Wednesday, October 3, 2012

Future Pension Promises Will Be Unaffordable and Unsustainable Unless the Private Sector is Healthy and Thriving

Pensions are guaranteed benefits in that if the employee works for a certain number of years at a certain average salary, that individual is promised a certain retiree benefit regardless of how or when that benefit is funded by the employer. At least that's the basic idea.

Historically, pensions fund payments have been possible largely due to being invested in stocks in a decent economy and a decent stock market environment.  As a result, pension fund investment returns have been sufficient to provide the promised benefits, assuming the required funding contributions from employees and employers alike were made on time and as specified. At least that's the way it worked in the past.

{NOTE: On the other hand, defined contribution plans provide no such guaranteed benefits to retirees. These defined contribution plans used to be called profit sharing plans but now consist primarily of 401(k)s and IRAs. In any case, these defined contribution plans assign both the entire risk and reward of successfully investing plan contributions to employees.}

Both individuals and nations today are risk averse due to the world's financial distress. As a result, the desire for safety and security are trumping the opportunity to earn outsized rewards as a result of investing success. Individuals are anxious to trade the chance to experience excess rewards for the "presumed" safety and security of guaranteed returns.

What's generally missing from the discussion is that the private sector is the basic source of our individual and our nation's wealth creation capability. As the private sector goes, so goes the ability to fund and pay for promised pension benefits.

Thus, if as a society we're not enjoying the benefits of a strong vibrant private sector economy, the wealth creation process fails as companies and employees earn less and are unable to contribute enough to properly fund the pension plans in order to be able to pay the promised benefits.

To state the blindingly obvious, there first has to be money available to pay the previously promised benefits. That money comes from earnings and from investment returns on that money. Thus, when the private sector wealth creation process weakens or goes AWOL, the money to pay promised retirement benefits will be missing as well. The expected investment returns on stocks won't match the expected returns due to the weak earnings and stock market performance of companies.

Thus, if stocks don't do well because companies don't do well as a result of a weak economy, the benefits owed by pension plans whose assumed investment returns haven't been realized will become unaffordable and unsustainable. Of course, there also will be fewer employees working and those employees who are employed will earn less than they would in a stronger operating environment.


Now let's look to Europe for an example of how this emotionally and financially difficult pension affordability issue can be. Greek-Spanish Pension Split Illustrates Europe's Dilemma is worth quoting at some length:

"The differences in approach could not be more distinct — or telling.
Two of the most economically distraught countries in the euro zone, Greece and Spain, mapped out additional budget cuts last week.

In the case of Greece, under last-chance pressure from its international creditors, the governing coalition tentatively agreed on an austerity package that includes some of the most severe cuts in public pensions ever imposed in a developed country. Pension payouts to retirees would be trimmed by as much as 10 percent.

And then there was Spain . . . . Spain has a stubbornly high budget deficit, its banks require tens of billions of euros in rescue loans and the government may soon have little choice but to request European aid.

Nevertheless, Mr. Rajoy (Prime Minister of Spain) declined to cut pensions or even to freeze them. Instead, his budget would actually increase payouts 1 percent next year on pensions for former public employees as well as on the social security payments that go to all retired Spaniards.

Politically, it is understandable that Mr. Rajoy would want to put a protective bubble around the country’s 10 million retirees at a time when people are marching in the streets and the economically crucial region of Catalonia is threatening to secede.

But pension expenditures represent the single biggest line item in the Spanish government’s budget, at nearly 40 percent of public spending and 9 percent of Spanish gross domestic product.

That 9 percent still trails France (15 percent) and Italy (13 percent). But given Spain’s rapidly aging population — 30 percent of Spaniards are expected to be older than 65 by 2050 — the portion of government spending on pensions seems certain to rise in the future.

The fact that Spanish public pensions are being enhanced is a reminder of one reason European debt and deficit problems have proved so difficult to resolve. . . . France, under its new president, François Hollande, has lowered its retirement age to 60 from 62 for certain categories of workers. . . .

Portugal, under pressure from a fresh wave of street protests, is likely to rescind a bold plan that would have required workers to increase their personal contributions to pension plans. And in Britain, the coalition government of Prime Minister David Cameron continues to resist any pension changes that would come down hard on older conservative voters.

“These policies are unsustainable,” said Jagadeesh Gokhale, an expert on pensions and social spending at the Cato Institute, a politically conservative research group in Washington. “The implicit liabilities of the pension programs will soon turn into explicit debts. But the political dynamic in Europe is opposed to policies that make economic sense.”

Pensions have become a critical lifeline in Spain. With the unemployment rate at 25 percent, and even higher among young people, many Spaniards have become reliant on pension-drawing parents and grandparents to support them. Economists estimate that as many as 1.7 million of Spain’s 16 million households have no salary earners. . . .

To pay for the 1 percent pension increase in the 2013 budget, Mr. Rajoy’s government dipped into its main safety net for retirees, the pension reserve fund. That could make it even harder for Spain to find the money for pension payments in coming years.

Senior members of Mr. Rajoy’s cabinet made no bones in laying out the political calculations behind the move. They argued that it was crucial for the economy and society to enhance support for pensioners.

The previous government in Madrid took some steps to address the issue in 2011, passing legislation that would increase Spain’s retirement age to 67 from 65. But it will not be until 2027 that the change takes full effect, limiting the near-term budgetary effect.

As for actually cutting pension payments, the notion remains politically off limits.

“There are a lot of pensioners who vote and the unions are dead set against it,” said Ángel de la Fuente, an economist based in Barcelona and co-author of a recent paper on pension policies in Spain. . . .

In Spain, the last-ditch pressure to do the really hard stuff has not arrived.

Not yet, at least."


Summing Up

Pensions are paid to those of us who have become non-productive people -- retirees. Accordingly, if sufficient money hasn't previously been set aside and invested properly to pay the required benefits, the money to pay the pensions will have to come from the current productive wealth creating private sector.

When this happens, pensions can only be paid by taking more money from current workers or companies in the form of unplanned contributions, raising taxes, borrowing or a combination of all three.

When a company's or government's debt levels have grown to the point that lenders are unwilling to extend further credit to that borrower, higher current payments from the productive segment of the society are the only viable and remaining funding source. Whether those contributions come from workers, companies or taxpayers, there will be of necessity a negative impact on the economy's ability to grow.

As the economy's ability to grow weakens, funding pensions becomes even harder. Corporate profits, personal earnings and government tax receipts all suffer as well.

Finally, as corporate profits suffer, the stocks of companies do poorly. It's then a vicious and self-reinforcing downward spiral at work.

Our U.S. pension system, just like that of European countries and companies, requires a strong, profitable, competitive and vibrant private sector and stock market for pension payments to remain viable.

Otherwise the pension promises simply won't be kept, regardless of who makes them and to whom they are made.

Thanks. Bob.

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