Financial Literacy

Government financial illiteracy

The Puerto Rican government just defaulted on a $227 million in bond payments. These payments were part of their $72 billion in government debt. How did tiny Puerto Rico accumulate such an unsustainable amount of debt? As tax revenue fell from their ever weakening economy, Puerto Rico borrowed an ever increasing amount of money instead of prudently laying off government employees and cutting services. This debt grew until it pushed them well beyond financial difficulty and into unsustainability. Investors were blindly attracted to Puerto Rico’s triple-tax exempt bonds (federal, state, and local tax-free) and didn’t pay attention to PR’s unsustainability until it was too late. To the financially literate, this debt default was predictable arithmetic.

The city of Detroit emerged from bankruptcy just months ago, after the judge eliminated $7 billion of its debt. After bankruptcy, Detroit’s bond credit rating jumped up from a junk level to “B”, and even “A” for revenue bonds. Too bad Detroit’s leadership doesn’t appear to have learned financial lessons from being the largest municipal bankruptcy in U.S. history. The city wasted no time in abusing their new asset, a high credit rating, by issuing $245 million in new bonds. This new debt will pay for some blight removal and public safety improvements. However, Detroit has a long history of being unable to maintain any recently improved areas: graffiti goes back up as soon as it is cleaned, scrappers return to buildings like locusts after they are boarded up, torn down homes become sites for illegal dumping, cleaned up parks go back to weeds and trash, etc. So much of this debt is likely to be spent on temporary benefits while the debt to pay for it is a permanent shackle of $12 million in annual interest expense. As additional proof of financial illiteracy, part of the bond sale will be used to to hire more police and give promotions – if you cannot sustainably hire and promote out of your current budget, then you cannot afford them! If you cannot afford to hire some police with your tax revenue, where will the additional money come from to ever pay back $245 million from a city whose population is declining? It appears to me that Detroit hasn’t missed a beat in its irresponsible financial decisions.

For many decades, the conventional retirement plan was called, “A 3-Legged Stool.” The legs of the traditional stool consisted of:

1. Your company pension (but these have disappeared), government employee pensions (but these are being reduced).
2. Social security income (but the whole program needs to be restructured, it is losing +$80 billion a year and the Baby-Boomer generation has barely begun to retire).
3. The last remaining leg is your own personal savings. How is yours going so far?

The retirement stool, in general, is now wobbly and falling over. Certainly our government leaders are going to do something about it, right?

What exactly are our political leaders doing about these programs?

• Social Security Retirement – financially unsustainable
• Social Security Disability – financially unsustainable
• State and local government pensions – many are financially unsustainable

Not much unfortunately, because they refuse to admit there is any financial problem.

Since personal savings for retirement are underfunded or nonexistent for many people, a large number of people are financially forced to work past their preferred retirement age. But if you do work after you starting to draw social security benefits, be aware that the government has two tax traps waiting for you:

1. If you earn more than $33,000 in retirement then 55% of your social security income is taxed at regular rates.
2. If you earn more than $44,000 in retirement then 85% of your social security income is taxed at regular rates.

Being taxed on social security is a penalty clawback on your retirement income that most people are unaware of until they actually incur them. Since few people know about these extra taxes, they do not plan for them and face even more financial struggle when they are least able to do something about it.

As I write this today, President Obama is speaking at the White House, claiming that “Medicare and Social Security are not in crisis.” However, the arithmetic highlights that they are in catastrophic shape:

• Using generally accepted accounting rules, Medicare is unfunded today by $27.5 trillion.
• Social security is unfunded today by $14.1 trillion.
• As a comparison, all of the annual wages and business profits for the U.S. economy is only $17.8 trillion per year.
• In addition, the U.S. federal debt is still growing much faster than the economy is growing – which is an unsustainable situation for any country.

The critical financial lesson for everyone today is:

1. The federal government cannot be trusted to fully pay promised social security payments.
2. Pension plans are increasingly reduced or eliminated.
3. So the only leg of the retirement stool that you can count on is your own personal savings. Make sure that you are properly supporting your retirement accounts.

Financial mistakes and chronic overspending by government officials are generally covered over by increasing taxes or selling bonds. Overspending can continue until that government entity is prevented from using either mechanism and is forced to deal with the consequences of their unsustainable financial situation. Although increasing taxes and selling bonds can go on for years or decades, depending on the size of the government entity, but sooner or later, a reckoning with financial reality must occur.

This reckoning with reality arrives in 4 common stages and you will recognize them in the news, recurring over and over from across the country and globe:

1. Continuing to increase taxes to pay for financial mistakes and unaffordable obligations.
2. Credit rating falling which makes it more expensive to sell bonds.
3. Debts consume a larger portion of budgets which siphons money away from normal government services. Residents then complain by voting out the incumbents, but it is too late and parties are too intractable to reach a sustainable agreement.
4. Bankruptcy or settlement. Where a judge or creditor committee rules on how little all of the creditors will actually receive, including bondholders and pensions.

