Economics & Growth | ESG & Climate Change | Monetary Policy & Inflation | US
As the parable goes, drop a frog into a pot of boiling water and it’ll jump straight out. Put it into tepid water and slowly bring it to the boil and the frog won’t notice until it’s cooked to death. Right now, I see at least three frogs in pots of different temperatures: retirement security, infrastructure and climate change. These are critical issues that take a long time to reach breaking point. We know they are there. We talk and research and disagree and write about them year after year, yet still we sit in the pot of water. We have great difficulty coming to the table to find solutions. We fail to hold our leaders accountable to make changes before it’s too late. In the worst case, we permanently damage the systems that sustain us; in the best case, we punt these problems down to the next generation.
Frog #1: Retirement Security
The same week that Senator Mitch McConnell (R, Kentucky) advocated state bankruptcy as a tool to reorganize state and local public pensions, the Board of Trustees of Social Security and Medicare issued their 2020 reports.
The trustees forecast that Social Security assets would run out in 15 years. Since revenues would no longer cover payouts, this would result in an estimated 21% benefit reduction for all beneficiaries, which would ultimately grow to a 27% cut with no action. Stated differently, payments from the system will come solely from revenues, becoming ‘pay-as-you-go’ or colloquially, ‘paygo’.
Changes in the composition of the US labour force since the recession have played a role in this asset depletion. Jobs that were created since 2009 tended to be lower-wage service jobs, part-time or freelance (‘gig’ economy) jobs, each putting pressure on Social Security payroll assumptions. In addition, according to the Bipartisan Policy Center (BPC), elimination of the Affordable Care Act excise tax plus persistently low interest rates contributed. Medicare Part A hospitalisation insurance is expected to become insolvent by 2026.
These reports were completed before the coronavirus pandemic began its economic damage. From the time of lockdowns in mid-March, more than 36.5 million people filed for unemployment insurance, or about 24% of pre-virus February employment. Needless to say, such high unemployment will significantly reduce payroll revenue. In turn, this will quicken asset depletion in the federal retirement programs and Medicare. According to the Committee for a Responsible Federal Budget (CRFB), the time period before funds run out in Social Security could be the early 2030s or late 2020s – and that estimate is two weeks old at the time of this writing.
The BPC also modelled the time to depletion of assets in the two Social Security programs, Disability Insurance (DI) and Old-Age and Survivors Insurance (OASI) in the COVID-19 world. They concluded that depletion may occur during the current decade.
As far as state retirement plans go, an independent research group based in Illinois, Wirepoints, used data from the Public Plans Database to complete a similar analysis for states and large municipal governments. (The Public Plans Database is a collaboration among the Center for Retirement Research at Boston College, the Center for State and Local Government Excellence, and the National Association of State Retirement Administrators.)
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As the parable goes, drop a frog into a pot of boiling water and it’ll jump straight out. Put it into tepid water and slowly bring it to the boil and the frog won’t notice until it’s cooked to death. Right now, I see at least three frogs in pots of different temperatures: retirement security, infrastructure and climate change. These are critical issues that take a long time to reach breaking point. We know they are there. We talk and research and disagree and write about them year after year, yet still we sit in the pot of water. We have great difficulty coming to the table to find solutions. We fail to hold our leaders accountable to make changes before it’s too late. In the worst case, we permanently damage the systems that sustain us; in the best case, we punt these problems down to the next generation.
Frog #1: Retirement Security
The same week that Senator Mitch McConnell (R, Kentucky) advocated state bankruptcy as a tool to reorganize state and local public pensions, the Board of Trustees of Social Security and Medicare issued their 2020 reports.
The trustees forecast that Social Security assets would run out in 15 years. Since revenues would no longer cover payouts, this would result in an estimated 21% benefit reduction for all beneficiaries, which would ultimately grow to a 27% cut with no action. Stated differently, payments from the system will come solely from revenues, becoming ‘pay-as-you-go’ or colloquially, ‘paygo’.
Changes in the composition of the US labour force since the recession have played a role in this asset depletion. Jobs that were created since 2009 tended to be lower-wage service jobs, part-time or freelance (‘gig’ economy) jobs, each putting pressure on Social Security payroll assumptions. In addition, according to the Bipartisan Policy Center (BPC), elimination of the Affordable Care Act excise tax plus persistently low interest rates contributed. Medicare Part A hospitalisation insurance is expected to become insolvent by 2026.
These reports were completed before the coronavirus pandemic began its economic damage. From the time of lockdowns in mid-March, more than 36.5 million people filed for unemployment insurance, or about 24% of pre-virus February employment. Needless to say, such high unemployment will significantly reduce payroll revenue. In turn, this will quicken asset depletion in the federal retirement programs and Medicare. According to the Committee for a Responsible Federal Budget (CRFB), the time period before funds run out in Social Security could be the early 2030s or late 2020s – and that estimate is two weeks old at the time of this writing.
