Storm survivors

Offshore financial centres have taken a battering recently, but they have shown remarkable resilience, says Matthew Valencia

Feb 16th 2013   




WHEN THE ECONOMIST INTELLIGENCE UNIT, a sister organisation of this newspaper, published the first bound edition of “Tax Havens and Their Uses” in 1975, a queue several blocks long formed outside The Economist’s bookshop in London. Interest in offshore financial centres (OFCs) kept growing over the following 20 years as dozens of new havens popped up, often with help from lawyers based in Wall Street or the City of London. Tax authorities did little to intervene. Beginning in the mid-1970s, Jerome Schneider, a well-knowntax planner”, hawked various tax-evasion schemes with impunity for more than 20 years, even advertising in airline magazines.



This tolerance ended in the late 1990s, when prosecutors began to catch up with Mr Schneider and his kind and the Organisation for Economic Co-operation and Development (OECD), a rich-country forum, declared war on “harmful tax competition”. Since then tax havens have been under sporadic attack, including two waves of blacklisting. In 2008-09 the G20 took up the cudgels, America put pressure on Swiss banks to reveal more about their customers and various tax authorities started paying for stolen information about offshore accounts.

 
Pressure on OFCs has since eased a little because they have all accepted, to differing degrees, that they need to exchange more information with their clients’ home countries. But they remain beleaguered as an increasingly confident band of “tax justicecampaigners pushes for more concerted action on tax evasion and avoidance, money-laundering and the proceeds of corruption.


Tax avoidance, the grey area between compliance and evasion, has shot up the political agenda. A recent cover of Private Eye, a British satirical magazine, caught the national mood, showing Santa Claus being booed for living offshore. Governments have been rushing out action plans. Britain has put tax compliance and corporate transparency at the top of its list of priorities for its presidency of the G8 this year. America’s media often suggest that Congress yank money back from tax havens to alleviate the nation’s fiscal woes.


The world has 50-60 active tax havens, mostly clustered in the Caribbean, parts of the United States (such as Delaware), Europe, South-East Asia and the Indian and Pacific oceans. They serve as domicile for more than 2m paper companies, thousands of banks, funds and insurers and at least half of all registered ships above 100 tonnes. The amount of money booked in those havens is unknowable, and so is the proportion that is illicit. The data gaps are “daunting”, says Gian Maria Milesi-Ferretti of the IMF. The Boston Consulting Group reckons that on paper roughly $8 trillion of private financial wealth out of a global total of $123 trillion sits offshore, but this excludes property, yachts and other fixed assets. James Henry, a former chief economist with McKinsey who advises the Tax Justice Network, a pressure group, believes the amount invested virtually tax-free offshore tops $21 trillion. His methodology is reasonably sophisticated but he admits his calculation is still “an exercise in night vision”.
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Once commercial transactions are factored in, the likely total for offshore wealth balloons. Over 30% of global foreign direct investment is booked through havens. Mr Milesi-Ferretti studied a group of 32 of them and found that international banks’ claims on these were of the same order as their claims on all emerging markets. Some OFCs are giants in certain kinds of business. The Cayman Islands (population 57,000) is the world’s leading hedge-fund domicile. Bermuda (population 65,000) is number one in reinsurance.


These two are famous but in many ways atypical. Many of their smaller competitors are what Jason Sharman, of Griffith University in Australia, calls “aspirational havens”: islands that turned to finance to reduce their reliance on tourism and agriculture, but have never got beyond selling a few thousand offshore companies a year.
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Evergreens


Nevertheless offshore finance has shown a “puzzling resilience”, confounding predictions of decline because of its supposed vulnerability to the regulatory clampdown imposed from outside, says Mr Sharman. An academic study last year found that OFCs’ foreign-owned deposits had actually risen slightly in 2007-11. Mr Sharman attributes their staying power to a growing clientele in Asia and other emerging markets which has offset a decline in America and Europe.



Offshore operators put the havens’ endurance down to their legitimate uses, such as their “tax-neutralrole in mediating international financial flows (of which more later) and the protection they offer from unstable or capricious governments—though they believe these uses are poorly understood.


Tax libertarians think the havens meet a need created by the complexity and punitive nature of some national tax codes. Their latest hero is Gérard Depardieu, who has taken Russian citizenship in protest against a proposed French supertax on the rich. Besides, they point out, OECD countries also compete on tax. Britain, for example, which has the second-lowest corporate-tax rate among the G8 (after Russia), recently cut it further.



