May 21, 2005

Why Truly Free Markets & Timely, Transparent Information Are Needed to Protect the Freedom of American Citizens

Crises often happen when individuals and organizations refuse to face reality. It is a common human problem.

These behavioral tendencies not to face reality are only magnified by the misguided incentives that pervade the public sector (here, here, here, here, here) and the portion of the private sector which uses power and influence to shelter itself from truly competitive market forces.

The underfunding of pension obligations (here, here, here) and healthcare benefit obligations committed to by both the public and private sector, including Social Security, represent prime examples of such foolish behavior.

Stanley Kurtz observes that we have a series of looming problems with pension liabilities that will put taxpayers all across America at serious financial risk:

Four years before the massive wave of boomer retirements begins, we’re beginning to see cracks in our pension system. The retirement of the boomers is a crisis in waiting. And the problem goes way beyond Social Security...

...our private pension system in danger of collapse, Social Security is even more important. But that’s all the more reason to put Social Security on safe fiscal footing. The private pension crisis Stone describes is quite like the one that confronts Social Security. Corporate pension funds are failing because, when times were good, companies raided their retirement trust funds and diverted the money to other expenses. Sound familiar? That’s exactly what we do with the Social Security trust fund...

Once bad economic times hit the airline industry, companies burdened with huge pension debts went bust. That’s what could happen to the United States itself if we pass through an economic rough patch while also being burdened with huge entitlement debt. Should that happen, there won’t be anyone to bail America out...

...pressure from boomer retirements-and from crises like the private pension fund meltdown we’re seeing now-could spook investors and send the economy south. The way to stop the ripple effect is to send out a signal that we’re putting our economic house in order. That’s why we’ve got to reform Social Security now...

So how do we get to the point of having what Kurtz calls "a crisis in waiting?"

One way was by creating mythical structures, like trust funds in government which have no connection to economic reality. For example, read this article on the underfunded highway trust fund. Then recall Al Gore's emphatic discussion of the Social Security trust fund - another mythical structure with only federal government IOU's but no cash - because all of that "money" has also been spent elsewhere.

Another way was by tolerating dishonest or misleading public debates which are enabled by a lack of timely, transparent information.

George Will offers these comments about a related and no less serious problem: the perverse outcomes that arise after the government intervenes in the marketplace:

Eyes glaze over at the mere mention of entities such as the Pension Benefit Guaranty Corporation or the Governmental Accounting Standards Board. But the PBGC's sudden prominence is symptomatic of the increasingly troubled relationship between America's welfare state and American capitalism, or those portions of capitalism that are appendages of the welfare state. And the GASB is pertinent to the parallel crisis of state and municipal welfare states...

When the PBGC took over responsibility for $3 billion of US Airways' promised benefits for current and retired employees, that put pressure on United to lighten its load. And now that the PBGC has lightened it, what is Delta, which has lost $6.3 billion in the last five quarters, to do? What about American, Continental, Northwest? The mere existence of the PBGC encourages a chain reaction. And outside the airline industry, many other corporations under stress are watching...

The judge, practicing industrial policy, said the deal reached through collaboration between United and the PBGC will help United attract financing to keep flying. But perhaps United -- or US Airways, or a carrier contemplating bankruptcy as a means of escaping "legacy'' costs -- should go out of business. The airline industry is afflicted with excess capacity and is hemorrhaging red ink -- more than $30 billion since 2000 -- largely because of the older carriers' promises of medical care and pensions for current and retired employees.

But muscular interests have huge stakes in keeping all existing airlines flying. The government has invested $9.5 billion in various subsidies for the big carriers which, in dire straits, might try to hand another $20 billion in pension obligations to Washington. Since 9/11, General Electric, which manufactures and maintains jet engines and leases more than 700 aircraft to airlines, wants all carriers to survive. American Express has paid Delta $750 million for frequent flier miles to award certain card users...

In what is perhaps anachronistically called the private sector, Standard & Poor's recently reduced its rating of General Motors' and Ford's bonds -- nearly half a trillion dollars of debt -- to junk status, largely because of upward spiraling legacy costs. But, then, to what extent is there a really private sector in an economy that socializes huge obligations through the PBGC?