The BPC also modelled the time to depletion of assets in the two Social Security programs, Disability Insurance (DI) and Old-Age and Survivors Insurance (OASI) in the COVID-19 world. They concluded that depletion may occur during the current decade.
As far as state retirement plans go, an independent research group based in Illinois, Wirepoints, used data from the Public Plans Database to complete a similar analysis for states and large municipal governments. (The Public Plans Database is a collaboration among the Center for Retirement Research at Boston College, the Center for State and Local Government Excellence, and the National Association of State Retirement Administrators.)
While many analysts primarily consider pension funding ratios, Wirepoints’ analysis computes assets relative to annual benefit payouts in order to find an estimate of how much time a plan may have left before reverting to a pay-as-you-go approach. (Note, thought that this analysis assumes no further contributions or investment earnings – and does not scrub illiquid assets out of the analysis – so please read this for a relative comparison across the plans rather than some absolute metric of a plan’s lifespan.) The asset/payout ratio skirts the controversies about discount rates and is comparable to the approach above with federal OASDI.
The Wirepoints study can be found here. We reprint one of their summary charts, with permission, in its entirety below.
You may note that the first plan to run out of assets first is not Illinois or New Jersey, but the Kentucky Employees Retirement System, which has 2.6 years to go (by the way, this analysis was done before COVID-19). In Wirepoints’ full analysis, there are 58 state and local plans that have longer than the 15 years left for the US Social Security system. Four plans in the state of Washington and the District of Columbia Police and Fire have more than 30 years to go – an amount of time most new hires (and actuaries) would be comfortable with.
A Caution to Bond Investors
The Kentucky ERS could be the next test case of running out of funds to pay retirees. Puerto Rico hit that wall a number of years ago and, after scraping funds from as many agencies and authorities they could manage, they stopped paying bondholders. As a territory, a unique form of reorganisation had to be crafted. Perhaps Kentucky ERS members would be willing to take a cut in their benefits (a long shot), members may press the state to raise revenues, or they may petition their US senator to come up with a bailout of some kind. If still in office, Senator McConnell may then have an opportunity to craft unprecedented legislation to take his home state through bankruptcy. (Pension plans, as well as states, are not eligible for bankruptcy under current law.)
A Digression on the Federal Reserve’s ‘Zero Bound’
Many pension analysts (of public, private and federal plans) would like to see plans use lower discount rates that better reflect current reality. This, mathematically, would greatly increase liabilities and reduce funding levels. Before 2000, it was possible to achieve a 7% earnings target, which, according to accounting rules unique to public plans, is also the discount rate for sizing future liabilities. But, beginning in 2001, funding levels began to fall and retirement plans were forced to invest in riskier assets in order to boost returns. Since then, dips in market returns (such as the recessions of 2001/2002 and the Great Recession) have depleted assets that are critical for compounding (see the chart and table on this here).
Events (such as the dotcom bust and 9/11) at the beginning of the 21st century coincide with the Federal Reserve’s steady march to the ‘zero bound’. During these last two decades it became apparent how difficult it would be to return to some level of normalcy (pre-2000? or whatever that may be). When the Fed initially hinted it would exit its Great Recession medicine there was a major market dislocation. Recall the turbulence in the summer of 2013 dubbed the ‘taper tantrum’? The Fed subsequently reversed its exit guidance in September 2013.
In December 2018, following repeated rate increases that accelerated from once in each of 2015 and 2016 to three in 2017 and four in 2018 to ‘normalise’ rates, markets dropped precipitously and the Fed reversed course. This is a simplification, of course; other factors such as the effect of the president’s trade tariffs on the economy also spurred the Fed to seek market stability.
Ironically, those market moves now pale in comparison to recent oscillations. Fed Chair Powell’s assertion that coronavirus will be with us longer than anyone would like will undoubtedly contribute to market volatility going forward. This is the same message that scientists have long been telling us, but coming from the Fed chair, markets listened. It is tough to envision how the Fed could move away from low/zero/negative interest rates in the foreseeable future. Unfortunately, this prospect leaves pension plan managers between the proverbial rock and a hard place.
It is also why we should consider retirement security with a broader view, rather than throwing bricks at public pensions. Understandably, people vote against candidates who want to reduce retirement benefits, whether federal Social Security, Medicare or state and local retiree benefits. People do not typically vote against candidates who fail to fill the potholes or repair century-old water pipes. The water in that kettle is just not hot enough. And besides, many can take their retirement benefits and move somewhere else where the roads are newer and water systems stronger – which brings us to Frog #2.