Critics counter that the use of offshore centres involves more sleight of hand than genuine competition. Money is routed through them merely to shelter it from taxes, undermining collection in the client’s home country, where he will continue to benefit from tax-funded public services without paying his way.


Ultimately, says Nicholas Shaxson, one of the offshore industry’s most prominent critics, its appeal rests on “providing rich individuals and corporations with financial boltholes, where they can do things with their money that they wouldn’t be allowed to do at home”. He believes that legally enshrined secrecy is just as important to the havens’ success as low tax.



Individuals have a right to financial confidentiality, but only as long as they set about their business lawfully. When it comes to tax crimes, money-laundering and the like, such confidentiality needs to be set aside. Some OFCs still make this difficult, and layering by service providers compounds the problem: try penetrating a Belize bank account fronted by nominees that is owned by a shell company in the British Virgin Islands (BVI) that in turn is owned by a foundation in Panama. Over the past decade the bigger OFCs have co-operated more with foreign law-enforcement agencies, but progress is patchy, and offshore structures still crop up regularly in corruption and money-laundering cases. A recent example is the alleged use of Cayman companies as conduits for bribes to Saudis by a subsidiary of EADS, a European aerospace and defence company.

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The scale of the offshore industry’s dirty-money problem is hotly disputed. Economists at Global Financial Integrity, a research group founded by Raymond Baker, an authority on financial crime, reckon that developing countries alone suffered illicit financial outflowsdefined as money that is illegally earned, transferred or used—of at least $5.9 trillion over the past ten years. Some say this estimate is too high, but the figure is clearly substantial. What is less clear is the proportion that ends up in OFCs rather than in one of the laxer onshore jurisdictions.


Estimates of tax-revenue losses onshore are equally imprecise. Some think, for example, that Britain’stax gap”—the difference between tax owed and collected—is much bigger than the authorities care to admit: perhaps close to 7% of the total collected in 2010-11. On the other hand tax losses are sometimes overestimated, for instance by assuming that the full rate would have been paid if the money had been kept there.

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At a recent conference Malcolm Couch, an official from the Isle of Man, one of the more transparent tax havens, delivered a few home truths to an audience of offshore worthies. OFCs should acknowledge that they, along with some of the big onshore hubs, have “to some extent been hijacked” by illicit money, he said, and should not be surprised when they are attacked for robbing other countries of tax revenues. They need to tread carefully because they face “an inherent existential threat”.


This special report will argue that tax havens are indeed facing serious threats but are also being presented with some enticing opportunities, especially if they have strong links with emerging economies. The best-regulated of them are no longer merelysunny places for shady people”. They can reasonably feel aggrieved when they are lumped together with the dodgiest havens, or when onshore jurisdictions themselves fail to practise the financial rectitude they preach to their offshore rivals.


All the same, the OFCs will remain under intense pressure as tax compliance receives more political attention. They will have to show not only that they have cleaned up but that they are making a constructive contribution to the world economy.


Onshore financial centres

Not a palm tree in sight

Some onshore jurisdictions can be laxer than the offshore sort

Feb 16th 2013


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SAM KOIM, THE chairman of Papua New Guinea’s anti-corruption watchdog, raised eyebrows at a meeting of financial crime-fighters in Sydney last October when he described how officials from his country were systematicallyusing Australia as a Cayman Islands” by laundering a significant portion of corruptly obtained funds through Australian banks and property deals. Papuans were thought to be the largest property investors in Australia’s far north. He vowed to keep up the pressure on Australia until it stopped taking such business.


The traditional image of a tax haven is a palm-fringed Caribbean island, a chillier outcrop in the English Channel or a European microstate such as Monaco or Liechtenstein. But offshore is not so much a geographical concept as a set of activities and offerings.


What havens generally peddle is an escape from high taxes and strict regulation, along with easy incorporation and secrecy. Some of the biggest tax havens are in fact OECD economies, including America and Britain, that many would see as firmly onshore. They provide something the offshore islands cannot: a destination for money rather than a mere conduit, with first-world capital markets and banks backstopped by large numbers of taxpayers.
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Latin Americans have flocked to banks in Miami for decades, both for legitimate reasons of confidentiality (for instance, fears that details of wealth held at home could be leaked) and to dodge tax. A congressional investigator, asked where America keeps its dirtiest money, answers without hesitation: “Brickell” (Miami’s financial district).


