Thursday, November 29, 2012

Kicking the Pension Underfunding Can Down the Road

A recent opinion piece by Robert C. Pozen, a non-resident fellow in Economic Studies at the Brookings Institute, entitled "The Underfunding of Corporate Pension Plans" examines how the current low interest rate environment is impacting the ability of corporations to guarantee their payouts to future pensioners.  I realize that I've posted on this several times recently, however, with the current seemingly endless period of very low interest rates and the growing number of pension-eligible Americans, this issue is going to get worse before it gets better and may well have a big negative impact on both future pensioners and the bottom line of many American corporations.

Pension plan future obligations are calculated using a "discount rate", the return that the plan can reliably expect to earn on its portfolio of investments between now and when the plan begins to pay out benefits.  Long-term benefit obligations are calculated using the benefit schedule and a projection of the life span of the workers who will collect these benefits.  The lower the discount rate (or rate of return) the higher the plan's estimated obligations and vice versa.  With the current low discount rate (or, in other words, low return on the low-risk investments (i.e. bonds) that are held by pension plans), there is a growing gap between what companies have set aside for our pensions and what they will have to pay out in the future.  This is what is termed the underfunding pension problem.  Corporations will have choices to make; make up the shortfall which cuts into corporate profits, raise pension contributions, invest in higher risk and hopefully higher return investments or cut benefits to existing and future beneficiaries.  Each option has both an upside and an accompanying downside.

Recently, the Senate passed Surface Transportation Bill S.1813 which changed the rules for calculating the future obligations of private sector, single-employer sector pension plans.  These changes can be found in Section 40315 , "Pension Funding Stabilization", hidden among legislation for child seats, odometer tampering  and impaired driving countermeasures.  Sneaky, huh?  In the past, corporations used a discount rate based on the average interest rate on two year highly rated, low risk bonds.  This new legislation allows corporate pension plans to now use a discount rate that is an average of interest rates over the past twenty-five years.  Keeping in mind that higher interest rates were the norm during most of the past two and a half decades, the discount rate for most pension plans will increase by one to two percentage points from four to six percent.  Remember, the higher the discount rate, the lower the plan's estimated future obligations which lessens the corporation's contributions.  Pension plan liabilities are estimated to change roughly 15 percent for every one percentage point change in the discount rate; the higher the discount rate, the lower the apparent, actuarial obligations.  As if by magic, pension underfunding has been cured!

Here are examples of how this change has impacted three large corporations:

1.) UPS - the required 2013 pension plan contribution drops from $1.62 billion to $47 million.
2.) Lockheed Martin - the required 2013 pension plan contribution drops from $2.35 billion to $1.4 billion.
3.) Boeing - the required 2013 pension plan contribution drops from $2.655 billion to $zero.

Just how big is this underfunding problem in Corporate America?  A study of 1,354 pension plans by David Zion, Amit Varshney and Nichole Burnap of Credit Suisse suggests that the private sector multi-employer pension plans (i.e union-related) alone are $369 billion underfunded with a funding rate of only 52 percent!  Many of the underfunded companies are found in the construction, transport, mining and supermarket sectors.  Funding rates below 65 percent are considered to be critical.

On the upside of the recent legislative changes, insurance premiums paid by corporations to the Pension Benefit Guaranty Corporation, a government entity that guarantees up to $56,000 in annual benefits for bankrupt companies with underfunded pension plans, will rise.  PBGC is currently protecting pensions for 44 million participants in more than 27,000 pension plans and in thirty-seven years, has covered pensioners in 4,300 failed pension plans.  In 2011 alone, 152 underfunded single-employer pension plans terminated, pushing PBGC's total obligations up to nearly $107 billion.  In 2011, the Pension Benefit Guaranty Corporation recorded a deficit of $26 billion and paid out nearly $5.5 billion to pensioners; under the new legislation, premium increases of $9.6 billion over the next decade would take place.  While it's a start, one would hardly expect that PBGC would have the means to bailout a massive pension failure.  Here's a quote from their 2011 Annual Report:

"Nonetheless, PBGC’s obligations are clearly greater than its resources.  We cannot ignore PBGC’s future financial condition any more than we would that of the pension plans we insure."

Reassuring, isn't it?  It's especially reassuring when one realizes that American taxpayers are on the hook for any PBGC funding shortfalls.

The new pension legislation is phased out by 2016, however, if interest rates are still very low at that time, we can expect lobbyists representing the pension plans of Corporate America to come begging hat in hand for another kick at the higher discount rate legislation can.  Right now, Congress is just kicking the pension can further down the road since the pension obligations will exist no matter what legislative changes are made.  Remember, the pensions must be fed!

