bonds. Bonds are sources of long-term income. As investors grow
older, they invest a greater percentage of their portfolios in bonds.
They are more concerned about income than they are about capital
appreciation. The louder the clock ticks, the more important income
is, compared to stock appreciation.
A major problem
for bond holders is the solvency of the issuing institution. Bond-rating
services are important for investors, including institutional buyers,
especially retirement fund managers. The less likely the ability
to repay, the lower the bond rating. The lower the bond rating,
the higher the rate of interest the issuing institution must pay.
that someone who has purchased bonds of an issuing agency whose
bond rating falls will suffer a loss of capital. The market value
of his bonds falls when the interest rate on newly issued bonds
rises. Bonds rise or fall in price inversely to the interest rate.
nation, municipal governments are facing downgrading of their bonds.
The reason is unexpected health care obligations for retired workers.
This problem is growing. There is no way out of it without governments
having to revoke promises, either to retired workers or to investors.
OF TAX EXEMPTION
of income tax-free returns has led millions of investors into buying
municipal bonds. In states with a state income tax, munis issued
by cities within that state are usually exempt from state income
taxes. This benefit seems great to rich people who have grown tired
of paying income taxes all of their adult lives. So, they choose
to buy munis instead of higher-interest taxable bonds. They enjoy
the pleasure of not having to report this income to the tax authorities.
tax revenues from income generated by various local municipal bonds,
the Federal and state governments have granted an implicit subsidy
to the debt instruments of local governments. This has encouraged
local governments to issue more debt than they otherwise would have.
They would have had to pay out higher rates of interest than they
actually agreed to pay. This higher cost would have made additional
debt issues less likely.
the bait of a lower tax burden. The municipalities took the bait
of lower interest rates paid by income tax-free debt instruments.
The result: lots of debt.
with this arrangement is that municipal governments are run by politicians
who want to be re-elected. Their time frame is relatively short:
the next election. They know that they will not be in office if
the obligations to pay off the bonds begin to squeeze the local
budget. They stay in office by delivering what appear to be free
services to local voters. So, they are tempted to issue debt as
a way of buying votes in the next election without personally suffering
the political consequences when the future debts come due. This
tends to increase the level of municipal debt.
A bond is a
promise to pay investors. The longer the debt repayment period,
the more likely it is that the debt level will increase because
of the time perspective of politicians, who issue debt and promote
bond issues to the voters. The politicians vote in terms of their
personal time perspective — the next election — on behalf of an
impersonal entity that in theory is immortal: the city government.
Just as the
hope of income tax-free returns lures investors into buying municipal
bonds that pay a lower rate of interest than corporate bonds of
equal risk ratings, so is the lure of free health care in old age
for municipal workers. They have for decades accepted wages that
are lower than those paid to employees in profit-seeking firms because
of the seemingly superior health care benefits that municipal governments
offer to their workers and retired workers.
investors make an assumption: municipal governments will fulfil
their obligations because they can tax residents to meet the payment
schedule. Because a city government can tax residents, investors
assume that residents cannot escape.
make an assumption: residents will have no choice but honor their
obligations to retired workers.
make an assumption: politicians will not increase the debt obligations
of the government to levels unsustainable by future tax revenues.
make an assumption: tomorrow will not come during their terms in
office. Different elected officials will be in office when the bills
thought of default is not on the minds of any of the participants.
They all assume that the municipality will always be able to meet
its contractual obligations. The system of negative sanctions known
as bankruptcy is widely assumed by all participants as somehow not
applying to municipal governments.
There is confidence
that governments can somehow escape the laws of economics. Somehow,
income will always be there for governments to tap. Somehow, obligations
will not exceed revenues. Somehow, the bills will not come due.
From time to
time, there is a newspaper report, probably run in the section on
city or county government, that raises the question of solvency.
A local reporter files a story on a report by some committee on
the escalating fiscal burden of employee retirement programs, especially
the portion associated with health care insurance. The story surveys
the fact of rising health care costs and compares this with expected
these stories, if at all, with no sense of alarm. They figure they
can always move away if the local tax burden gets too high. They
don’t think of what this legal tax burden will do to local property
values. This unintended consequence is never mentioned in the article.
Readers see rising prices on property, and they conclude that there
will always be someone ready to buy their homes, no matter what
the property tax burden is.
In other words,
they discount the risks of the future. So do local politicians.
So do bond investors. So do employees of the local government. So
do retired employees.
This is the
great threat of debt in our era. People do not believe that governments
will default. They assume that political promises to pay will be
honored by voters in the future. After all, these promises have
been honored so far.
June 10, 2007 story run by the Los Angeles Times, “Public
sector reels at retiree healthcare tab,” a reporter dutifully reported
on growing evidence that municipal governments have run up bills
to municipal employees on a scale that the public has not imagined.
began with a human-interest story. An 83-year-old San Diego woman
who suffers from hallucinations if she doesn’t receive her medicine.
She also suffers from cancer and diabetes. She is now facing homelessness.
She had been a county employee. She has a $1,000 a month pension.
She also has medical coverage for whatever Medicare does not cover.
The story says she may lose this coverage. “Where has compassion
gone?” she asks.
It has little
to do with compassion. It has to do with politics. This woman made
the mistake of confusing compassion and politics. So have tens of
millions of Americans who are dependent on government payments for
work performed or taxes paid decades ago.
The issue is
contract, not compassion. The courts cannot measure compassion.
They can read contracts. If courts allow politicians to break contracts,
those who are dependent on former political contracts are at risk.
