March 16, 2017

The Origin of the Pension Debt Problem

There is no doubt that the welfare state as a socio-economic project has reached the end of the road. The European economy is in perennial stagnation, best described as a state of industrial poverty: they still enjoy the relatively advanced standard of living that comes with an industrial society, but there is no longer any advancement in prosperity from one generation to the next. Children grow up to a life less prosperous than what their parents enjoy, and it is not just a matter of government debts that burden the incomes of future generations. 

High taxes stifle entrepreneurship, productive investments and private consumption; as a result, the labor market does not offer the young generation anywhere near the opportunities that previous generations enjoyed. One fifth of the young generation is left out of the labor market; for those who have jobs, high taxes discourage career development and suppress the benefits from education. 

Entitlements, in turn, discourage workforce participation and perpetuate dependency on a government that is no longer able to provide what it once promised. Together, high taxes and entitlements create a vicious circle, a whirlpool that sucks thriving economies into the dungeons of stagnation and industrial poverty.

At the heart of the welfare state is the idea that some individuals can be forced to provide for other individuals without any concern to the ability of the providers to honor the promise. It is not the designated providers that make the promise - it is government. This promise is often given out by means of traditional European parliamentarianism, a system that lacks the checks-and-balances functions of the American constitution. As a result, a majority of self-appointed entitlees can elect a legislature that makes it mandatory for a minority to foot the bill for whatever the entitlees demand to have provided for them. 

It is important, however, to keep in mind that the process through which a welfare state is created does not have to be one of entitlees vs. providers. It is just as often - especially in modern, mature welfare states - a matter of the providers supporting, even actively perpetuating the welfare state. The reason is often political vanity: it is considered a sign of education and intellectual refinement to be in favor of big, government-run entitlement programs. 

Sooner or later, the ideology behind the welfare state - egalitarianism - becomes self evident and rises beyond question. Entitlees take for granted that their benefits will continue to come in; providers will appreciate the opportunity to pay high taxes, mostly out of misguided virtue. Alternatives to the welfare state fade from the political spectrum and society stands unprepared when the welfare state runs out of the providers' money.

That is, essentially, where the European welfare state is today. In the United States, things are not yet as bad, but without substantial U.S. entitlement reforms the differences will fade into irrelevance.

One of the many symptoms of the American welfare state's ailment is the public pension system. In its seemingly mundane and unexciting existence, it has become a concentrate of the thoughtlessness that is the very core of the welfare state. We do not even have to go as far as to Social Security; the state-level pension systems are good enough examples. The blog ZeroHedge has an overview:
Along with the student loan debt bubble and other major financial factors, the looming pensions crisis is bound to be the death of us all. Because it’s based on a future promise to pay, it has long been a benefit dangled to solve strikes and union disputes – because, in the end, it is just more debt, whether private or public. With tens of trillions in unfunded liabilities, the weight of an avalanche remains dangling over our heads. An aging population is cashing in on needed retirement benefits while the younger generations must support multiples that are unsustainable financially. Somewhere between the retiree that needs clothing, food and lodging, and the bankruptcy of cities and state governments is the makings of the next economic crisis.
ZeroHedge is wrong in comparing student loans to state pension funds. Those are two different problems with two different causes and two different solutions. Nevertheless, the blog is spot on in referring (indirectly via other blogs) to the state pension system in South Carolina. On December 3, 2016, the Post and Courier, based in Charleston, SC, reported that the state government pension funds...
serve roughly one out of nine state residents, and the shortfall — $24.1 billion — is more than triple the Palmetto State's annual budget. That's left lawmakers and the state's investment managers scrambling for a fix, as the burden grows for workers and taxpayers. Teachers, firefighters and other government employees have been required to pump ever-rising amounts of money into the pension system, only to see their retirement plans become increasingly uncertain. Costs have soared for state and local governments, school districts and public colleges. The pension shortfall is the “state’s biggest problem of the decade,” said Sen. Kevin Bryant, R-Anderson, co-chairman of the Joint Committee on Pension Systems Review.
Originally, government retirement plans were of the defined-benefit plan, in other words the retiree would get a certain percentage of his salary during a specified part of this labor-active years. This type of pension plan is a prime example of the core problem with the welfare state: in order to pay for the pensions, the pension system needs contributions from current employees that are at least as big as the pensions being paid out. 

