Welcome to the 44th issue of Allison’s Ode to the Second Moment, a newsletter about the grave dangers of misspricing insurance.
You may not have heard about it, but Spanish pensions are in deep trouble—serious trouble. Spanish state pensions have a terrible combination of being exceedingly generous, an average 83% replacement rate, and facing unfavorable demographics, Spain has the world’s second oldest population after Japan. Reforms in 2013 increased the retirement age and encouraged people to work longer. But a generation of young, marginally-employed Spaniards means less tax revenue and a reckoning may be coming even sooner than projected.
The Socialist government proposed a financial transaction tax to help pay for pensions. This seems counter-productive to me. It is not realistic to rely on the government and younger taxpayers to finance generous pensions for all. Spain needs to diversify its sources of retirement income. About 50% of Spaniards receive some form of pension benefit from their employer, either a Defined Benefit or a Defined Contribution, but the contributions to these plans are small. Of course they are! Why would anyone bother contributing to a pension account at work if they expect a pension with an 83% replacement rate from the government?
Spain should grow and strengthen occupational pensions. Bigger occupational pension schemes gives the government room to reduce state pensions for high earners. Benefits in the private sector are pre-funded, which means the pension assets are invested in financial markets. Growing private pensions requires a healthy financial sector, which suggests a tax on finance isn’t such a great idea.
I shouldn’t throw stones
Tax reform in the US limited the size of the state and local (SALT) deductions on individual taxes. Brookings argues this may result in underfunded pensions because it leaves state governments with less space to increase taxes.
For the record, I support limiting the SALT deduction. After all, we keep saying we want a more progressive tax system and here it is. I think many people say they want a progressive tax system, but they don’t count themselves as high earners, even if they are.
If the concern is pension underfunding, then maybe the federal government can take a more active role in helping states close the gap. Perhaps the feds should offer tax-exempt status on pension bonds if states cut future benefits and pay their full contributions. I am not sure we need to keep a regressive deduction just so states can keep underfunding their pensions.
Long-term care insurance
One of the biggest risks in retirement is financing long-term care. People who reach retirement age are living longer than ever, but many aren’t living well and need constant care. In the last few decades, insurance companies sold long-term care policies to insure against the risk of needing such care. However, these insurers didn’t anticipate how many people would need long-term care, how expensive it would be, and how few people would let their coverage lapse. In short, the insurers underpriced these policies.
Now, the market for long term care policies is shrinking because offering these policies is so expensive. If you do have a policy, The Wall Street Journal reports, odds are your premiums are increasing—a lot.
Something needs to be done about this market. Americans are only getting older and needing more long-term care. If the insurance market totally implodes, then the burden will fall on family members and Medicaid. Neither of those solutions is good for the economy. It seems we need government intervention to make the private insurance market viable. I am not sure how it should work and I do not have any indication this a priority of the administration. I am just putting it out there.
Black-Scholes saves lives
Maybe that’s an overstatement. Here is an interesting story about the early days of the modern derivatives market in Chicago. Speculators in the wheat derivatives market, or “plungers” as they were called, gained and lost large fortunes on a dime. This is what happens when you have a thin market without any common way to estimate value. There was a mini-epidemic of plunger suicides.
This may be a spurious correlation, but the creation of Black-Scholes, which is a method to value to derivatives, coincided with the growth of the derivatives market, without a corresponding increase in suicides.
Economists have opinions
Zvi Bodie has some investment advice: buy TIPS and portfolio insurance; he suggests stock derivatives. He is not calling for a stock market crash yet, but says the market is “fully priced” and a correction will happen someday.
Alan Krueger thinks the labor market is dominated by monopsonists, a few powerful employers who depress wages. Krueger makes some compelling points, but I’d like to see evidence that workers are paid less than their marginal product.
Pension funds are betting on unrealistic investment returns . Actually, that's less of an opinion and more of a fact.
If you are looking for something to watch on Netflix, I suggest this documentary on the art market, Blurred lines. It features some of the biggest movers and shakers in the art world....and me! I am not a big art expert, just a fan. If you watch it, you might think Pension Geeks are cultured people who can hang with famous artists.
Also, a programing note: I am taking a six-week newsletter hiatus to finish my book about risk. You’ll hear more about that later.
See you in March, Pension Geeks!