Slide 1CHAPTER OUTLINEWhat is the ProblemWhat is the Source of the Problem?How Could a Pension be Underfunded?Defined Benefit CharacteristicsDefined Contribution CharacteristicsWhat Makes One Better?RisksSocial Security and MedicareAnnual Deficits (Present Value)Dependency RatioSlide 13State and Local Defined Benefit Pensions and Their DeficitsSlide 15Cities in TroubleGood News?16-1©2015 McGraw-Hill Education. All Rights Reserved ©2015 McGraw-Hill Education. All Rights Reserved Chapter 16Is the (Fiscal) Sky Falling?:An Examination of Unfunded Social Security, Medicare, and State and Local Pension Liabilities16-2©2015 McGraw-Hill Education. All Rights Reserved CHAPTER OUTLINE•What Is the Source of the Problem?•How Big Is the Social Security and Medicare Problem?•How Big Is the State and Local Pension Problem?•Is It Possible That the Fiscal Sky Isn’t About to Fall?16-3©2015 McGraw-Hill Education. All Rights Reserved What is the Problem•Social Security will take in less in taxes than it will pay in benefits and its Trust Fund will run out by 2040.•Medicare will take in less in taxes than it will pay in benefits and its Trust Fund will run out by 2020.•State and Local government worker pension funds have insufficient assets to cover projected benefits16-4©2015 McGraw-Hill Education. All Rights Reserved What is the Source of the Problem?•Entitlements•A program where, if you meet certain criteria, you are entitled to benefits.•Social Security •age 62 for modest benefits•67 for full benefits•Medicare •age 65•Underfunded Pensions Promises16-5©2015 McGraw-Hill Education. All Rights Reserved How Could a Pension be Underfunded?•There are two types of pensions•defined benefit program •A pension plan that defines eligibility for retirement and benefits according to a set of rules and a formula.•defined contribution program•A pension plan in which those enrolled, as well as their employer, contribute to an account according to a formula, and the investment of that account is under the control of the employee.•Defined benefit programs can be underfunded if the formula is wrong.16-6©2015 McGraw-Hill Education. All Rights Reserved Defined Benefit Characteristics•A percentage of salary is deposited with an investment firm.•There are no names on accounts. It is not “your” money.•If you meet the eligibility rules (such as age + years of service >85) you get a specified pension (such as 75% of your last year’s salary) until you die.•When you die, your heirs get nothing from the pension fund, but your spouse may continue to receive an income.16-7©2015 McGraw-Hill Education. All Rights Reserved Defined Contribution Characteristics•You, your employer, or both contribute a percentage of your salary to a fund.•The account belongs to you.•You can retire and collect what is in your account (deposits plus interest)•If you set it up this way, your heirs may get the balance on the account when you die.16-8©2015 McGraw-Hill Education. All Rights Reserved What Makes One Better?•Defined benefit•Lower investment fees result in better long term rate of return for retirees•Good for people who begin and end their work lives with the same employer.•Defined Contribution•Greater flexibility•Good for people who change employers and would not be eligible for benefits under the rules (age + years of service)16-9©2015 McGraw-Hill Education. All Rights Reserved Risks•Defined benefit•Your employer won’t deposit enough.•ERISA was passed to prevent that.•ERISA doesn’t apply to State and Local Government. •Your employer will go bankrupt•Pension Guaranty Trust insures against this.•Defined contribution•You will outlive your money.16-10©2015 McGraw-Hill Education. All Rights Reserved Social Security and Medicare•The present value of anticipated benefits minus the present value of anticipated taxes.•Social Security $12 trillion •Medicare $4 trillion16-11©2015 McGraw-Hill Education. All Rights Reserved Annual Deficits (Present Value)16-12©2015 McGraw-Hill Education. All Rights Reserved Dependency Ratio16-13©2015 McGraw-Hill Education. All Rights Reserved Social Security and Medicare Deficits as a Percentage of Project Payroll16-14©2015 McGraw-Hill Education. All Rights Reserved State and Local Defined Benefit Pensions and Their Deficits•Stated vs Actual Liabilities•State pension funds are (by law) allowed to discount future liabilities at a rate that is much higher than they typically can get on relatively safe investments.•Discounting future liabilities at higher rates artificially decreases their true liabilities. •Underfunded by $3 Trillion16-15©2015 McGraw-Hill Education. All Rights Reserved States in TroubleActual Liabilities/Assets > 3(figures in billions)State Stated LiabilitiesActual LiabilitiesAssetsIllinois $151 $233 $66Connecticut $45 $69 $20South Carolina $42 $64 $20Kentucky $45 $63 $21Rhode Island $14 $21 $7Several states have figures >2.5. No state has assets to cover their stated liabilities.16-16©2015 McGraw-Hill Education. All Rights Reserved Cities in TroubleCity Unfunded Liability(billions)Unfunded Liability as a Percent of City Tax RevenueUnfunded Liability per Household in the CityChicago $45 763% $41,966New York $122 276% $38,886San Francisco $9 306% $34,940Boston $8 430% $30,90116-17©2015 McGraw-Hill Education. All Rights Reserved Good News?•GDP could grow more rapidly than is projected•Social Security and Medicare could be reformed to close their respective funding gaps.•Rates of return on investments may be