Can this party go on? Under new IRS rules, from last month America’s banks have had to report interest payments to non-residents. In some circumstances this information could be shared with 80 countries that have information-exchange agreements with America. The regulations were bitterly opposed by Florida’s banks and politicians, who worried that Latin American depositors would flee in droves. They lost, victims of America’s need to offer some form of reciprocation as it presses foreign governments to provide details of Americans who hold money abroad. The scale of the withdrawals from Miami is not yet clear.


America’s other offshore speciality is shell-company registration. States such as Delaware and Nevada offer cheap, easy incorporation, with anonymity guaranteed. Registration agents do not even have to ask for ID, as they do in most tax havens. And what is not collected cannot be passed to the police, which is why criminals and debtors love American shells. Martin Kenney, a fraud-busting lawyer in the BVI, finds them harder to penetrate than vehicles in the Caribbean, where “there will at least be some sort of lead, even if only nominees, to help you start pounding through the layers.” Dodgy operators also like the air of legitimacy around an American company, and the ease with which shells can be used to open corporate bank accounts.


Delaware is America’s incorporation giant, with 945,000 active entities. It makes so much money from company fees that it does not need to levy taxes on sales or personal incomes. Like some of the classic offshore havens, it is a small state with an economy that relies heavily on services for non-residents. Its political class, left and right, is all in favour of crafting local laws to accommodate corporate customers. Registrations grew by an average of 7% a year in the decade to 2011, and anything that interferes with them is fought tooth and nail.


Delaware’s corporate spectrum is broad, with a few thousand public companies at one end, overseen by its world-renowned Chancery Court, and hundreds of thousands of tiny, opaque LLCs (limited-liability corporations) and partnerships at the other. Delaware lawyers say the sleazy reputation of the smaller entities is unjustified, and that many LLCs are created by respectable companies for joint ventures and property transactions. Jeffrey Bullock, Delaware’s secretary of state, insists that it has struck the right balance between curbing criminality and “paying deference to the millions of legitimate businesspeople who benefit” from hassle-free incorporation.


 
But according to a World Bank database, American shells are the most popular corporate vehicles among perpetrators of large-scale corruption. An avid user was Viktor Bout, known as the “Merchant of Death”, a convicted arms smuggler. In a study last year three academics, led by Griffith University’s Mr Sharman, approached shell-company providers around the world posing as corrupt officials and money-launderers.


They found that OECD countries were less compliant than tax havens with international standards on corporate transparency, that America was among the least compliant, and that Delaware was one of the worst states (with not a single fully compliant response). Investigators joke that Delaware stands for “Dollars and Euros Laundered And Washed At Reasonable Expense”.


A federal bill supported by Barack Obama, which would force states to collect information on beneficial owners (the human sort rather than “legal persons” such as trusts), has been stalled for several years. The formidable anti-reform coalition includes the national lawyers’ association and the United States Chamber of Commerce.


Britain, too, offers lax rules to crafty operators. A report last year by Global Witness, a campaigning group, highlighted the use of British shells as cover for allegedly corrupt funds originating in Central Asia. The main shareholder of one of the companies was a Russian who had died years before the company was registered. Other firms featured nominee shareholders and directors from the BVI and the Seychelles who were, as the authors put it, “paid to pimp their identities” (perfectly legally) for their customers to hide behind.


Investigators also point the finger at limited-liability partnerships, introduced in Britain a decade ago at the urging of accounting firms whose partners were hoping to dilute their long-standingjoint and severalliability. This corporate form has since been widely misused by people other than accountants to hide or shift dirty money. Most LLPs do not have to file tax returns, be audited or have real people as directors.


A 2011 report by Britain’s Financial Services Authority concluded that British banks suffered from serious flaws in their controls so that, knowingly or unknowingly, many of them were handling the proceeds of corruption. Most worrying, the regulator found there had been little progress in compliance since its previous review in 2001. And even as the British government bludgeons rich nationals who use offshore structures, it continues to offer wealthy residentnon-domsjuicy tax advantages.


The City of London first dabbled in offshore finance in the 1950s with the creation of the “euromarkets”—unregulated finance in dollars and other currencies outside their home markets. This grew rapidly, fuelled by Wall Street firms that used it to escape restrictions at home. The City’s offshore connections strengthened from the 1970s to the 1990s when British overseas territories in the Caribbean joined the crown dependencies of Jersey, Guernsey and the Isle of Man in tailoring their laws to attract deep-pocketed non-residents. Today London is at the centre of a vast hub-and-spoke system, with the offshore territories acting as feeders.


