Sunday, October 17, 2010



Employees who are covered under the State and County Employee Retirement System may be facing a serious situation where all possible options end up with negative consequences for everyone. Let me first state the first phase of the problem. Yes, it comes in two phases.

Employees who work for the State or Counties are covered under a defined benefit pension plan. This means that the retiree will receive or is receiving a certain benefit at normal retirement age based upon his years of service, highest 3 years of pay of the final 5 years multiplied by a certain percentage. The formula was changed for new hires a few years ago so we won't work with specific percentages.

As of a few months ago, the pension fund was underfunded by about $6.2 billion to as much as $7 billion dollars. Yes, that's billions. There is no way that the fund can make up that shortage to meet emerging liabilities of payments to retirees. Here's why.

When the actuaries set up the assumptions of a plan, they assume a certain rate of return (8% for ERS), a certain rate of turnover, a certain rate of deaths and disabilities. This brings them the annual cost of the plan to fund it to meet retirement payments. Most plans use funding assumptions that are conservative in nature and make funding corrections over a period of perhaps 10 years. Some may even use a second set of funding techniques, such as amortization schedules and use the most conservative funding schedule.

In the case of the ERS, it appears that in years that the plan had investment gains, the year's deposits were adjusted downward to lower the pension cost to equal the gains in the investments. This is well and good, but in defined benefit plans, shortages must also be made up immediately. That means, when the economy is good, the governments are flush with gains and cash and the politicians spend whatever excesses show up in the budget.

Just in case some of you went to private school, let me explain it simply. If you have a pension plan with one employee who is due to retire in 10 years, the "normal cost" (excluding interest, mortality, etc) each year is $10 to fund a $100 liability in 10 years. Suppose you're 5 years down the line and you experience an investment loss of 40%. So instead of having $50 in the fund, which is the reserves required, you only have $30. If you keep putting in the normal $10 each year rather than $14 to catch up, you will only have $80 to fund a $100 liability. Calculations become dynamic when you add in interest because for every year you're underfunded, you get further away from the possibility of making up the shortage. Now, plug in assumptions where you have to fund for potential 80,000 current and future retirees, some of whom are scheduled to retire in 1 year.

When the economy is bad, the sword is equally sharp and the governments must put in more to make up for the shortage at a time when tax revenues are down because business activity is down. So the shortage cannot be made up unless they increase tax rates on the private sector. When that happens, private investors will take their money and capital elsewhere, thereby increasing the shortage in tax collections.

In 1964, Hawaii changed the temporary 1% excise tax to a permanent 4% tax. Soon thereafter, the Big 5 companies left Hawaii, followed by Dillingham. No one in their right mind would domicile themselves in Hawaii and subject their world wide income to such a hideous tax. When they forced Bishop Estate to sell their land, Bishop took their investment capital that was now converted to cash out of Hawaii. At least with the land, they were stuck in Hawaii. We liberated their capital and it took Hawaii 10 years to recover from the recession caused by the first Gulf war.

States cannot print money. Aside from tax revenues, they can borrow by floating bonds. But no one would buy such bonds if the State faces such a liability in their pension plan. They could unload the pension obligation onto the Federal government under the Pension Benefit Guaranty program. Or, the employees could agree to take a fraction of the benefits promised.

We'll have to see how it plays out.

The retirees are also given free medical coverage by the State and Counties. Newly hired employees are not eligible for this program. Most retirees pay for their own Medicare premium and buy their own supplemental plans like Medicare Advantage. Not so with State and County retirees. They are reimbursed for their Medicare premiums and have free coverage for the supplemental benefits to where there is no co-pay, deductible or "donut" holes under Medicare Plan C.

Here's the bad news. Under the new Healthcare law that was just passed, it's difficult to determine how much the State and Counties are underfunded in their healthcare plan but a good guess would be between $7 billion to $10 billion.

What do they do? The employee/retiree under the ERS wears two hats. One as a taxpayer and another as beneficiary who was promised a benefit in retirement. If you believe that the State will tax the private sector, then you must stop being a taxpayer and divest yourself of all investment holdings in Hawaii. If you don't, you'll be asked to shoulder the taxes required to make the ERS whole.

If you're retired, you could consider moving to a state that is fiscally conservative and not subject your pension to Hawaii taxation. New York and California are in worse financial condition than Hawaii and they will tax residents to get out of the hole, thus further increasing the already high cost of living in those states. More likely, they will declare bankruptcy to offload their public employee pension liabilities. Then, we may see anarchy. Note France and Greece. Those public sector employees/retirees won't give up their entitlements.

There are solutions but I won't go into them. Politicians who attempt to solve the problem will be thrown out of office by the public sector unions.

We cannot control our politicians. We can only control how we react to the situation they've placed us in.They love money (power) and use people. We must, as a community, begin to love people and use money or resources to take care of each other without government interference.

Meanwhile, our kupunas will once again be thrown under the bus because they have already outlived their productive life. It is imperative that we step up our volunteering to help them.

I have not offered financial or investment advice. I merely point out potential solutions each individual could consider. Please see your financial and tax advisor before taking any action. Chew your food well before swallowing. Look both ways before crossing the street and, of course, when swimming, don't breathe while your head is under water.

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