade into a fire hydrant.  The severe reputational hit to the game’s iconic player, coupled with his months-long absence from competition in early 2010, generated uncertainty as to whether Woods could ever recover the form and likeability that helped drive tremendous growth in the sport’s popularity and television revenue.

Overall, the PGA Tour did an excellent job confronting these challenges and building an even stronger brand.  Remarkably, the tournament schedule was not cut back, as Finchem and his team attracted new sponsors to the Tour’s value proposition.  The Tour occasionally needed to provide financial assistance to events held in smaller markets such as Tampa and Hilton Head Island, but their negotiating position generally remained strong.

Source:  http://www.pgatour.com

In the aftermath of the Tiger Woods scandal, the Tour recognized that its marketing campaigns were insufficient in developing enough fan interest in other players.  Through advertising and social media, golfers including Rory McIlroy, Dustin Johnson, Adam Scott, Keegan Bradley, Luke Donald, and Bubba Watson gained more attention among sports fans besides diehard golfers.  Even controlling for Woods’ play, television ratings in 2011 and 2012 were up significantly from corresponding 2010 levels.

With a record long-term television contract in place, the Tour is strongly positioned going forward, thanks to diversifying its sponsorship base and better promoting its players.  Tiger Woods’ ascendancy to #1 will only magnify the effectiveness of these initiatives.

New Year’s Resolution to Save More? Here’s Some Motivation…

Here is a thought exercise -- think about what you spend money on and if there is a way to cut back on individually small expenditures. Suppose that you routinely order an extra drink or two at a coffee shop or bar. And let's say you're able to pinpoint a few other items to save on, and can spend an average of $15 less per day.

Saving an extra $15 per day, and investing this amount at the end of each year, can boost your finances considerably more than you’d expect.  With inevitable fiscal pressures threatening the viability of Social Security, Medicare, and pension systems, you would be very wise to do this if at all possible.

If you’re 25 now, let’s consider the extra money you’ll have at age 65.  Assuming 6.5% investment returns and a 2.5% inflation rate, saving an extra $15 per day will generate extra pre-tax savings of… $1,433,208!

Note:  Your contributions will need to keep up with inflation, which should rise at a similar rate to your income.  In this scenario, you would save $15.38/day next year, $15.76/day in 2015, etc.

You may be wondering how $15/day could generate so much additional wealth for you.  Perhaps you’re in a position to save an extra $5, $10, or $25/day rather than $15.  If we modify the rates for inflation and investment returns, how would that impact the savings calculation?  What if you want to save money for a 5- or 10-year goal, rather than 40?

If you want the answers to any of these questions, e-mail me at krkreflections@gmail.com and I will send you a very user-friendly Excel spreadsheet where you can obtain these findings instantly.

Excise Tax on Medical Devices

The Patient Protection and Affordable Care Act, more commonly referred to as Obamacare, will have far-reaching consequences in the health care industry. (See the first paragraph of this previous post for my take on how congressional bills are named.)

Without getting into the political, moral, and religious implications of the legislation, it is important to consider the economic impact.  Let’s look at one single provision of the ~400,000 word statute.  To raise tax revenue, a 2.3% excise tax on the sales of medical devices went into effect on January 1, 2013.  At first glance, this figure may not seem especially high, but this tax is on sales, not profits.

Traditional corporate taxes are paid on profits, so if a company sells $10 million of furniture, and incurs $9 million of expenses, its pre-tax profit is $1 million.  The federal corporate tax rate of 35% is applied to this figure, so $350,000 goes to the federal government and $650,000 is kept by the company.  A start-up company is likely to lose money for years, and it pays no federal tax because it is unprofitable.

The Obamacare tax on medical device companies, which manufacture a wide array of products, behaves differently.  Start-up companies now have to pay taxes despite being unprofitable, which is devastating from a cash flow perspective and could threaten their viability.  The 2.3% tax on top-line revenues has a huge effect on the profitability of mature companies as well.  These calculations below illustrate comparing 2012 vs. 2013 for three hypothetical companies with pre-tax profit margins of 20%, 5%, and -10% (start-up):

Pre-Tax Profit Margin = Pre-Tax Profit / Gross Revenue
Net Income is based on 35% corporate tax rate

20% Pre-Tax Profit Margin
	2012		2013
Gross Revenue	$1,000		$1,000
Medical Device Tax	$0		$23
Adjusted Revenue	$1,000		$977
Expenses	$800		$800
Pre-Tax Profit	$200		$177
Net Income (Profit)	$130		$115
Net Income fell by 11.5%

5% Pre-Tax Profit Margin
	2012		2013
Gross Revenue	$1,000		$1,000
Medical Device Tax	$0		$23
Adjusted Revenue	$1,000		$977
Expenses	$950		$950
Pre-Tax Profit	$50		$27
Net Income (Profit)	$33		$18
Net Income fell by 46.0%

10% Pre-Tax Loss for Start-up Company
	2012		2013
Gross Revenue	$1,000		$1,000
Medical Device Tax	$0		$23
Adjusted Revenue	$1,000		$977
Expenses	$1,100		$1,100
Pre-Tax Profit	-$100		-$123
Net Income (Profit)	-$65		-$80

Net income fell by $15, but actual cash loss was $23 because losses for a start-up can only be offset by future gains

These results are staggering, because a 2.3% tax may not register as being huge, but it is extremely problematic for the industry.  Profitability falls by 11.5% for a firm with a pre-tax profit margin of 20%, and 46.0% for a firm with a pre-tax profit margin of 5%.  Start-up companies looking to create innovative products that could help save or improve our lives now face a huge additional financial burden that could threaten their existence and cause a slowdown in entrepreneurial capital flowing into the industry.