Banks in Jersey, for instance, who could not possibly find borrowers for all the deposits they take in, pump most of them into the Square Mile, where they finance a variety of activities at the big banks and securities firms.


Ronen Palan of London’s City University calls this “Britain’s second empire”, noting that one-third of all international deposits and investments flow through Britain and its offshore satellites. The strength of their relationship shows up in IMF data that make it clear Britain’s and America’s financial links to offshore centres are far closer than the euro area’s and Japan’s.


America has its own (smaller) offshore zone of influence. This includes the Marshall Islands, a former possession, which offers some particularly impenetrable corporate structures and is one of the five most secretive tax havens, according to a ranking by the Tax Justice Network. The islands’ corporate registry is run by a private company in Reston, Virginia, which casts an odd light on America’s relentless bashing of the tax regimes in Switzerland and the Cayman Islands.


Britain aside, the European Union has several other tax havens. Ireland is popular with mutual funds and tax-planning companies. The Netherlands is the world’s largest venue for tax-treaty shopping. Multinationals put foreign investment through Dutch holding companies to avoid withholding taxes on dividends. U2, a stadium-filling rock band, upset fans when it moved part of its business to the Netherlands to cut its tax bill.


Luxembourg has bigger and broader offshore offerings, hosting large numbers of “tax-efficientcorporate transactions and thousands of mutual funds with around $3.2 trillion in assets, though most are managed elsewhere. As in traditional tax havens, finance plays an outsized role in the economy: in a country of 525,000, some 13,000 jobs are linked to the fund industry alone.


Luxembourg works hard for new business. The Grand Duchy now presents a bigger competitive threat to the BVI than its Caribbean neighbours do, says a lawyer in Road Town.
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FATF chance
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Luxembourg has a poor record on tax transparency and combating financial crime. Along with Austria it has held out against full participation in the EU’s savings directive, under which members swap information on bank interest paid to each other’s citizens. Of all OECD countries, it is the furthest from meeting the requirements of the Financial Action Task Force (FATF), the multilateral body that sets standards for anti-money-laundering. And the rest of the OECD, in turn, is mostly less compliant than the leading OFCs (see chart 3).


This highlights a serious flaw in global anti-money-laundering standards. Small OFCs and developing countries have been arm-twisted into adopting a stringent set of rules, which they have done mostly without kicking up a fuss for fear of being blacklisted.


Meanwhile the advanced economies that insisted on the standards, and to which they are probably better suited, have been less conscientious in applying them. The majority of OECD countries are only partially compliant with the FATF standard on effective sanctions against failures of anti-money-laundering measures.



Richard Hay of Stikeman Elliott, who advises offshore law firms, suggests that these double standards, far from being accidental, are the result of “a policy of commercial hegemonydesigned to keep tax havens in their place.



How Not to Run a Pension

By John Mauldin

Feb 13, 2013



“The government is the prisoner of the bureaucracy. We have 4,021 associations and 6,200 codes. You simply cannot change things. There are 600,000 tax elements. No one really knows who pays what.”

– A journalist in Greece



For all the focus on the unfunded liabilities of Social Security and Medicare, there is another unfunded crisis brewing, and this one is in your own back yard. It’s coming to you even if you live outside of the US; it just might take a little longer to get there.


I wrote ten years ago that state and local pension funds might be underfunded by as much as $2 trillion. It turns out that I was being overly optimistic. New government research suggests that the figure might be as high as $3 trillion. But what if you take into account that retirees are living longer? An IMF study that we’ll look at in a few minutes does just that. And if we live a lot longer? Oh my. The problems are not universalsome cities and states will do fine, while others are already in deep kimchee – but it’s a big problem and getting worse.


At the end of the letter, I’ll add a personal note on housing. Longtime readers know that I was bearish on housing well before the bubble. I sold my home (for personal reasons) and decided to lease until things became more settled. I have said several times that I would tell you if and when I decided to buy a home. Now, I have put an offer in on an apartment and it has been accepted. But it’s more complicated than that. (Isn’t it always?)




How Not to Run a Pension


It is almost too easy to pick on California and Illinois, but I am going to do it anyway in order to create a teaching moment. Plus, this sorry tale will make us think about the nature of the social contract and the fabric of society. It would be almost be funny if it were not so serious.
Let’s start with a few paragraphs that appeared in the Wall Street Journal. Carl Demaio writes this week:


Consider California, where just 10 individual pensioners will cash $50 million in pension checks from state and local governments over the next 25 years. Already some 30,000 retired California government employees pull in pensions higher than $100,000 a year. One retired librarian in San Diego receives a $234,000 annual pension. Beach lifeguards in Orange County are retiring at age 51 with $108,000 annual pensions plus health-care benefits.


