Silver Tsunami

Welcome to the second annual installment of our April tinfoil hat series, where we role-play Al Gore and attempt to shine the harsh light of inconvenient truth on the crumbling facade of government narrative.

Last year we looked at the “War on Cash” (update - anybody else catch Apple CEO Tim Cook saying “I’m hoping to be alive to see the elimination of money” earlier this year at their annual shareholder meeting?...).  This year, we’re going to take a look at the “Silver Tsunami” (catchy, but blatantly stolen unfortunately - can’t take any credit for coining that one) headed our way. We originally wanted to also spend a little time mocking the charade that is government data releases, but that turned out to be too long and dry even for us.  Maybe next year.

Silver Tsunami, or Lies That Pension Plan Tell and Why Your Taxes are Going Up

There have been a recent spate of articles on the looming pension crises (yes, plural) in this country - one in the New York Times about Oregon’s pension issues, one from CNN about the pension issues facing teachers in Kentucky, several about the overall problem in general, and that’s to say nothing of the previously identified basket cases of California, Connecticut, New Jersey, Illinois, and the Central States pension.
As an aside, we are totally on board with the recent teacher strikes.  Classroom funding and teacher salaries should absolutely be increased as of yesterday.  The issue at hand here is with pensions...and in fact, it’s because of those pensions that classroom funding is low to begin with.  Here’s how pension funds are supposed to work:

Employees are offered a pension in retirement, fully vested after a certain number of years working for the company and payable as a certain percentage of your salary - something like “after 20 years you’ll receive 65% of your final 3 years’ salary paid in monthly installments for the rest of your life”.  The key here is that “rest of your life” part - this is a really great benefit that makes up for less-than-top-dollar public service positions. It used to be that everybody was on some kind of pension plan, but pension plans have disappeared over the years in favor of defined contribution plans (401(k) plans, etc., where you are individually responsible for providing for your own retirement).  With a pension plan, companies are responsible for assessing how much they will owe in future pension obligations once their employees retire, estimating future investment returns, and from those numbers calculating how much money they need to contribute to the pension plan in the current year to make sure it has enough money to meet those future obligations.

It’s essentially the same thing as the retirement planning we’ve done for some of you, just on a company level instead of an individual level.

Now, let’s play “what if”.  Say you said long-term investment returns will be 10% per year, and using that rate of return, you as a company needed to contribute $100,000 per year to your pension fund to keep it fully funded.  But what if your employees kept living longer than your actuarial assumptions predicted when you initially calculated those funding amounts? What if actual investment returns weren’t 10%? What if they were only 5%?  What if they were negative? Well, then you’d have to contribute more than $100,000 per year to the fund...but what if investment returns were negative because there was a recession and you didn’t have $100,000 to contribute?  What if you only contributed $25,000? And what if the next year, you used the $100,000 contribution to instead acquire a smaller competitor’s company, because near-term business success is more important than ephemeral pension obligations 30 years down the road, right?

Eventually, that “30 years down the road” becomes “right now”, and you have no money to pay your pension obligations.  That “what-if” game is, in reality, made even worse by a giant dose of moral hazard in the form of politicians and self-serving actuarial hijinks.  You know what doesn’t get the union vote when campaigning for office? Pension reform. You know what does? Increasing pension benefits. And the best part is that despite exacerbating the pension funding crisis, you’ll still be out of office for years before it’s a problem!  Just kick that can and pass that buck.

We like to assume a conservative rate of return of about 5% when doing retirement planning - this builds in a margin of safety into the plan, but also means that the present amount needed for retirement will be higher, since it grows less at 5% than, say, 7%.  Pension plans are incentivized to keep return assumptions artificially high, as that makes them look less underfunded than they are and lessens the contribution they are required to make into the fund.  But when actual investment returns continue to fall short of their assumption year after year...let’s just say the numbers on that Tax Foundation graphic are likely more than a little optimistic.  For the country as a whole, the “official” funding shortfall is about $1.5 trillion (with a “t”). It reality, it’s probably twice that.

So what happens next?  Try and close the funding shortfall.  Unlike the federal government and social security, states can’t just write IOUs and then print money to cover their borrowing.  They actually have to raise the money, and they do that by...yep, raising taxes. The sad part will be that the tax is ostensibly for something desirable - half a percent increase in property taxes to increase classroom funding in your school district, say.  Why is classroom funding low? Because the state teachers’ pension fund is requiring all the school districts to contribute 20% more to the fund so that it doesn’t run out of money in five years, meaning that they have to divert funds that were originally intended for their classrooms, or extracurricular activities, or salary raises, or whatever.  It’s a vicious cycle that will have to repeated every couple years. A half percentage hike in property taxes does not close a 30% funding shortfall.

At a certain point, people who can will move to a more tax-friendly state.  This is a huge problem for Connecticut at the moment - a lot of hedge funds used to be based in Connecticut, but then the state raised taxes so they moved (to the tune of 20,000 residents and a total of $2.6 billion with a “b” in state income from 2015-2016) - though we are sure Connecticut is not alone.  This loss of income means there’s less money for all state and local services, so taxes have to raised again to try and make up the difference. At which point more people who are able leave, and you start the cycle over.

Eventually, when the electorate rejects any more tax hikes, it ends up in court, and the final endgame is a two-thirds reduction in pension benefits coupled with higher taxes on everybody and a pretty bleak near-term future for the municipality.  It’s a lose-lose proposition. There are plenty of ways to avoid such a dystopia (shout out to Michigan), but proactivity and foresight unfortunately seem to be in short supply across the board at the moment.

There are so many ways you get taxed.  Federal income tax, sure. But also state income tax (for most, but not all states), property tax (especially bad in those states without an income tax), sales tax, estate and gift taxes (not applicable for most), hotel taxes, vice taxes (alcohol and cigarettes), gas taxes...taxes are everywhere and on everything.  And if you happen to live in a municipality with a struggling pension plan, expect to see your taxes go up.

No, let us amend that.  Expect to see your taxes go up no matter where you live.  Because while the focus of this particular note was on state and local pension issues and associated tax hikes, there is a little nation-wide pension fund called Social Security that is going to be bankrupt by 2034 according to the Trustees of the Social Security fund itself.  So we’re going to ignore the most recent (and temporary) tax break that was signed into law last year, just like the federal government is ignoring its own looming pension crisis.  Can, kicked.

Sorry to end on a bleak note - this was a bit of an April showers of a newsletter.  Just put that tinfoil hat away for another year and we’ll try and round up some May flowers for you next month.