A Wall Street Journal article (available for a fee) describes more about the PBGC and illustrates how meddling by the PBGC in the marketplace reinforces the wrong incentives, thereby only creating an even greater likelihood of more costly problems in the future:

While UAL Corp. was getting approval this week to dump United Airlines' pension woes on the federal government, Congress was working to make that a harder act to follow for other companies with underfunded pension plans. In dealing with the growing problem, though, legislators face a tough balancing act.

Congress has been drafting legislation that would strengthen the finances of the beleaguered Pension Benefit Guaranty Corp., the federal agency that insures private-employer defined-benefit pension plans. It's the PBGC that would be responsible for $6.6 billion of United's unfunded pensions...

But while the legislation could shore up the PBGC's finances, lawmakers must avoid steps that could give companies another reason to abandon defined-benefit plans by making it even more costly to keep them afloat...

Congress is acting because the prospect of more bankrupt pension plans would plunge the PBGC, which already has billions of dollars more in commitments than it can cover, even more deeply into the red -- and raise questions about whether a taxpayer bailout will be needed down the road. Employer groups warn that companies will be tempted to freeze or end their plans if they're compelled to pay higher premiums...

The vast majority of plans taken over by the PBGC have been from companies that have been liquidated. In those cases, the PBGC asks the bankruptcy courts to agree to turn over the pension plans to the agency. In other cases, companies on their own can use bankruptcy proceedings to convince the judge that they can't survive without shedding their pension liabilities. The PBGC must accept the court's rulings. Also, the PBGC can initiate a pension-plan takeover by going to court and asking for the termination of company plans.

Most of the PBGC's money comes from investment returns on corporate assets assumed from companies that turn over their pension liabilities to the government. The agency also collects premiums -- totaling on average $1 billion annually -- from employers whose plans it guarantees. So far, the PBGC hasn't gotten any taxpayer money, and has only a relatively small line of credit from the U.S. Treasury of $100 million...

Some analysts warn that a bailout of the PBGC funded by taxpayers could be on the horizon...

Two ideas being pushed by the White House...are stirring concern among employers. One would boost premiums paid by companies to the PBGC to $30 a year from $19 for each employee covered by a pension plan. The premium proposal also would increase so-called variable premiums pegged to the level of a companies' underfunding. Another administration proposal would create a new formula for measuring assets and liabilities.

James Klein, president of the American Benefits Council, a trade group for large employers, said that businesses are worried that the new formula for measuring pension-plan health would cause nearly all plans to be considered less than 100% funded. In that case, most companies that offer defined-benefit pensions would have to pay both the higher flat rate and an additional variable premium.

The result would be that healthy companies would see their total premiums increase 240% under the proposal, more than double the increase for weaker companies, according to an analysis by Watson Wyatt Worldwide, a consulting firm.

"While the pension funding environment desperately needs fixing, we believe that the administration's proposal will likely damage an already weakened defined-benefit system," said Sylvester Schieber of Watson Wyatt.

PBGC Executive Director Bradley Belt said the administration is sensitive to the negative impact of legislation. But the United situation "is a wake-up call," he said. "We have to have tougher funding rules, we need more transparency in the system, and we need to address risk in a more meaningful way."

In yet another example of how the misguided incentives of the public sector are costly, a recent Fortune magazine article (also available for a fee) describes how healthcare benefit liabilities in the public sector are another time bomb set to explode in the near future:

There is a time bomb quietly ticking away in the netherlands of state and local government, and it is set to blow up in the next few years. When it detonates, the damage will easily run into the hundreds of billions of dollars—forcing tax hikes and public service cuts that will affect the lives of millions of Americans unless dramatic action is taken soon. Why? Because, unlike the private sector, the majority of government employers—48 out of 50 states and more than half of all municipalities—still provide health-care benefits for their workers after retirement. The problem is, lawmakers haven't bothered to set aside nearly enough money to pay for these contractually guaranteed benefits. With health-care costs soaring and the rolls of public workers at retirement age growing fast, the tab for these obligations is expanding exponentially. And the bill is now coming due.