Note that those benefits are cost-of-living-adjusted. But the problem is not just in California; it is nationwide.


A 2011 study by the Congressional Research Service pegged the combined liabilities faced by state and local pension funds at over $3 trillion. That is more than all the bonded debt officially listed on state and local balance sheets combined. To put the issue in perspective, all the federal tax hikes approved by Congress on Jan. 1 would pay less than 20% of America's state and local pension debt over the next 10 years. (Wall Street Journal)


Another study by the Congressional Budget Office comes to the same general conclusion. You can read it here.


Steven Malanga wrote a powerful essay for the City Journal exposing the huge problems in just one California pension fund, CalPERS (California Public Employees’ Retirement System). It is a well-written chronicle of how one fund has locked California into a debt spiral that threatens the solvency of the state: The Pension Fund that Ate California.


It is almost impossible to read Malanga’s report without comparing it to Michael Lewis’ essay on Greece. For the past two weeks I have written about regulatory capture in Greece and how the Greeks must break the control of vested interests over government.


The corruption that Malanga chronicles is similar: the vested interest of public employee unions trying to get the “best deal” for their members is no different from what I described going on with various Greek industries. Whether it is Greek or California taxpayers, someone has to pay for all those promised benefits.


The State of California recently passed a “balanced budget.” But it is only balanced if you ignore the sound accounting practices detailed in the Congressional Research Service report cited above. And even that report assumes investment returns that CalPERS has not achieved for the last five years.


CalPERS manages $230 billion. The fund now calculates that it is underfunded by $80 billion. The management arrives at this number by assuming they will make 7.5% (which they only recently dropped from 7.75%). In 2009, they estimated that the fund was underfunded by only $49 billion. That means they missed their targets by $30 billion in a roaring bull market.


In a December 2011 study, former Democratic assemblyman Joe Nation, a public finance expert at Stanford University, estimated that CalPERS’s long-term pension debt is a sizable $170 billion if CalPERS achieves an average annual investment return of 6.2 percent in years to come. If the return is just 4.5 percent annually – a rate close to what more conservative private pensions often shoot for – the fund’s long-term liability rises to a forbidding $290 billion. (Malanga)


I was just in Norway. It has a sovereign fund that is larger than CalPERS but that benefits from some of the best management in the world. My talks with people involved in the fund and those who are very familiar with it suggest that they would be very happy to get 4% over the next 5-10 years.


And CalPERS ranks in the bottom 1% of all pension fund managers. Given all the resources they have, they are spectacularly bad at managing money. And when I saythey,” I mean the board of directors.



Malanga points out that CalPERS is a wholly owned subsidiary of the government-employee trade unions that control the board. He painstakingly chronicles the extent to which the unions dictate policy and investment decisions, leaving the professional management shackled.


Remember the Greek journalist who told us this?:


The government is the prisoner of the bureaucracy. We have 4,021 associations and 6,200 codes. You simply cannot change things. There are 600,000 tax elements. No one really knows who pays what.


The number of regulations differs from Greece to California, but the principle is the same: regulatory capture of the bureaucracy by government workers’ unions has handcuffed government, not just in California but all over the US.


Let’s think about what it means for a pension fund to be $290 billion underfunded in a state with a (plus or minus) $100 billion annual budget. And bear in mind that instead of the $3 billion a year in taxpayer support CalPERS assumes it will need, it could soon be 4-5 times that much.


Go to your own state budget and figure out how to carve out 10-15% from it. Given that a huge percentage goes to health care, education, and security, there is just not that muchwaste” in state budgets. And the states with pension problems tend to be the ones with higher taxes already.


CalPERS now consumes (or will shortly) more than the 23-campus California State University System, which gets $2 billion annually. And that is not the entire shortfall in California; it is just one fund, albeit the largest. Other funds have similar issues. Taxpayers’ costs are projected to rise to more than $7 billion by 2014-‘15 – if you believe the funds’ own expectations for investment returns. You shouldn’t.



Above we see a chart of projected CalPERS returns, showing what they would be over the next 30 years if they ran at 7.5% or 5% or 2.5% (hat tip to Mike Shedlock). The numbers on the left are in billions. The fund might be doing quite well in 30 years at a steadily compounded 7.5%, but at 2.5% or even 5%? Not so good.


