John Pelletier Op-Ed: Did You Know That You are an Insurance Company?

by John Pelletier, Director of Champlain College’s Center for Financial Literacy

If you pay income or real estate taxes in Vermont, you are like an insurance company. You are insuring, with your taxes, the retirement pension and healthcare benefit promises made to state employees and public school teachers. Here are the risks you are insuring: investment risk, longevity risk and economic growth risks.

Like all insurance companies, you are only on the hook if there is a big loss that has not been saved for. But here is the problem—our state retirement and healthcare plans are currently on an unsustainable path. Without changes, it’s likely that in the future Vermonters will be hit with big tax increases to pay for these promises.

Since 2001 Vermont’s pension obligations have grown much faster than the assets held in the pension plans. In 2001 the funded ratio (the ratio of the actuarial value of assets to actuarial accrued liability) for the state employees’ and state teachers’ retirement plans was 93% and 89%, respectively, and in 2017 was 71% and 54%, respectively. Vermont has no funds set aside to pay for the expensive and growing healthcare retirement benefits.

Investment Risk is the risk that plan returns are below expectations.  According to USA Today we are currently in the midst of the second longest bull market in history (9+ years) and second in terms of investment gains (over 300% in market gains). Are Vermont’s pensions prepared for the next inevitable bear market—a decline in the value of equities that is greater than 20%?

Many in the investment industry are warning investors to expect lower equity investment returns over the next decade because stocks appear to be expensive right now.

Bonds are a very important source of pension plan income. In 2000, ten year treasury bonds returned about 6.4% in interest a year, but only 3% a year today. Experts expect interest rates to continue to rise. If a pension’s bond portfolio has a 7 year average duration, these bonds will decrease in value by 7% if interest rates increase by 1%.

Our state pension plans are based on an expected return of 7.50% a year. Is that a realistic expectation for the future? Calpers, one of the largest pension plans in the country, reduced its return expectations to 7% in 2016.  Milliman, the world’s largest provider of actuarial services, in a 2017 study, stated that a more realistic rate of return assumption for public pension plans is 6.71%.

This return estimate is consistent with actual public pension returns according to a recent Wall Street Journal article:  median annual public pension returns were “6.79% over the past decade and 6.49% over the past 20 years.” In fact, over the last 10 years the Vermont state employees’ and state teachers’ retirement plans have had average annual returns of 4.8% and 4.6%, respectively.

Longevity Risk is the risk that plan beneficiaries live a lot longer than we expect.  If you were born on this date in 1948, you are 70 years old today. In 1948 the life expectancy of a newborn child was 70 years. Today the life expectancy of someone born in 1948 is 85 years. Life expectancy has increased by two years each decade.  A World Economic Forum report titled “We’ll Live to 100—How Can We Afford It?” notes that people born in the US in 2007 have a life expectancy of 103 years. Our public pension and healthcare plans were designed for 10 to 15 years of retirement, not 20 to 45 years. Without changes, many individuals will collect retirement benefits for more years than they worked.

Economic Growth Risk is the risk that Vermont’s economy and tax revenues do not grow as quickly as expected. The current economic recovery (9+ years) is the second longest in US history. At some point in the future we will have another recession and that will result in a material drop in Vermont’s tax revenue.

Vermont’s economic growth has been slow since the Great Recession. According to Bureau of Economic Analysis real gross domestic product growth in Vermont has ranged between 0.5% and 1.5% a year from 2014 to 2017.

Vermont’s population and its labor force are shrinking. This puts severe limits on Vermont’s economic growth potential. Vermont should expect subpar economic growth in the future compared to other states.

Vermont is the second oldest state in the nation. Only Maine is older. In fact, 1 out of 6 Vermonters is older than 65. Unless things change, Vermont will have many fewer wage earning taxpayers in the future. How will Vermont fund these retirement benefit promises with a shrinking tax base and low economic and tax revenue growth?

Vermont has made promises to its state employees and teachers. We need to make sure that we can keep these promises without drastically raising taxes on Vermonters or dramatically reducing state services through budget cuts. There will be another stock market crash and recession. Will Vermont be ready or will it submit a big insurance claim to its taxpayers?

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John Pelletier is the Director of the Center for Financial Literacy at Champlain College, and a member of VBR’s Pension Reform Task Force