This article was published by The McAlvany Intelligence Advisor on Monday, September 7, 2015:  

Think of it this way: a plan is a system or program whereby promises are made to beneficiaries based upon contributions made to the plan by those beneficiaries and by the plan sponsor, either a local or state government or a private entity, company, or corporation. The assumptions are that the monies will be invested carefully, prudently, and wisely until they are needed. For those services the plan sponsors take a fee.

A state is a series of promises made by politicians in an attempt to buy votes, paid for by present and future beneficiaries, but with little or no concern over whether the monies will be there in sufficient quantities to meet those promises. By that time the politicians will have long since left the scene, leaving others to clean up the mess.

Boston University Professor Laurence Kotlikoff has figured out the scam: Don’t tell all the truth about just how much is owed. In recent testimony before a Senate committee Kotlikoff was blunt:

Almost all the of the government are being kept off the books by bogus accounting….

 

The government is 58 percent underfinanced … is 33 percent underfinanced … so the entire government enterprise is in worse fiscal shape than is, but they are both in terrible shape.

Just how terrible? Explained Kotlikoff:

If you take all the expenditures that the government is expected to make, as projected by the Congressional Budget Office (CBO), all the spending on defense, repairing the roads, paying for the Supreme Court Justices’ salaries, Social Security, Medicare, Medicaid, welfare, everything, and take all those expenditures into the future … and compare that to all the taxes that are projected to come in, and the difference is $210 trillion.  That’s the fiscal gap.  That’s our true debt.

Now that the truth has been told it’s clear that there’s no way those promises will, or can be, kept. It’s like a family with credit card debt of, say, $30,000. It’s possible for the family to make monthly payments, adding a little extra every month to pay down the principal. Every credit card statement comes with the pay-off calculation: the more above the minimum is paid, the sooner it’s paid off.

But if the balance is, say, $300,000, there’s no way.

The US economy generates about $18 trillion in goods and services, and the government at all levels skims off an estimated 40 percent: in round numbers, about $7 trillion. If the $210 trillion that Kotlikoff says is owed is correct, even if interest on that debt is just 2 percent (it’s more than that, of course: 30-year government bonds pay more than 3 percent), that’s $4 trillion. That leaves just $3 trillion left to pay for everything else.

It’s called mathematical suicide.

On a vastly smaller scale, it’s what’s been happening to public pension plans, according to the National Association of State Administrators (NASRA) in its most recent review of 126 of those plans: promises have been made by politicians who have long since left the scene that won’t ever be fulfilled. And the is just now beginning to sink in. One of the bookkeeping shenanigans is the “interest rate assumption,” which most plans, until very recently, have pegged at 8 percent. But, even with the huge gains being enjoyed (until recently, that is) by those plans, they are falling further and further behind. They are learning, if they haven’t already, that once behind, it’s hard to catch up.

Last Thursday the San Diego County Employees Retirement Association announced it was reducing its interest rate assumption from 7.75 percent to 7.5 percent, while the next day the New York State Common Retirement Fund (third largest in the country) said it is planning to drop its internal assumed rate to 7 percent for the 7.5 percent it has been trying to match for the last five years.

CalPERS (California’s pension system) is talking about dropping its rate below the current 7.5 percent, while Oregon’s Public Employees Retirement System and Texas’ Municipal Retirement System is considering doing the same thing: cutting its rate by – ready? – one quarter of one percent.

But none of this is helping. Despite the fact that local and state government contributions to those plans have more than doubled over the past decade, while contributions by plan participants have increased by 50 percent over that span, the total unfunded liabilities, according to Pew Charitable Trusts, actually increased last year by $54 billion, with that total coming in at $1 trillion.

Pew used soft language to describe the reasons why:

The recession exacerbated the challenges – but many states entered the recent downturn with fundamental weaknesses in their retirement systems that stemmed from early mistakes and decisions.

“Mistakes?” A careful review of history shows that pension managers in the 1960s were much more in tune with reality, with internal interest and investment assumptions coming in at between 3 and 3.5 percent. However, politicians discovered another mathematical anomaly and they turned it to their favor: every one percent increase in those assumptions actuallyreduced the plan liabilities by 12 percent. So, by expanding the portfolio to include real estate, stocks, commodities and even investments in hedge funds, those assumptions gradually moved higher, topping out at about 8 percent.

If one looks back at the Standard and Poor’s 500 Index, made up of 500 of America’s largest corporations with stocks traded either on the NYSE or the NASDAQ, one can see a period of time when stocks averaged – on a compounded annualized rate, called CAGR – from January 1, 1964 through 2014 – 10.05 percent. If one uses January 1, 1994 as a starting point, that CAGR was 9.43 percent.

But if he starts from January 1, 2000, the CAGR is only 4.2 percent. Even if he starts from January 1, 2007, the CAGR of the S&P 500 is 7.04 percent.

And that would only apply to pension plans investing all their funds in stocks. They only have a percentage invested in stocks, with the rest “allocated” according to some fancy formula among other classes of investments.

Even after one of the most extraordinary stock market runs in history, however, states are still having trouble making their pension plan minimum payments, their ARCs (annual required contribution). The total for all 126 plans that NASRA analyzed was supposed to be $92 billion last year, but they only contributed $74 billion. And among all 50 states, fewer than half actually contributed as much as 95 percent of their ARCs.

Those 126 plans cover about 20 million people, people who are making plans based upon those plans actually keeping their promises. For the United States as a whole, considering the government as a gigantic welfare state pension plan, every individual dipping his spoon into the government trough is going to be disappointed.

Especially when the extraordinary returns over the past six years aren’t likely to be repeated any time soon. As Jason Zweig wrote in the Wall Street Journal just months before the current correction:

After more than six years of a bull market [in stocks], investors should stare a cold, hard truth straight in the face: future returns on stocks are likely to be far slimmer than the fat gains of the past few years.

The scam is the same: make promises that can’t be kept and leave someone else to clean up the mess later. For those pension plans, later is now. For the US as a whole, that time is coming.


Sources:

Wall Street Journal: Public Pension Funds Roll Back Return Targets

Pew report: US unfunded public pension liabilities hit $1 trillion

USAWatchdog.com: Financial System Will Collapse Just a Matter of When-Laurence Kotlikoff

Long term graph of Standard and Poor’s 500 Index

CAGR of S&P 500 from 1994 to present

The New Era of Low Stock Returns

Explanation of SPX

The New American: Social Security Disability Trust Fund Could Be Depleted by Late 2016

The New American: U.S. Financial Outlook has “Worsened Dramatically”

The dividend yield on the S&P 500

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