The next chart shows that even if you assume a 5% return, you are down almost $1 trillion in 30 years.
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Think 5% or 2.5% is pessimistic? CalPERS made a 1% return over the past year it reported, to June 2012. In a bull market, thank you. Over the last five years? A negative 0.1%, basically flat. (CalPERS annual report)


Let me say a small word in defense of the CalPERSes of the world. If you are a fund this size, you don’t invest in the market; you are the market. The fund did very well in the ‘90s. CalPERS has lagged its peers badly, but I know of no very large ($50-100 billion+) public pension fund that has gotten 7.5% over the last five years. There may be one, but I can’t find it. Smaller funds can be more nimble in selecting investments. CalPERS has to invest an average of $230 million in 1,000 different assets and funds and strategies. That is an impossible task and one that will only get harder as it grows, which it must if it is to meet the needs of its 1.3 million (and swelling) current and future beneficiaries.


I must admit, it is fascinating to GoogleCalifornia pension problems.” You can spend hours swept up in the sheer scandal of it all. Hundreds of state employees who are managers and who theoretically get no overtime are allowed to work second jobs in their departments and get paid for them. Doctors in the prison system can make hundreds of thousands of extra dollars a year. Prison guards retire with $100,000 a year – and can then take another job and get more benefits from another pension fund! Cool.
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Stupid Government Tricks



Until this past January 1, California state employees were allowed to buyair time” of up to five years to shorten their required time on the job before they would qualify for a full pension. The rationale by CalPERS was that as long as the fund got 7.5% annually there would be no risk to the fund.


“Ultimately, we don’t truly know until everybody who has purchased dies,” said Amy Norris, a Calpers spokeswoman, referring to the size of the payouts. “Our actuaries say that it is safe to say it is cost-neutral at this point.” Fifty thousand employees have elected to participate.


California public-sector employees now earn approximately 30% more for doing the same jobs as workers in the private sector. California did pass some modest pension reforms last year, mostly affecting future workers and retirees. Current retirees saw no reductions. But within a few months legislation was introduced that exempted 20,000 workers, and unions are looking for other such exemptions. In a Democrat-controlled legislature, they could quite possibly pass.


Double dipping” is my personal favorite of the scams that are being run. Why not retire with your $100,000 pension and then take another job and earn another $100,000 pension? One San Jose police chief now gets over $400,000 a year, after he retired from his San Jose job and went to work in San Diego.


The current San Jose police chief will retire at 51 with a $150,000 pension, and he too can take another job, although he has “no immediate plans.” He is not alone.



Illinois Is Digging a VERY Deep Hole
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Illinois has a $33 billion state budget – and five pension funds that are officially underfunded by almost $100 billion. Remember that sky-high projection of investment returns by CalPERS? Illinois pension funds estimate they will earn anywhere from 7.5% to as much as 8.5%. But the state-employee fund made less than 0.1% last year, barely beating out CalPERS.


(By the way, you can see the projected returns of your state funds in a January 2013 NASRA Issue Brief. Scroll to the bottom. I was aghast to see that much of Texas was looking to make 8%! The Houston firefighters project 8.5%! I keep reading about problems with the funding of liabilities in Houston. As I said, this is a nationwide scandal. California and Illinois are just the easiest to pick on.)


Without 8% returns, the shortfall for the Texas Employees Retirement System (ERS) could be twice the current projections. The system is scheduled to pay out $133 billion between now and 2045. It has $11 billion. For these assets to cover future payouts, ERS would need to see average investment returns of 21.5% per year – or see big-time payouts from the government budget. Think they can find an extra $5 billion a year for the next 20 years? From a $30 billion budget? And get 8%?


But back to Illinois, which has a legal problem. It is one of two states (New York being the other) that in its Constitution is prohibited from impairing promised retiree benefits. This makes for a rather tough negotiating stance.


You can find the same exotic stories about large pensions in Illinois that you do in California; but it seems to me the pension for rank-and-file teachers is not overly generous, considering that they pay 9.5% of their salary into the pension fund, while the state is supposed to fund less than 10% of that amount and then doesn’t even manage to do that. Putting the teachers on Social Security would cost the state a lot more (6.2% in matching funds).


Yes, there are the 28 Illinois state troopers who retired at 51 and draw over $100,000 a year. And the politicians get eye-popping amounts, but their retirement fund is underfunded by 74%. Care to make a wager which pension fund gets enough money to survive, the teachers’ or the politicians’?