This phenomenon is already weighing on state and local governments. Consider the estimated $17 billion in unfunded retiree health benefits that California's largest school districts have now racked up...or the $26 million a year that the city of Buffalo now shells out on health care for its retirees (more than it spends on health care for active workers and equivalent to about 20% of the city's annual haul from property taxes)...

So why, you're wondering, haven't you heard much—perhaps not anything—about this impending crisis? The reason is simple: State and local governments don't have to disclose the extent of their health-care liability for retirees, so they don't. And what's worse, they habitually foist the cost onto the next generation of legislators.

That's about to change. The Governmental Accounting Standards Board, which sets the accounting rules for state and local governments, will soon force public-sector employers to show on their financial statements the total dollar value of the retiree health-care promises they have made to each worker and retiree. They'll also have to book an expense in their annual budgets for the dollars that will be required to fully fund those retiree health-care liabilities over a 30-year period...The rules kick in for budgets in fiscal years closing after December 2006...

Under the current system, municipal and state governments make room in their budgets every year for the amount of money they need to cover retiree health care over the next 12 months only. The problem with that pay-as-you-go accounting system is that it ignores the value of the health-care benefits that retirees and active workers alike have already earned but not yet received...There's a precedent in the private sector for this kind of shift in accounting standards—and it's not pretty. Back in 1990, the same rules that are about to take effect for state and local governments were forced on U.S. corporations. Companies suddenly began disclosing huge retiree health-care liabilities on their balance sheets and dramatically increased health-care expenses on their income statements. And Wall Street promptly threatened to punish the stocks of companies offering retiree health care to workers. Executives responded, of course, by taking an ax to the plans. From 1993 to 2003 the number of large companies offering medical coverage to retirees dropped by half, from 40% to 21%...

Since governments aren't yet required to disclose their anticipated liabilities, no one knows what the scope of the damage will be...

...In many public systems, half of the active workers are now eligible for retirement. Compounding the problem is the fact that public-sector workers are typically eligible to retire with full pension and health benefits at a much younger age (often in their mid-50s) than their private-sector counterparts. That puts the government employer on the hook for even more years of retiree health care. And all this is happening against a backdrop of health costs escalating at a far greater pace than the tax base...

...But the only real solution, he says, is to get rid of the retiree health benefit altogether for newly hired employees...

That's proving to be a tough sell with union officials. "We have traded wage increases and other benefits for this," says Ken Loeffler-Kemp, a Duluth-based representative with the American Federation of State, County, and Municipal Employees. [Editorial comment: A questionable claim these days.] Indeed, don't expect the public sector to follow the lead of many corporations, which have simply eliminated retiree health care for active workers and retirees alike. For starters, government employees are far more likely to be unionized—a mere 9% of all private-sector workers are now represented by a union, compared with about 43% of all state and local workers. And elected officials are often loath to take on those powerful unions, whose members can both vote and strike...And even if they wanted to eliminate the retiree benefits of existing employees, lawmakers would probably run into a brick wall, since courts have almost uniformly enforced public employee retirement benefits once they've been granted.

So what's the solution? There's certainly the possibility of offloading more state and local health-care spending to the federal government...

While eliminating retiree health care may not be possible, cutting back on the generosity of the benefit is...health-care benefits cut continually during the past five years, mostly in the form of increased premiums and co-payments for prescription drugs. She also says that in an effort to drive down the plan's costs, her organization has proposed an increase in the eligibility requirement for full retiree health care from the current five years of service to 20 years. But the idea hasn't taken hold with legislators. "Lawmakers are in the same health plan," notes Melton. "And it's a lot easier to win three two-year terms of office in order to get that five years than it is to meet a 20-year vesting requirement."

Wherever there is money and power involved - and especially when there are no free market forces - we should expect politicians, bureaucrats, unions, and business executives to act in their own parochial self-interest.

Only by having truly competitive free market forces, assisted by identifying the right metrics and publicizing them in a timely and highly transparent way, is there any chance of creating pressures which force these players to act in an economically rational manner.

Unfortunately, this hasn't happened in the past, especially in the public sector, and we are now about to pay the consequences.

It will be quite a price to pay. And we did it to ourselves by allowing the size of government to grow in conjunction with the economic demands of excessive public sector union contracts as well as by not insisting on truly free markets and timely, transparent information.