Tuesday, November 27, 2012

Taxing the Deceased - A Complicated Issue

We are hearing a lot about the looming fiscal cliff but there is one aspect of the pending changes to the tax code that has received little or no coverage, the impact of the expiring tax cuts on the federal estate taxes and state estate tax revenues.  A paper by Norton Francis of the Urban-Brookings Tax Policy Center looks at the negative impact of the sunset of the 2010 Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act (the 2010 Act) on state tax revenue and suggest that the resurrection of revenue from federal credits for state estate and inheritance taxes may help states replace this lost income.

Let's open by taking a look at the history of estate taxes in America.  The modern federal estate tax was launched in 1916 and, in 1924, was expanded to include gifts (i.e. transfers of money between individuals).  The 1924 law stated that gifts that were given while the giver was alive would be taxed as part of the estate but that taxes paid on these gifts would eventually reduce the total tax owing on the estate.  A state tax credit equal to 25 percent of the federal tax was implemented to share the estate tax with states and, in 1954, was changed from a percentage of the federal tax to the "credit for state death taxes" or CSDT of up to 16 percent.

Before the implementation of the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) in 2001, every state imposed an estate tax equal to the credit for state death taxes of up to 16 percent which had the effect of transferring the estate tax revenues from the federal level to the state level.  This also meant that all states had roughly the same taxation level for estates, handy if you happened to inherit property located in more than one state.

How much revenue did the estate tax raise prior to implementation of the EGTRRA changes?  In 2000, the federal government collected $24.4 billion from estate taxes from an aggregate gross estate value of $130.4 billion.  It seems like a pittance when compared to a trillion dollar deficit but every penny counts.  

All of this changed in 2001.  Much to the surprise of most analysts, President Bush's 2001 Economic Growth and Tax Relief Reconciliation Act (EGTRRA) actually ended up with a complete phase-out of estate taxes in 2010.  It also phased out the state level CSDT by 25 percent a year in each of 2003, 2003 and 2004 and replaced it with a tax deduction in 2005.  How did these changes impact Washington's estate tax revenue?  Between 2001 and 2009, the federal estate tax revenue ranged from $21 billion and $25 billion despite a five-fold increase in the exemption, a two-thirds drop in taxable estates and a 10 percentage point drop in the top tax rate.  This relatively stable federal government estate tax income stream was maintained for two reasons:

1.) The average value of estates rose.

2.) Replacing the CSDT with a tax credit shifted between $4 billion and $5 billion in tax revenue per year from the state level to the federal level. 

By 2010, fewer than 7,000 estates paid $13 billion in taxes and fewer than 1,500 estates paid $3 billion in taxes in 2011.

In 2001 when EGTRRA replaced the CSDT with a less valuable deduction, states acted in different ways.  Some did nothing since their state estate taxes were coupled to the CSDT and ended up collecting no taxes.  Others repealed their own estate taxes, also resulting in no estate tax revenue.  Some states adopted their own estate taxes further complicating the issue for estates with holdings in multiple jurisdictions.  Here is a chart showing which actions each state took in response to the end of the CSDT money-maker:

Here is what happened to estate tax revenues in New Mexico which did not amend its tax laws when the federal government ended CSDT (a dormant state) (please note that federal tax revenues are in green and state revenues are in blue):

Revenues dropped from $28 million in 2003 (one percent of total revenues) to zero by 2010.

Here is what happened to estate tax revenues in Maryland which has its own inheritance taxes:

Maryland's estate tax revenues barely budged since they decoupled their estate tax system from the federal system.

The tax provisions of EGTRRA were extended by the 2010 Act until the end of 2012 and will expire on January 1, 2013.  The 2010 Act actually reinstated the estate taxes for 2011 and 2012 with a higher exclusion amount and lower tax rate and, what's worse for Americans is that, on January 1, 2013, the top federal tax rate on estates will rise from 35 percent to 55 percent and the estate property exclusion will drop from $5.12 million to $1 million.  This higher rate will be a bit of a windfall for Washington, bringing in an estimated $31 billion in 2013.  Restoration of the CSDT in 2013 would reduce federal government estate tax revenues by $5 billion and would increase the revenues in dormant states (those that had estate taxes that referenced the CSDT prior to its expiry but which now have no estate taxes) by $3 billion (i.e. see New Mexico above), half of which would end up going to California and Florida.

