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The Great Subsidy Debate that Nobody Talks About

Most Baby Boomers today are preoccupied with the question whether they can afford to ever retire. Most young people are preoccupied with the question whether they will ever have jobs to build the wealth that their parents and grandparents have enjoyed.

The financial crisis of 2008 sparked a massive shift in the distribution of societal benefits between savers and debtors. For decades it paid to be a saver. Even on safe investments, an investor received a decent return on savings relative to inflation. Since the crisis of 2008, this is not the case and most savers receive less return on investments than the cost of borrowing secured capital. It is difficult for savers to generate a return in excess of the rate of inflation, while secured borrowers can borrow at the rate of inflation. There is a clear incentive to borrow rather than save. From one perspective, subsidies are being paid to borrowers at the expense of savers. (And this subsidy is not just to consumers that are borrowers this is also a subsidy to governments and the people that benefit from the government entitlements that are financed by debt and not equity.)

The prime reason interest rates are now artificially low is because governments and individuals are so indebted that the economy could not currently survive a return to more normal interest rates and rates of return. But let’s examine the incredible distortive effect that this “subsidy” generates.

You retire I retire

Prior to 2008, a worker with a defined benefit taxpayer supported pension plan (DBTS) making $100,000 per year after 30 years of service would generate an actuarially calculated pension in the $750,000 range. This assumes a 7% investment return. This person would have made approximately $300,000 in contributions to the $750k value pension. In 2012, given a 2 to 3% expected annual return, this same DBTS pension is worth approximately $2 million with the same $300k contribution to the plan. In 5 years, the DBTS worker’s net worth has increased by $1.25 million with no additional personal contributions. This uplift in net worth has been, for the most part, tax free! (During this same period, the value of the savings of the non-pensioned individual is actually less than it was in 2007.)When one calculates the additional benefit of lifetime benefit plans, combined with the defined benefit pension plan, given relative rates of return, the real compensation package for the $100k DBTS worker is now actually closer to $200k, while taxes are being paid on $100,000 of income only.

The 80% of society that does not have a defined benefit pension plan now has to save $2 million after tax to retire at the same level as the DBTS worker above. However, the ability to save $2 million is almost impossible because the expected rate of return on savings is at or less the rate of inflation. The person without a pension is now in a position where they have to work well into their 70s before he or she can contemplate retiring.

Take it out on the young people

So the 80% of society with no pension will work much later thereby depriving young people of opportunities to fill some of the job spaces left when baby boomers retire. Young people in their 20s today now find themselves in the same situation as the baby busters of yesterday- where it is impossible to find jobs because of the boomer bulge. While the children of baby boomers anticipated an easy entry into the workforce after the majority of boomers had retired in their 60’s, they may now have to wait a decade longer before the boomer bulge has left the workforce.

As many non-taxpayer supported, actuarially sound, private sector retirement plans can no longer afford defined benefit pensions or benefit plans for life, new entrants into the workforce are given defined contribution plans with few benefits for life. Again, even if the young people can find a job they get less than their predecessors when they get there. Additionally, like the non-pensioned boomer they too are caught up in the savings at rates below inflation conundrum!

Where does the money come from and who pays?

Of course, this $1.25 million in up-lift of net worth to a DBTS recipient is not paid for by a pension plan that is actuarially sound. (If it was actuarially sound the pension plan may not be solvent and a defined contribution plan would probably result). So who pays?

Mostly taxpayers who have no defined benefit plan. And where the taxpayers cannot pay then governments deficit finance and place these costs onto the shoulders of future generations - the same young people who can’t find jobs and who will never have access to defined benefit pension plans.

What other impacts are we talking about here?

First and foremost, we have inter-generational tensions. The Occupy Movement, while never expressing itself in these stark monetary terms, nonetheless is clearly motivated because young people know they are getting less - they are just not sure how much and why.

The Tea Party wing of the U.S. Republican Party has also come about because supporters believe they are not receiving their fair share and that the only way to address this imbalance is to discontinue the benefits or “entitlements” of others.

Many U.S. states are successfully rolling back public sector entitlements. In Europe, countries are rolling back entitlements simply because the governments (and the taxpayers) have reached the limits of their debt pool and no longer can afford to borrow to pay the beneficiaries.

Canadians are too politically correct to challenge governments on the DBTS “entitlement” issue. But some groups are speaking out and some governments are taking very small baby steps to address discrimination and cross-subsidization between those with taxpayer supported plans and those with no plans. Artificially low interest rates also skew investment markets and create distortions that could result in more serious economic shocks. Artificially low interest rates are a ‘bubble’ creating machine. The real estate market is the prime example. We know that the low rates permit people to buy more house than they can afford. But another real fear is in the real estate investment market. People (without DBTS pensions) know they can only get inflation-based returns (or less) in the stock market. So what are they doing? They are buying speculative real estate investments for the rental market driving up rental property and speculative condominium prices. Any slight change in interest rates or market demand for rental properties could spark a serious real estate crisis in Canada. And who would get hurt if there was a serious real estate shock in Canada. The non-pensioned people of course!

Will this change in the foreseeable future?

The short answer is probably not. Despite many good years where governments should have paid down their debts in order to be able to withstand economic crises (such as the one we are in today), they did not. And there is little hope that they will ever do so in the future. Many businesses are acting like non-pensioned savers. They are wary and accumulating capital for fear indebted governments will trigger another economic shock or worse economic collapse. Central bankers admonish business to spend more in the hopes that new business spending will somehow generate demand and bring back 5% or more economic growth. But this is not likely to happen. Businesses instead are saving and returning capital to investors (as dividends) because this is the only way they are going to attract capital (from savers) for operations. And it is highly unlikely that consumers are going to trigger 5% growth either. Consumers are paying down debt and attempting to save for retirement. The big bulge baby boomers are not spending; there are too few people behind them to support them in retirement, let alone spend the economy out of its long term funk.

Is there a solution?

The best and ideal solution would be to return interest rates to normal levels. Of course, governments will not do this for fear that it would trigger another global economic crisis. One partial fix is to address the policy and entitlement inequities and unfairness that are prevalent today due to low interest rates and the subsidy from savers to borrowers. In the short term, entitlements should be structured on a “pay as you go” basis. In other words, governments have to discontinue the subsidy from those without benefits to those with the benefits. Every pension plan should be based on actuarial principles. And governments need to find a way to mitigate the tax on savers. While they roll back the subsidies for those with the entitlements, they should drastically increase the tax benefits for savers and particularly those without pension plans. This would encourage older workers to retire and open up jobs for young people. It might be one way to marginally level the inter-generational playing field. For reasons that may relate more to “political correctness” than good policy, at this stage we are not seeing any of the main political parties in Canada pick up these issues.

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