Monday, July 29, 2013

The Unsteady States of America?

The Economist reports, The Unsteady States of America:
When Greece ran into financial trouble three years ago, the problem soon spread. Many observers were mystified. How could such a little country set off a continental crisis? The Greeks were stereotyped as a nation of tax-dodgers who had been living high on borrowed money for years. The Portuguese, Italians and Spanish insisted that their finances were fundamentally sound. The Germans wondered what it had to do with them at all. But the contagion was powerful, and Europe’s economy has yet to recover.

America seems in a similar state of denial about Detroit filing for bankruptcy (see article). Many people think Motown is such an exceptional case that it holds few lessons for other places. What was once the country’s fourth-most-populous city grew rich thanks largely to a single industry. General Motors, Ford and Chrysler once made nearly all the cars sold in America; now, thanks to competition from foreign brands built in non-union states, they sell less than half. Detroit’s population has fallen by 60% since 1950. The murder rate is 11 times the national average. The previous mayor is in prison. Shrubs, weeds and raccoons have reclaimed empty neighbourhoods. The debts racked up when Detroit was big and rich are unpayable now that it is smaller and poor.

Other states and cities should pay heed, not because they might end up like Detroit next year, but because the city is a flashing warning light on America’s fiscal dashboard. Though some of its woes are unique, a crucial one is not. Many other state and city governments across America have made impossible-to-keep promises to do with pensions and health care. Detroit shows what can happen when leaders put off reforming the public sector for too long.

Inner-city blues

Nearly half of Detroit’s liabilities stem from promises of pensions and health care to its workers when they retire. American states and cities typically offer their employees defined-benefit pensions based on years of service and final salary. These are supposed to be covered by funds set aside for the purpose. By the states’ own estimates, their pension pots are only 73% funded. That is bad enough, but nearly all states apply an optimistic discount rate to their obligations, making the liabilities seem smaller than they are. If a more sober one is applied, the true ratio is a terrifying 48% (see article). And many states are much worse. The hole in Illinois’s pension pot is equivalent to 241% of its annual tax revenues: for Connecticut, the figure is 190%; for Kentucky, 141%; for New Jersey, 137%.

By one recent estimate, the total pension gap for the states is $2.7 trillion, or 17% of GDP. That understates the mess, because it omits both the unfunded pension figure for cities and the health-care promises made to retired government workers of all sorts. In Detroit’s case, the bill for their medical benefits ($5.7 billion) was even larger than its pension hole ($3.5 billion).

Some of this is the unfortunate side-effect of a happy trend: Americans are living longer, even in Detroit, so promises to pensioners are costlier to keep. But the problem is also political. Governors and mayors have long offered fat pensions to public servants, thus buying votes today and sending the bill to future taxpayers. They have also allowed some startling abuses. Some bureaucrats are promoted just before retirement or allowed to rack up lots of overtime, raising their final-salary pension for the rest of their lives. Or their unions win annual cost-of-living adjustments far above inflation. A watchdog in Rhode Island calculated that a retired local fire chief would be pulling in $800,000 a year if he lived to 100, for example. More than 20,000 retired public servants in California receive pensions of over $100,000.

Money (That’s what I want)

Cleaning up the mess in local and state government will take time. Circumstances vary widely from place to place, but a good starting-point would be to abandon the accounting tricks. Only when the scale of the problem is made clear can politicians persuade voters of the need for sacrifice.

Public employees should retire later. States should accelerate the shift to defined-contribution pension schemes, where what you get out depends on what you put in. (These are the norm in the private sector.) Benefits already accrued should be honoured, but future accruals should be curtailed, where legally possible. The earlier you grapple with the problem, the easier it will be to fix. Nebraska, which stopped offering final-salary pensions to new hires in 1967, is sitting pretty.

Yet sooner or later, some of these problems will end up in Washington, DC. In Detroit, a judge ruled this week that federal bankruptcy law trumps a state law that makes it impossible to reduce pensions. But the issue will arise again, and will not be truly settled until it reaches the Supreme Court. Many places like Detroit will surely have to break some past promises—and rightly so. And given the size of many of the black holes, the state or federal government may have to help out. Taxpayers should not bail out feckless local governments or investors who should have known the risks. But they should help pensioners left stranded through no fault of their own. Some state and municipal workers do not qualify for the federal Social Security system; they get only the pensions promised by their employer. If these do not materialise, there should be a backstop to ensure that they receive at least a basic pension.

Americans in virtuous states and cities will be just as furious about their tax dollars flowing to Detroit and other distressed places as Germans are about euros going to southern Europe. But the truth is that America’s whole public sector still operates in a financial never-never land. Uncle Sam offers an array of “entitlements” that there is no real plan to pay for. Barack Obama is on his way to joining George W. Bush as a president who did nothing about that, while Republicans in Congress imagine they can balance the books without raising taxes. The government spends more on health care than many rich countries and still does not cover everyone. America’s dynamic private sector is carrying on its back an unreformed Leviathan. Detroit is merely a symptom of that.
Last week, I covered Detroit's cries of betrayal and stated:
"Sadly, what is happening in Detroit will happen in many more U.S. cities struggling with crippling public debt. The articles serve as a painful reminder that public pensions are not as sacred as people think. When the money runs out, pensioners face huge cuts to their pensions as cities try to assuage bondholders to keep lending them money."
It's foolish to think that this problem is unique to Detroit. But The Economist article is overly alarmist. While the financial crisis and years of neglect (governments not topping out state plans) have hit state pension funds, the recovery in the stock market and rise in interest rates means the deterioration in slowing.