It is interesting to see how changes to federal legislation regarding mundane issues such as estate taxes can have such a big impact on the level of revenues at the state level and how these changes can lead to confusion for both taxpayers and legislators.  Until the President and Congress come to a saw-off regarding the expiring 2010 Act, states and taxpayers will find it very difficult to plan for their futures.  As an aside, I also find it hard to imagine that governments around the world will not be tempted to take a greater share of the estate pie in this age of rapidly growing debt levels.  It's a target that is just too easy to hit, particularly over the next 20 years as baby boomers depart this orb in growing numbers.

Monday, November 26, 2012

A Fiscal Cliff Compromise

 A brief opinion piece on the Brookings Institute website by William A. Galston gives us an interesting solution to the coming fiscal cliff political brinksmanship.  The Republicans are firmly entrenched in their "no tax increases" philosophy and the Democrats don't want to increase taxes on families making less than $250,000 per year.  Since the two sides of the spectrum obviously cannot agree on long-term changes to the tax code between now and December 31, 2012, a bit of tweaking here and there may just solve the problem at least temporarily.  Without such an agreement, one thing is certain, the world's markets will react adversely.  As it stands now, taxes will go up on January 3, 2013, impacting the "middle class", resulting in slower economic growth according to Congressional Budget Office projections and a loss of confidence in Congressional ability to problem solve. 

Let's look at the summary of tax receipts as a percentage of GDP from 1930 to 2017 from the Office of Management and Budget:

Since the Second World War, total tax receipts have almost never been higher than 20 percent of GDP and have averaged 16.0 percent since 1930.

Here is a summary of total outlays as a percentage of GDP over the same time period:

Since 1976, it is rare that outlays have been less than 20 percent of GDP, ranging from 18.2 percent in 2001 and 2001 to 25.2 percent in 2008.  And thus, the problem.  The author notes that the U.S. government will need revenues of between 20 and 21 percent of GDP to stabilize the national debt (note the word "stabilize" rather than the word "reduce").

Since past history shows that reforming the tax code is a very long and painful process even under the best of circumstances where both sides aren't acting like elementary school children, an interim solution is required that will prevent both sides from pouting.  Here are Dr. Galston's suggestions:

1.) Both sides accept a cap of $50,000 on itemized deductions (i.e. health care, mortgage interest, charitable deductions, state and local taxes, tax preparation fees etcetera).  This would have the greatest impact on individuals making more than $200,000 annually.

2.) Republicans would agree to raise the tax rates on dividends and capital gains, closing the gap between the very low rates of today and those that were in place before the Reagan-era tax reform.  Here is a graph showing what has happened to dividend and capital gains tax rates since 1961:

Common sense would tell us that it looks like there should be plenty of room to move rates up, unfortunately, there is a shortage of that particular commodity in Washington.

3.) In return for these compromises, the President and his fellow Democrats would agree to leave the rates on earned income at current levels.

This scenario gives both sides of the spectrum some form of a victory that they can brag about to their backers, however, in this winner-take-all, loser-gets-nothing world, it is unlikely that even modest compromises like these will be palatable to both sides.  That said, perhaps this solution is just too simple for the complex minds of Congress to absorb.

Wednesday, November 21, 2012

The Blessing of a National Debt/The Spectre of Debt Default

A brief article on the Knowledge at Wharton website examines the spectre of a default on United States Treasuries.  It gives us an interesting look at background information about America's mounting debt and what could happen to the "riskless" Treasury market in the worst case scenario.

Here is a quote from Founding Father Alexander Hamilton:

"A national debt if it is not excessive will be to us a national blessing; it will be a powerful cement of our union. It will also create a necessity for keeping up taxation to a degree which without being oppressive, will be a spur to industry.

Let's open with a look at the latest debt numbers.  The debt can be broken down into two parts, the marketable debt which includes Treasuries and the non-marketable debt which includes intra-governmental loans, basically, money that is borrowed from one part of government to fund another part.  Here is the breakdown:

Notice that nearly 67 percent or $10.887 trillion of the total debt is marketable and just less than half that amount (33.05 percent) or $5.374 trillion is non-marketable.  With total debt of over $16.2 trillion dollars, the debt ceiling of $16.4 trillion is likely to be breached by the end of 2012 or early 2013 at the latest.