Social Security obligations are unfunded. Some estimates are that
these two programs are unfunded in the range of $70 trillion. Yet
these obligations are not counted as part of the on-budget debt
of the United States government. This figure is in the range of
Why the discrepancy?
Legally, it exists because the U.S. government says that Medicare
and Social Security obligations, unlike public debt in the form
of T-bills and T-bonds held by the public and the Federal Reserve
System, do not constitute legal obligations of the United States
government. Some future Congress may reduce the payments. That is
have obligations to retirees analogous to the obligations of the
U.S. government to retirees. The courts are far less willing to
enforce these contracts, compared to bonds.
The trade unions
of course will battle any such unilateral default. But these unions
are growing less and less powerful over time. As voters grow tired
of the burdens imposed by retired workers, the municipal workers’
unions will face a restricted market.
not enamored of trade unions in our day. Well over 85% of all American
workers are not represented by trade unions. Most of those who are
represented by unions are government employees. Voters who are not
union members are not reliable supporters of tax policies whose
main beneficiaries are retired city or county workers.
obligation of the Los Angeles Unified School District for health
care coverage is in the hundreds of millions of dollars, the article
reports. “These costs are just crushing,” said district general
counsel Kevin Reed.
Over the next
three decades, the state of California is facing annual payouts
of a billion dollars a year, and maybe more.
County’s retiree healthcare tab is on track to grow larger than
the value of all its assets by 2012, according to a government
report, which would make the county at that point “technically
This is not
way into the distant future. This is in the next five years. And
the flow of red ink is just getting started.
In just four
years ending in fiscal 2004—05, the cost of providing healthcare
to the average Los Angeles County retiree doubled. By 2011, government
retiree healthcare costs statewide are projected to be nearly
triple those in 2004.
are now in the process of re-negotiating contracts regarding health
costs for retirees. The era of such benefits is coming to an end
in the private sector. But it seems to persist in the public sector.
It will not persist for long. When taxpayers see their property
taxes rise and the value of their homes fall, they will be in no
mood to suffer escalating capital losses because of promises made
to municipal unions a generation ago.
of California estimates that the price tag for providing such
health benefits has reached more than $500,000 for a married retiree
and spouse who live 20 years after retiring. Because many government
employees retire before 60 and since life expectancies continue
to grow, the cost could easily reach $1 million for some employees.
This is not
going to happen. Any retiree who expects it to happen is living
in a fantasy world. Voters will not suffer capital losses and ever-rising
taxes in order to maintain contractual obligations negotiated in
better fiscal days.
is a matter of voluntary considerations and individual circumstances.
It has to do with charity. “Where has compassion gone?” It went
away a long time ago, when union members decided that contracts
negotiated on the threat of organized simultaneous walkouts by workers
became a substitute for compassion. When political power was substituted
for compassion, compassion moved off the scene.
cites a statement from an employee of an accounting firm that helps
municipal governments track their future obligations. “I can’t tell
you how surprised many of our clients have been,” he said.
Accounting actually matters. But politicians have paid little attention
to accounting. Neither have union leaders, who for years could take
credit for negotiating on-paper successes in future health care
retirement benefits. Neither have retirees.
How large are
the benefits? Consider this. The article describes a retired employee
of San Diego County who served 30 years. At the time of his retirement,
he was earning $80,000 a year. His retirement pension is $70,000
a year, plus the health care benefits.
officials are considering a plan to reduce the health care benefits
of high-salaried employees. This of course is a means test. It is
a clear violation of contract. The municipal union is fighting this
decision. But the union is not in a strong bargaining position.
The county charter allows the retirement board to cut off retirement
benefits to all retirees in one fell swoop.
County has no such loophole. State law prohibits this. It is facing
costs of $20 billion over the next 30 years.
There is some
talk that the various governments should put aside present revenues
to pay future obligations. This has not been done in the past. Will
this work? No.
California Health Care Foundation projects that, thanks to skyrocketing
healthcare costs, an upcoming surge of retirements and lengthening
life spans, the price to governments of continuing to provide
coverage at the current rate will increase 15% a year over the
next 15 years. Even if public employers had many billions to invest
— which they don’t — insurance costs will continue to rise much
faster than investment earnings, the foundation says.
battle looms among retirees, bond investors, and taxpayers.
bubble has obscured the future of housing prices in an era of huge
public employee retirement obligations.
This much is
certain: contracts will be violated. The question is: Which group
will be the biggest losers? Retirees, bond investors, or taxpayers?
When you consider
a place to live out your golden years, one consideration should
be local municipal bond obligations. Counties and cities without
a long tradition of bond issues are preferable to those that have
run up large liabilities. But equally important is the obligation
to retired workers.
are generally far more exposed to lawsuits for default and union
pressures than small towns are. They have run up larger bills. This
is another reason for retirees to get outside of large cities.
Don’t own a
home on the fringes of a tax-hungry city. Nonincorporated areas
are being swallowed up by cities, which don’t allow county residents
to vote on the absorption. County taxpayers are regarded as under-taxed
fish to catch. So, it is better to be in a small incorporated city.
This keeps urban debt monsters at bay.
are higher-risk investments than most investors believe. I think
it is much safer to buy a bond fund filled with bonds denominated
in currencies other than dollars. This way, you hedge your risk
against a depreciating dollar. You must pay income taxes on the
income. Better this than to pay the inflation tax when the dollar
is debased by the Federal Reserve System in order to pay off government
debts at all levels.
the dollar does not involve breaking any legal contracts. That’s
why it is so predictable, long term.