Still, there is no denying many U.S. local and municipal pensions face the same dire outcome that Detroit now faces. When cities can't cut public services or raise taxes, they will cut public pensions. Moreover, while The Economist is right that public sector employees should retire later and pension abuses must be halted, the shift to defined-contribution schemes will only ensure more pension poverty down the road.

And while the focus is on the United States, Don Pitts of the CBC reports that Detroit's meltdown is a wake-up call for Canadians:
Detroit pensioners woke up last Friday to shattered retirement dreams, and the haunting question that people around the world are now asking themselves is, "What about mine?"

In its bankruptcy filing last week, the city declared its pension and benefit commitments to be part of its debt, leaving a Federal judge to decide how to distribute Detroit's remaining assets between pensioners and other creditors.

From a business point of view it is all quite rational. Over the years, the city government made more promises than it could possibly afford to pay. About $18 billion more.

But there's more happening here than rational business decisions. In bankruptcy, when there just isn't enough money to go around, each of the creditors takes a share of the hit. This time they are expected to get between 10 and 20 cents for every dollar they are owed — and that includes the city's pensioners.

People who have worked a lifetime for the city, responsibly choosing a job and sticking with it because they knew it included a safe pension, abruptly have to think again.

They could have taken their skills and commitment elsewhere, taken risks and pursued more adventurous jobs, sailed around the world or lived cheap on the beaches of Goa, or taken a flyer on a career as an actor or novelist. In other words, they could have lived like the grasshopper instead of the ant in the Aesop's Fable — making enough for a roof and entertainment week to week but never setting a penny aside for the long winter ahead.

And eventually relying on social assistance in their old age. As the Wealthy Barber author David Chilton has said, people without a pension generally don't save enough.

But the pension contributors in Detroit weren't the fabled grasshoppers, they were the ants. They were the responsible ones who considered the future and planned ahead so they could pay their own way. They chose jobs with salary agreements that included the promise of a fund for their retirement.

Every month money was taken from their pay. Every month, the paperwork showed that their employer had added its share to the pension pot. Periodically a form would arrive in the mail telling them how much they would get if they continued working until the age of 65. But all the time the paperwork was a lie.

And as I mentioned last week, there is a growing view that the crisis in Detroit may not be unique, that there are more public-sector bankruptcies to come. Others have weighed in on the subject since, some seeming to blame pensioners for the growing potential financial crisis, saying they are taking more than their share.

The point they're missing is that pensions are crucial to a healthy economy.

As everyone keeps telling China, until the country develops a reliable social safety net, a consumer-led society can never take off. Employees must be able to trust their pensions will actually be there when it comes time to draw on them, or their ant-like personalities will force them to hoard even more when they're working, instead of recirculating that cash into the economy.

And safe pensions do exist. The best ones are those that money managers give themselves.

In this type of blue ribbon pension there is no promise to pay on some future day. The money is set aside in a separate account. It is well managed in diversified investments. Its future value, and thus the amount added to the fund each year, is determined by realistic long-term rates of interest. It is not based on a 30-year-old promise by some now-defunct politician and subject to the whims of whoever is calling the political shots today.

Detroit has shown that the promises of politicians don't last 30 years. And neither do the promises of companies.

Canada's own Nortel, the airlines and the Detroit auto makers themselves are just a few of the private firms proving that promises given years ago to inspire loyalty when workers were desperately wanted are worth nothing when the workers are no longer needed.

As the blue-ribbon pensions show, money actually set aside and invested wisely over a 40-year working life provides a reliable retirement income. Stocks really do return 8 per cent over the long term. Bond returns are low now, but many years in the last 40, bonds were paying double-digit rates.

But as with those blue ribbon pensions, the secret is that the money must actually be set aside and invested by honest, qualified professionals. Pension funds that do that, like the Ontario Teachers Pension Plan, or the Canada Pension Plan, provide reliable returns.

Without that, a promise to pay is only as good as the changing fortunes of the organization making the promise.

Pensions backed by promises from governments with relatively low debt, like Canada's, are safe for now. And as CBC's Amber Hildebrandt has reported, in Canada cities are backed by their respective provinces if things go sour.

Other governments and companies are not in such good shape. In the wake of Detroit, employees and unions making deals with healthy governments and private sector employers must learn not to accept promises. They must demand that cash be set aside now, placed in a well-run fund, and managed for the long term.

Either that or the ants might as well join the grasshoppers. Buy a sailboat, and don't come home till you are old and sick and looking for social assistance.
What we need in Canada is to stop dithering and build on the success of Canada's top ten. We need to rethink our pension system and improve it by enhancing the Canada Pension Plan for all Canadians. That is the ultimate wake-up call from Detroit's meltdown for us Canadians.

Finally, take the time to read John Mauldin's latest, A Lost Generation. It is superb and highlights the problem of how U.S. monetary policy has disproportionately boosted the fortunes of the financial and wealthy elite while the younger generation struggles to find full-time employment. "We may be seeing a new underclass develop, which has disastrous implications for the country."

Indeed, class warfare is alive and well in the United States and despite the rhetoric, politicians from both parties aren't addressing this issue. The young generation can't find work and retirees living on meager fixed incomes are facing cuts to their pensions. This is the real "Unsteady States of America" that The Economist and the financial media willfully ignore.

Below, Mark Binelli, a Detroit native and contributing editor at Rolling Stone magazine and Men’s Journal, discusses Detroit's bankruptcy with Amy Goodman of Democracy Now.