And while all this sounds delectably scandalous, it is actually very sad. Consider this story:


Last Thursday night, 57-year-old Dick Ingram, a bald guy in a dark suit, stepped onto the stage in a cramped, muggy auditorium at a south suburban high school. In his remarks to an audience full of teachers, Ingram repeated the same message he's been delivering for months: Be afraid. Be very afraid.


Ingram is in charge of Illinois’ biggest pension fund, called the Teachers Retirement System. With $52 billion in unfunded liabilities, it’s arguably worse off than any state pension fund in Illinoiswhich is saying something, considering Illinois has the worst-funded pensions in the country.


“I don’t think it’s any secret that finances in the state of Illinois are a train wreck,” he told the crowd of about 350 working and retired teachers. “We cannot, today, feel secure in telling a 45-year-old or a 25-year-old teacher in Illinois that they’re gonna get their pension,” he told the crowd. “We face the possibility, and the real likelihood, of insolvency.”


Several teachers at last week’s meeting excoriate[d] Ingram for talking too much, saying he’s just providing fodder to politicians who want to cut teachers’ retirement benefits.


But if you stop and consider what’s going on here, it’s pretty radical: Ingram, the guy in charge of the retirement savings for 370,000 people, is telling anyone who will listen that the money may not be there when they quit workingthat teachers, in his words, have “been getting screwed for decades.” (Illinois Public Media)


These teachers put in 9.5% of their salaries, and their retirement could be in jeopardy. Think about what it would be like to work for 35 years, doing the right thing and saving. You make your retirement plans, and then at some point, say 10 or 15 years into your career, the deal changes.


This is rubber-meets-road sort of stuff. Much of our society is finding itself severely burdened to meet past promises made by politicians. It is pretty easy to make them when you are spending someone else’s money, especially when that someone is 30 years in the future. Except that now the future is here. The bellwether is San Jose, whose citizens voted last year (70% in favor) to cut current pensions and benefits for municipal employees. That’s liberal, socially progressive San Jose, which finds itself under severe funding pressure just to fulfill basic city services.


I have talked about the “abuse” of the California pension system, with double-dipping by policemen, et al.except they are doing nothing illegal or even unethical. They are taking deals offered to them under terms both parties agreed to. The fault, dear Brutus, is not in our stars but in our politicians and we who elect them.
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Catastrophic Success
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Underfunded pensions are not a problem that is going to go away. Let’s assume that the secular bear market finally runs its course, the financial repression of the Fed and ECB ends, and interest rates go back to normal so that pension funds again have a chance at those juicy 7% returns. We make up for lost time with a few more dollars of funding, and then it’s problem solved, right? That is the line you hear from pension consultants.


But what almost no pension fund does is to plan for the current trend of people living longer to continue. We have added almost two years of life expectancy every decade for the past century, although the number of additional years you can expect to live if you make it to 65 is not as dramatic. Still, the increase is significant.


The International Monetary Fund did a study last year that asked, “What if we live three years longer by 2050?” That is far less than trend for the last century, but even that small increase yields some very interesting conclusions:


...if individuals live three years longer than expectedin line with underestimations in the past – the already large costs of aging could increase by another 50 percent, representing an additional cost of 50 percent of 2010 GDP in advanced economies and 25 percent of 2010 GDP in emerging economies. For private pension plans in the United States, such an increase in longevity could add 9 percent to their pension liabilities. Because the stock of pension liabilities is large, corporate pension sponsors would need to make many multiples of typical annual pension contributions to match these extra liabilities.


Thus, we may need to add 50% to the pension underfunding I highlighted earlier. It gets ugly. (You can access the IMF study and see commentary here.)


I can hear a few of you objecting that this is a problem that remains far in our future. Why worry about 2043? Well, because pension returns rely upon compound interest, the eighth wonder of the world. A dollar in a pension fund doubles every 10 years at 7.5%, and in 30 years that dollar invested now is $8. If we wait for ten years to invest it, it only becomes $4 in 30 years. And there will be only $2 in the pot if we wait 20 years to find out that today’s retirees are living another three years on average.


Pensions require initial savings and compound interest to work. If you fail to properly fund your pension or if you get low returns, your retirement will suffer. We all know that is the case for private funds, but it is the same for public funds as well. Taxpayers will have to make up the difference if returns are lower or benefits rise due to longer lives.


Or retirees will not get what they were promised. Ask Irish pensioners what a 15% cut in their pensions feels like. Ask people in any country that has seen the ravages of inflation.