Current examples of governments in these 4 stages of financial distress:

• Detroit’s Wayne County is headed toward bankruptcy, exactly following the city of Detroit did two years ago. The county has a structural deficit of $50 million that no tax hike can fill.
• The city of Chicago’s credit rating was recently dropped below investment grade to junk and laid off 1,400 school administrators to fund a pension payment.
• The state of California continues to ratchet up swaths of their already-high tax rates to fund their escalating liabilities for pensions, health care, and high-speed rail projects.
• Greece’s economy has hit a wall after defaulting on their sovereign bonds with the IMF and may get kicked out of the Euro currency; Greek banks have issued stringent capital controls. How this unfolds will affect Italy, Spain, and other insolvent debtors using the Euro currency.
• The territory of Puerto Rico hired bankruptcy attorneys as it is about to default on $72 billion in debt that it can never repay.
• Venezuela just issued more capital controls on Venezuelan’s traveling abroad (reducing the currency they can exchange) to delay their inevitable default on bonds.
• Argentina has been going through bond restructuring (bankruptcy) since this January.
• And you may remember that the credit rating for the U.S. Federal Government was downgraded in the summer of 2011; from the highest rating of AAA down to AA+.

Moody’s Investor Service just lowered the city of Chicago’s credit rating to junk-bond status.

First of all, what does this mean?

It means that, in Moody’s opinion, the bonds issued by the city of Chicago are more likely to default, so much so, that they are below an investment-grade credit rating. The Moody’s Baa2 rating prevents financial fiduciaries from investing in these bonds because they are too risky. So institutions will have to sell their bonds and it will now be far more difficult and expensive for Chicago to sell bonds in the future.

How did this happen?

When government credit ratings are impaired, it typically means structural spending (ongoing financial commitments) are growing far beyond their ability to tax. In Chicago, and the state of Illinois, their credit ratings are impaired because government employee pension obligations are continually being underfunded. What triggered the latest credit-rating decline was the Illinois Supreme Court’s recent decision to uphold the state law forbidding benefits that had been earned from being reduced.

The state of Illinois has the greatest unfunded state pension in the country and the city of Chicago has a $20 billion deficit for its four pension plans. The Illinois Supreme Court’s ruling will make it more difficult to reduce any government pension liabilities, so these unfunded liabilities will continue to grow. These unfunded liabilities are already unsustainable so some form of restructuring will have to occur as government services are slowly reduced from a lack of funding.

What should happen?

It is easy to actuarially map-out pension obligations. To be continually funded, these obligations must remain at an affordable and sustainable financial level. This is financial literacy 101 and must always be done before any financial commitments are made. Whether it is a household, company, or government, you cannot escape basic financial literacy. In my opinion, sooner or later, government employee retirement plans will be forced to transition toward private retirement plans, which means mostly self-funded accounts with some contribution from the employer. Until this happens, cities and states, like Chicago and the state of Illinois, will stumble along with unsustainable debts that will consume an increasing amount of their budgets until they go bankrupt; just like Detroit.

When President Bush entered office in 2000, the federal debt was $5.7 trillion.

Eight years later when President Obama entered office in 2008, the federal debt had nearly doubled to $10.6 trillion.

The current federal debt is $17.5 trillion and is projected to be just over $20 trillion when President Obama leaves office in three years; once again, doubling in only 8 years.

Unfortunately, the economy has an annual GDP of only $16.3 trillion today. There is no government in history that been able to pay its debts once the national debt exceeds the economic output of the country. The U.S. passed that point in 2011 and is continuing to increase its debt instead of reducing it.

For anyone who thinks this isn’t a problem, let’s look at two more ways to view our national debt:

• U.S. Federal debt per U.S. citizen $55,000
• U.S. Federal debt per U.S. taxpayer $151,000

Can you write a check to pay for your personal share of the federal debt?

How about just the interest on your personal share of the federal debt for 2013 of $3,700?

Ok, the size of the federal debt still doesn’t concern you yet? Let’s move on to the final federal debt number.

Today, the U.S. federal government has unfunded liabilities. These are promises that have already made to retirees, veterans, government employees, Obamacare, etc. But there is no plan to raise the money to pay for them, no source of funds, no available funds, which is why they are labeled as “unfunded.” This U.S. unfunded liability balance is $129.3 trillion today, or $1,116,000 per taxpayer.

That’s right. Sooner or later, each taxpayer is liable for the $1,116,000 in unfunded promises that politicians have made on your behalf. Do you still think financial illiteracy is not a problem in Washington?

The state of Illinois has a spending problem that they’ve hidden with ever-growing borrowing. Their borrowing has been so reckless that the state’s credit rating is now the lowest in the country (California has the second worst credit rating in the nation). This poor credit rating prevents Illinois from issuing bonds at a cheap rate, or possibly at all in the future.

The primary financial problem is $130 billion in unfunded pension liabilities that is owed to state workers. Illinois simply hasn’t made sufficient payments to the pension plan for so long that it is likely they will never be able to catch up. Plus, the payments that have been made in the last few years were funded by – you guessed it, borrowing more money. To anyone with financial literacy, this cringe-worthy tactic is the definition of a downward spiral to bankruptcy. It is like an individual getting a new payday loan to pay part of his or her credit card bill, every month. How many months can this continue until insolvency?

The Illinois Comptroller, Judy Baar Topinka, just wrote in her 2013 annual report that, “Illinois spent $1.45 billion last year in interest payments alone. This is money that cannot be used on pressing needs.” What she said is correct because all interest payments are pre-spent monies that cannot be spent on anything else.

Financial literacy matters for any institution that would like to remain solvent; a household, a city, a company, a state, and even a country. If you want to know what the titans of financial illiteracy are up to, the politicians in Washington D.C, you can view it at: http://www.usdebtclock.org