Pensions, Social Security and Moral Hazard

Friday, 08 Oct 2010 08:21 AM

By Barry Elias

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How many of you would find it acceptable to receive a lifetime annual pension totaling $600,000, regardless of whether you are employed and/or receive additional pensions or assistance?

Answer: Probably most — if not all — of the world population.

This isn't imaginary: a recently retired municipal employee of Bell County, Calif., receives a lifetime annual pension of $600,000 based on an ending annual salary of $800,000.

I favor a compensation package that is commensurate with the value-added production by the individual. But the aforementioned individual doesn't seem to qualify.

Twenty years ago, I questioned the sustainability of our pension system that essentially guarantees an 8 percent annual return ad infinitum. Today, the pension system is underfunded by more than $2 trillion.

When Social Security was adopted in the early 1930s, benefits were awarded at age 65, which was the approximate average life span. The demographics were such that 15 workers supported each beneficiary, the tax was 2 percent of income (equal split between employee and employer), and the average benefit period was one year. Hence, each worker provided one beneficiary with benefits for 1/15 of a year.

Today, 3 workers support each beneficiary, the tax is 15 percent (including 2.9 percent for Medicare beginning in the 1960s), and the average benefit period is 12 years. Therefore, each worker provides one beneficiary with four years of benefits. The burden on each worker, adjusted for inflation and productivity, has roughly increased 60-fold. Moreover, the ratio of workers to beneficiary is anticipated to drop to 2 in the coming decades, thereby increasing the worker burden.

Interestingly, the return on investment for Social Security is essentially zero, since we borrow from ourselves.

The intragovernment debt (mostly comprised of U.S. Treasury bonds purchased with excess funds in the Social Security and Medicare Trust funds) total roughly $4.5 trillion. The government (tax payers) essentially borrow this money (from taxpayers) to fund current expenditures. Any interest we earn on this money is paid by us (zero return).

This has created the moral hazard for individuals to enhance their return by claiming additional benefits (retiring early and collecting benefits for many decades).

This system isn’t fair, prudent, productive or sustainable in the long run. In fact, the system is underfunded by more than $100 trillion over the next 75 years. (Essentially $1 trillion each year needs to be set aside to earn interest and fund this future liability.) Our total debt (private and public) stands at four times income (GDP). This figure is increasing, since we are currently generating annual deficits totaling more than $1 trillion. Adding $1 trillion more debt per year (7 percent of current GDP) is a staggering proposition.

The inherent flaw with the pension and Social Security system is that it is severely undercapitalized. It isn't based on a closed catastrophic insurance pool, whereby premiums provide reserve capital, which is liquid and safe, to provide the required benefits upon demand (automobile liability insurance). Social Security guarantees payment based on an ill defined (open) retirement age and retirement life span. The pensions system provides a guaranteed return even if the investment becomes worthless.

The moral hazard was set forth as a public policy template, and it was reinforced and enabled by the financial community as well as consumers.

Financial institutions were poorly capitalized, which was an essential cause of the financial crisis. Liquid capital reserves were well below the recommended 6 percent to 8 percent range of total assets (possibly as low as 1 percent to 2 percent).

They utilized the funds to make additional loans, which were high risk (subprime loans to entities that did not possess adequate levels of assets and/or income). In essence, when asset prices decreased more than 2 percent (1 percent in the case of Fannie and Freddie Mac), these investments became losing propositions.

To meet cash flow requirements, some underlying assets needed to be sold, which placed downward price pressure on these assets. Since, the underlying assets were interconnected with an excessive amount of derivative products, the downward price pressure affected these as well, creating a magnified effect (due to excessive leverage: debt to equity ratio).

Financial professionals contributed significantly to the moral hazard. Recently, a manager with a portfolio of $4.5 billion, remarked he is "going crazy," because macroeconomics is factoring into the decision making of his clientèle.

The money managers seemed to believe that demand for financial assets is a given; all they need to do is recommend a specific stock. This world view and perspective is, at best, myopic and ill-advised. Investment decisions are based on numerous criteria including, but not limited to, psychology, emotion, sociology, history, and politics (not simply which stock an analyst recommends).

Consumers added to this moral hazard. They were willing to accept additional risk and debt with a belief system that prices will appreciate (at worse, they could liquidate their position, pay the outstanding debt, and still earn a profit).

In February 2008 (seven months before the significant market decline), I suggested to a suburban Philadelphia couple, both nearing 90 years of age, that "cash is king" in their situation (their portfolio seemed unduly weighted in risk based assets).

Subsequently, I was informed by one of them that their portfolio suffered a 50 percent decline in market value following the September 2008 crash. (Apparently my recommendation wasn't accepted.)

Antithetically, I exited the market on March 17, 2008, when the Dow Jones Industrial Average was 12,000, the day that J P Morgan purchased bankrupt Bear Stearns with government assistance. The Dow subsequently dropped to 6,500 in September 2008.

This excessive liability and debt creation was perpetuated by a public policy view that deficiencies would be remedied by government intervention (increased taxes and/or borrowing).

This enables a greater dependency on government and further consolidates power.

Diversification and hedging are critical to preserving an acceptable level of risk and return within a transparent market where decisions by the masses and averaged into pricing (not by a select few, who may possess imprudent judgment, thereby affecting many lives, over long periods of time, with ineffective, and possibly harmful policies).

The solution involves a system based on diversification, risk hedging and more individual involvement and responsibility, since individuals have a greater propensity to make prudent decisions that affect their daily lives.

Reward responsibility by providing a tax deduction for savings up to 15 percent of total income (you can save more, but it will be from after-tax income).

This savings account would be registered to the individual with their social security number (not in a government account). The asset allocation and monitoring is completely controlled by the individual.

For those seeking safe, liquid, insurable investments, interest bearing accounts will be available. This would preclude the potential for a 50 percent market-value decline as experienced by the suburban Philadelphia couple. This methodology may require a sliding scale phase in process to accommodate the unfunded liabilities currently in the system.

Public policy spanning many decades (possibly a century) have created market distortions and subsequent dislocations.

Ironically, they exacerbated the underlying causes and created a negative feedback system. In some cases, the distortions and dislocations may have been purposeful to create a dependent demand for government intervention and solutions.

Natural forces and processes initiated by individuals, steeped in a market with competent and transparent oversight, tend to permit more productive resource allocation that add value and benefit society over the long term.

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