When you sit down with your financial planner, you make assumptions about how long you will live. And then, if you are prudent, you make plans to live much longer than that. You want to make sure you will have enough funds to meet your needs for your entire life. And that means planning on living a few years longer than the average person in your family has in the past.


Yet we don’t do that with our pension funds. Just as we assume that the past performance of 8% returns in the last bull market will somehow materialize in our future, we also assume that the actuarial tables of the past will continue to apply, even though they have been regularly updated for a century.


Most of us would deem it a success if we lived ten years longer than the current average. Yet such a success on the personal level would be catastrophic for our pension funds, if we all managed it. Thus, living longer may turn out to be a catastrophic success!


I happen to be part of the bunch who thinks the biotech revolution is just beginning and that we will end up living a lot longer (on average) than anyone now expects, and be healthier to boot! Of course, the counterargument is that many of us won’t get there because we refuse to take care of the basics of eating right, exercising, not smoking, and taking our medicines.


Whatever your view on longevity, a three-year average increase over the next 40 years seems a most reasonable and conservative assumption – which means that every dollar our public and private pension funds save now is even more important for future retirees. Unless we want to burden our children and grandchildren in the rapidly approaching future, we need to deal with our pension issues today, before we find them consuming the funds we need for basic services or forcing tax increases that will hurt overall growth and job creation. The choices are difficult now, but they will only get harder if we wait.
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Time to Buy a House?
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Let’s move briefly to another topic. The lease on my home here in Dallas was going to be up at the end of this year, and I more or less intended not to renew it and to start to pay attention to what the housing market is doing, come fall. Then my landlord dropped me a note a few weeks ago saying he would let me out of my lease if I moved out in a month. He evidently thinks the real estate market is good in Dallas, which is what I am hearing from my realtor friends.


A few months ago I dropped by the new apartment of my good friend David Tice. (Some of you will remember him as the man who started and ran the Prudent Bear funds.) He had purchased two apartments in a local high-rise with stunning views of downtown Dallas, and combined them into one apartment. I fell in love with the energy of the views and the location.


As it turns out, I can get two adjoining spaces in the same building with slightly different views but still that dramatic downtown view I love. The odds of getting two adjoining apartments to come on the market at the same time are not high, so I decided to go ahead and accept the offer to move.


Prices have dropped considerably for comparable places in Dallas and are now beginning to find a market. So we made an offer, and it was accepted. Now comes the hard part: getting financing, taking on a construction project to turn the two units into one, finding a place to live in the meantime, and then moving.


I am finding out that financing is not straightforward. I asked my investment-banker friends what the loan would be and got quoted a very nice rate for a ten-year ARM. But the mortgage desk would not do it (this is a very large, name-brand bank). Since it is two apartments and two titles and someone is leasing one of the units right now, and since there will be significant construction costs, what I want to do does not fit into a simple, check-the-box home mortgage. No exceptions allowed! I was rather surprised that it would be that hard. I clearly qualified, or so I thought. I dropped back to punt, and the realtor quickly introduced me to two local banks that do custom projects like this. So that process begins this week.


Additionally, David (and another local friend) did something that I want to do, too. He got a yen-denominated loan. We are working out how to do that. (I would love to speak to a senior investment-bank executive of a large Japanese bank. I sense an opportunity here.)


As I promised years ago when I last talked about buying, I will let you know the details as they developcosts, interest rates, interim loans, etc. But at least here in the Dallas market (and I know it’s true in other markets as well), this bear is coming out of hibernation. Stay tuned.



Looking Over My Shoulder



The world doesn't sit still, and as you all know, neither do I. Each week I delve into 100-plus articles, economic forecasts, investment outlooks, financial reports, etc., all of which come to me through my own extensive network. My goal, of course, is to be constantly building on my own research, staying right on top of what's going on out there. This learning experience is a labor of love for me, and one I'm pleased to share with you through my Over My Shoulder service.


As I filter through my weekly reading, I pick out the 5-10 items that I think will be most important to your investments and money management. This research, compiled by my contacts, is generally information you will not come across in your own ongoing reading – and that's why I think you will find a subscription to Over My Shoulder very useful. Subscribers have given me very positive feedback, and I encourage you to join us in reading, thinking, and preparing for the events of 2013 – this most pivotal of years.



And now I face the joys of jury duty in a few hours, although no sane attorney would want me on a jury. At least I will get in some reading time, waiting for them to reject me. And with that I will hit the send button.


Your contemplating life more than usual analyst,


John Mauldin
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Copyright 2013 John Mauldin. All Rights Reserved.