Fortunately, the average interest rate on America's marketable debt sits at a very low 2.075 percent, down from 2.306 percent in October 2011.  Interest on the non-marketable portion of the debt is slightly higher at 3.588 percent, down from 3.932 percent a year earlier.  This averages out to 2.560 percent when all debt is included.  Here is a bar graph that shows how interest rates on the outstanding debt have changed over the past 24 months and how much cumulative monthly interest has been paid on the debt:

Finally, to put all of this into perspective, the latest GDP figures from the Bureau of Economic Analysis show that the U.S. GDP reached $15.7757 trillion in the third quarter of 2012.  This means that the current marketable debt-to-GDP ratio is 69 percent and the current non-marketable debt-to-GDP ratio is 34.1 percent for a total debt-to-GDP ratio of 103.1 percent.  This is up very substantially from the 60 percent level reached during the balanced budget years of the Clinton Administration.  According to University of Connecticut School of Law Professor James Kwak, the debt-to-GDP could well rise to 200 percent by 2035, a level that is higher than that of all European debtor nations. 

Now that we have the latest data in mind, let's go back to the "spectre of default", a subject that is particularly pertinent now that the fiscal cliff is staring us in the face.

As most of us know, if our spending exceeds our earnings for very long, eventually, we will find it difficult to get additional credit and lenders will force us to pay higher and higher interest rates because they will be increasingly worried about default.  Unfortunately, such does not appear to be the case for the United States; month after month, we watch Washington's debt rise as interest rates fall to multi-generational lows.  As the world's reserve currency, investors regard Treasuries as "riskless" because the government stands behind them with the power of taxation.  For a very short time, it appeared that the euro might provide some competition for the power of the almighty U.S. dollar as the world's choice of reserve, however, as we have seen over the past two years, Europe's sovereign debt crisis has removed the euro from the competition.  The only currency that could ultimately replace (or accompany) the U.S. dollar, China's yuan, is not quite there yet, however, as shown on this graph, the Asian impact on the world's economy will continue to rise at the expense of the current developed economies, particularly that of the United States:

Just to show you how powerful the U.S. dollar is as the world's reserve currency, at the end of September 2012, foreign nations owned $5.455 trillion worth of Treasury securities or 50.1 percent of the total marketable debt.

Unfortunately, there is no political will to actually reduce the debt.  Every suggested remedy is unpalatable to one side of the political spectrum or the other.  While the investment community generally regards Treasuries as "riskless" because of the government's power of unlimited taxation, in reality, such is not the case.  At some point, no matter what the current perception is, it may be necessary for the government to default when the debt reaches an unserviceable level.  Since 1800, 68 governments have defaulted on their sovereign debt with Russia (1998) and Argentina (2002) being the most recent cases.  Admittedly, neither of these nations had currencies that were the world's reserve, however, both defaults sent shudders through the world's economy.  

What would happen if the United States did elect to default?  First, the government may choose not to default on all of its debt; it could choose to delay interest payments and/or extend maturity dates on some or all bonds.  The losses on Treasuries would impact Treasury investors, other levels of government, corporations, pension plans, insurance companies and would likely result in dropping stock market and real estate valuations.  Interest rates on Treasuries would rise as the risk premium rose and this would push up interest rates for consumers, corporations and municipal and state governments.  Credit default swaps on Treasuries, a form of insurance that pays off when a bond defaults, would have to be paid out, likely bankrupting the firms that sold them along with the owners of the swaps.

Since it appears obvious that the debt burden cannot rise forever, Washington has choices to make:

1.) Cut spending.

2.) Raise taxes.

3.) Allow inflation to rise which would both increase tax revenues and shrink the "real value" of older debt.  This would have the downside of impacting the value of savings.

4.) Allow the economy to grow at a faster rate than the debt.  This would produce bigger tax revenues that could potentially pay down the debt if spending growth was restrained.

Each of these ideas has politically driven weaknesses; no one wants to cut their pet program (i.e. social safety net including Medicare and Social Security and defense and raising taxes is politically unpalatable to conservative Americans.  Promoting economic growth has not worked in the past; over the past decade, debt growth has outstripped economic growth, leaving America with a debt-to-GDP level that is up two-thirds from its level at the turn of the century.

The authors suggest that raising taxes, while unpalatable, is probably the most reasonable scenario.  Total federal, state and local tax revenue in the U.S. was 24.8 percent of GDP in 2010, the lowest among all G-7 nations.  By comparison, taxation as a percentage of GDP was 31 percent in Canada, 42.9 percent in France, 36.3 percent in Germany, 43 percent in Italy, 26.9 percent in Japan and 35 percent in the United Kingdom.  As well, 150 nations around the world have a form of national value-added tax.  The overall tax rate on goods and services in the United States was 4.5 percent in 2010 compared to more than 10 percent in much of Europe.  While increases in income tax revenue generally reduces economic output, such is not the case for value added taxes.

One way or another, Washington has a long way to go before we can be assured that we are going to avoid the spectre of default.  Perhaps the national debt has not proven to be the blessing that Alexander Hamilton foresaw.