Frog #2: Infrastructure
Many, many trade associations, think tanks and others have decried the poor state of US infrastructure. We quote from the Bipartisan Policy Center website, one of whose policy priorities is infrastructure:
“Communities across the United States face a severe shortage of affordable homes and a growing need to repair, replace, and modernize their critical infrastructure—roads, rails, bridges, drinking water and wastewater systems, ports, airports, civic buildings, broadband, and more.”
Bipartisan Policy Center webpage, sourced 13 May 2020
We remind readers that during the 2016 presidential debates, then-candidate Clinton said she would push for $500 billion investment in infrastructure. Then-candidate Trump, predictably, doubled-down and said he would invest $1 trillion in infrastructure. Peter Navarro and Wilbur Ross later drafted a white paper focused on incentivising private investment in infrastructure – to satisfy the president’s campaign promise.
Fast forward past many federal ‘Infrastructure Weeks’ and now the deficit narrative is likely to water down or prevent passage of meaningful federal infrastructure investment. The latest House legislation to help state and local governments navigate the economic damage from the coronavirus was proclaimed by Senate Republicans as ‘dead on arrival’.
As we discussed in our last post, states and local governments picked up the pace on infrastructure investment over the last few years. But now, the fiscal burden of coronavirus has made the municipal bond market more expensive for issuers. Rightfully, protecting health and helping the unemployed are priorities. However, we know that strong infrastructure supports a resilient economy and would help with recovery. By the time the virus recedes and we have the room to consider recovery, the federal deficit narrative will loom larger.
For those who would like to go deeper on the topic of our ever-expanding deficit and debt, we recommend the CRFB’s recent discussion and webinar, Is the Fed Buying Our New Debt?
Frog #3: Climate Change
In the not-too-distant past, the federal government engaged in policies when faced with harmful environmental pollution. The federal government created the Environmental Protection Administration during the Nixon administration, following a decade of concern about air and water pollution. Contaminants in the Cuyahoga River, Ohio, caught on fire in 1962. The federal government also passed Superfund to clean up the worst polluted sites, the Clean Water and Safe Drinking Water Acts, promoted cleaner automobile emissions and coal plant stack scrubbers to limit acid rain. Following the New York Love Canal and Missouri Times Beach environmental catastrophes, the federal government bought out and evacuated homeowners located on harmfully contaminated land (interesting history here). There was little controversy that this pollution was caused by us humans and that policies should be crafted to reverse the damage.
As focus shifted the discussion to the broader topic of climate change, the anthropomorphic connection between environmental pollution and climate change became harder for many to grasp. Admittedly, it is easier to see the harm of a toxic waste dump near your children’s playground than grasp a connection between carbon pollution from automobiles and natural disaster events. I highlighted a long list of scientists around the world, economists, central bankers, Nobel Laureates and government researchers who echo the same themes: climate change is a serious problem that will impede the rate of global growth and cause increasing losses to infrastructure and property — with little question that humans play an important role. On a more mundane level, warmer and wetter storms challenge the capacity of our many combined stormwater and sewer systems. Overflows spread pollution into homeowners’ basements and across the landscape. This is just one issue that not only affects coastal communities, but midwestern communities near rivers and bodies of water.
The Atlantic hurricane season begins on 1 June. Colorado State University’s Tropical Meteorology Project forecasts an above normal activity this year. An update is expected on 4 June. As authors Klotzbach, Bell and Jones typically warn:
“As is the case with all hurricane seasons, coastal residents are reminded that it only takes one hurricane making landfall to make it an active season for them. They should prepare the same for every season, regardless of how much activity is predicted.”
Extended Range of Forecast of Atlantic Seasonal Hurricane Activity and Landfall Strike Probability for 2020, sourced 14 May 2020
Wildfire season may also affect certain areas more than normally this year. See this collaborative report from the US, Canada and Mexico. For more background, see this report from global reinsurer, Munich Re.
Are we ready, willing and able to respond to multiple disasters? The coronavirus will continue to be with us during this year’s hurricane and wildfire seasons and beyond. Much of the public policy focus has been on lockdown, quarantine, testing, and the adequacy of protective supplies to manage the viral spread, and it has been on re-opening the economy. However, should a major storm make landfall, people trapped in their flooded homes will need to be rescued. The elderly will need to be evacuated from nursing homes and the sick from hospitals. Evacuation routes and temporary shelters could be necessary. How would social distancing and those that are ill be managed? Is FEMA prepared to manage and financially support both?
I worry that one of these frogs is about to boil.
Natalie Cohen is founder, principal author and publisher of The Public Purse. She has deep experience in the municipal bond market, credit research, bond insurance, risk management, rating agency and government.
Disclaimer: This article was originally published on “The Public Purse” and submitted to Macro Hive for republish. (The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)