At a time where tens of millions of baby boomers are requiring more health care services, it is instructive that many medical device manufacturers have resorted to layoffs over the past two years to cut costs in response to this excise tax.  The companies will also have no choice but to pass on costs to hospitals, physicians, and consumers, thereby increasing, rather than decreasing, the cost of health care.  This illustrates yet another example of government policy producing unintended economic consequences.

Source:  http://mblb.com/wp-content/uploads/2012/04/Medical-Symbol2.jpg

General Motors and Chrysler

A contributing factor to Barack Obama's defeat of Mitt Romney on November 6, 2012 was a New York Times op-ed authored by Romney on November 18, 2008. General Motors and Chrysler were hemorrhaging money amidst the sharp economic downturn, attributable to both low demand for automobiles and an unsustainably high cost structure. If the automotive manufacturers closed down entirely, many suppliers (primarily located in the Midwest) would have suffered irreparably and be forced to shut down their own operations. Having read Romney's op-ed the morning of publication, his methodical outline of the situation was rooted in a unique perspective – his father actually ran a Detroit car company called American Motors.

http://www.nytimes.com/2008/11/19/opinion/19romney.html

The New York Times editorial staff’s headline associated with Romney’s op-ed, “Let Detroit Go Bankrupt,” ended up resonating very poorly among some of the 2012 electorate because of the negative connotations associated with bankruptcy.  In debates and on the campaign trail (particularly Ohio and Wisconsin), President Obama repeatedly accused Romney of wanting to let Detroit go bankrupt.  This charge was not effectively countered by the Romney campaign, and losing Ohio sealed his fate on Election Day.

In this context, it may be surprising that the actual content of Romney's fateful piece is in fact quite moderate and business oriented, rather than politically oriented. He addressed failures of management, GM and Chrysler's lack of product competitiveness amidst high gasoline prices, and how labor unions had extracted untenable wages, benefits, and pensions during the good industry years of the early 2000s.

Crucially, Romney became the first major public figure to propose a long-term solution other than just throwing money at the problem, and some of his proposals were indeed incorporated by the Obama Administration in early 2009. The government would oversee a pre-packaged bankruptcy process, where the companies could avoid liquidating all their assets, and customer warranty agreements would be protected.

A critical difference emerged, however, between Romney's proposal and what the Obama Administration implemented. The next article below discusses this difference, centered on the companies' creditors. While the bankruptcy process may not seem like an incredibly compelling topic, the consequences of these 2009 actions are far-reaching, and almost certainly affected you as taxpayers or your family members as investors and/or pensioners.

Source: http://kids.britannica.com/comptons/art-54773/Detroit-Michigan

Lending to a Company

In order to finance operations, companies need to obtain cash by either borrowing money (debt) or issuing equity (stock). When most people think of the financial markets, the stock market immediately comes to mind, yet the credit market is much larger. In the stock market, if you purchase five Apple shares at $500/share, you pay $2,500 to own 0.0000005% of the company's market value of $500 billion, hoping the market value will increase over time.

A company's equity represents what is left over after paying all other obligations, and is driven by earnings (profits). Earnings fluctuate, and a struggling company may experience a decline in its stock price. A firm can struggle to the point where its liabilities exceed its assets, such as GM and Chrysler, and the value of its stock becomes worthless ($0/share). Investors in the stock market demand a higher rate of return than investors in the bond market, because it is a riskier investment and they need to be compensated for taking that extra risk.

While this prioritization holds true between debt and equity, debt itself can be divided into different tranches that vary according to risk and return. This diagram depicts different investments that can be made in a given company, and ranks the investment types from lowest risk to highest risk.

Source:  https://www.fiig.com.au/learn/educational-articles/2009/07/10/capital-structure---a-detailed-assessment

Before the Equity investors can be paid $1 in dividends, the company is legally obligated to pay all other investors. The Senior Secured Debt investors may demand a 4% annual return, 5% for Senior (Unsecured) Debt investors, 8% for Subordinated Debt investors, and Equity investors receive whatever is left over. Debt investors receive their principal back with interest, but don't receive any upside – a lender to Apple ten years ago would receive the same amount of money whether Apple's stock was $10/share or $500/share.

Without going into great detail here, the GM and Chrysler bailouts deviated from what always happens when a company files for bankruptcy. The Senior Secured Debt investors consisted of banks, mutual funds, and pension funds. Many of you have investments in corporate debt through mutual funds (401k and brokerage accounts), and you have family members who receive private or public pensions. Many such funds lent money to GM and Chrysler, either directly or in the secondary market, knowing that by law, they would receive top priority on any money that could be recovered from the companies in the event of bankruptcy.

In the 2009 bailout, this fundamental principle was completely revamped. Politically favored groups (i.e., United Auto Workers union) had claims in the Senior Unsecured Debt tranche, which was below the Senior Secured Debt group consisting of the banks and investment funds. Despite having legal priority, the Senior Secured group was substantially pressured and felt, shall we say, obligated to accept far worse terms than what the Senior Unsecured group received. Tens of billions of U.S. taxpayer dollars were also used to indirectly prop up the Senior Unsecured group, and you will be financing the principal and interest on that loss for decades to come.

The managed bankruptcy process provided an opportunity to make Detroit sustainably competitive with other automakers (many of whom have significant operations in the U.S.). Instead, very little was done about its burdensome cost structure. Moreover, arbitrarily overhauling bankruptcy law increases the risk premium required by lenders, so automakers and other industries with similar issues will incur more interest expense in the years ahead. Increased expenses leads to fewer profits, which leads to lower stock prices, which leads to less money for investors and pensioners, and results in fewer jobs in those industries. Time will tell if these issues will (yet again) cause financial hardship for GM and Chrysler.