Even though South Carolina introduced optional defined-contribution plans in 2000 and 2002, the problems created by defined-benefit plans continue to plague the system. 

In a nutshell, here is how the defined-benefit problem works. Assume that B is the benefits being paid out "today" to eligible retirees; b is the share of the earnings of "today's" employees that is paid into the pension system; Yc is "today's" employee earnings:

(1) B = b*Yc

Statically, this looks fine. The problem, though, is that a fiscal equation like this one is never static. B continues to change over time with the population of retirees, just as employee income changes with the changing employee population. Therefore, what really matters is that the changes in the variables defining B and b*Yc are in a balance that guarantees a continuous non-negative cash flow:

(2) dB = dYc

where, of course, dB is the rate of change in B per period of time, and dYc is the rate of change in Yc per period of time. 

To be more specific, the change in B is dependent on the rate of change in income that past employees - now retired and collecting pensions - experienced during their active years. Therefore, to be perfectly accurate:

(3) dYh = dYc

where Yh is the historic income of current retirees.

Here we have the core of the welfare-state problem. The promise that government has made to its employees comes in the form of B. The providers for B, current employees, are asked to deliver on the promise by means of b*Yc, which over time means that their income must increase at a rate dYc that exceeds the rate of increase in pension benefits. In other words, their income has to "outrun" historic incomes of past employees, namely dYh.

In the last couple of decades, more and more states have discovered that dYh > dYc - or, put differently, the historic accrual of pension benefits exceeds the current rate of growth in the income that can pay for those benefits. The immediate solution, of course, is to go back to equation (1) and raise b, the pension contribution share of current income. 

We know this increase as a de facto tax hike - a pension tax hike. That, however, only goes so far: there is a limit to how much you can eke out of a person's current earnings before he begins to protest (through his union). Another solution, therefore, is the defined-contribution plan where benefits become dependent on what current employees can contribute. Unfortunately, nationwide participation in defined-contribution plans is not very large: according to Investopedia, only approximately one quarter of all retirement assets belong to defined-contribution plans. 

More importantly, though, is the problem that even defined-contribution plans are exposed to the problems associated with defined-benefit plans. At some point, people who have paid into a defined-contribution plan want to retire, and unless the plan leaves them completely in the dark about their monthly retirement checks, they will eventually have to lock down a benefit. Even if that lock-down happens at the point of retirement, the workers who approaches retirement is not going to appreciate complete uncertainty about his cash flow after he retires. 

Furthermore, even if the pension a current retiree gets is defined by his historic income, his pension is still vulnerable to cash flow deficits. Any pension plan where current workers pay into a pool, and the pooled money is then invested and used to pay current retirement benefits, still runs the risk of a cash-flow imbalance similar to that described in equations 1-3 above. The core of the problem remains: current providers pay for benefits to current entitlees.

The only way to isolate individuals from the cash-flow imbalance problem is to completely individualize retirement accounts: Jack's pension benefit payments out of his paychecks go toward Jack's future retirement; Joe's current pension benefits are paid out of her individual pension benefit payments when she was working. 

Fundamentally, a welfare state is a pay-as-you-go redistribution system. So long as we keep it, despite tweaks and twists, it will continue to rely on the providing population's income outgrowing the entitled population's benefits. That is unsustainable in the same way as our state pension systems are unsustainable. Since the very idea with a welfare state is exactly that, namely economic redistribution under a general pay-as-you-go system, and since the very existence of that redistribution system slowly brings modern industrial economies to a halt, the welfare state is basically digging its own grave, a cubic inch at a time.

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