Sunday 22 June 2008

Funding Greece’s Social Insurance System - Part I

I am constantly amazed when people – usually the elderly and the media – complain about Greek pensions or healthcare. Paradoxically, in cost-benefit terms, Greece has one of the most generous systems in the world. Consider that:

• Most Greek public pension and healthcare schemes are based on a single bi-monthly or monthly contribution that is not linked to wage levels but to years of registration in the fund;

• Under the old scheme, most taxpayers will pay in 25-30 years of contributions, before retiring as early as 50-55, when life expectancy is between 75-80 years;

• Most taxpayers will therefore take out far more than they will pay in in pensions alone, not counting healthcare costs.

Some protected classes, such as farmers and independent employees, chronically under-report their income, so the state is deprived of their financial contributions not only from pensions and healthcare, but also from income taxes, dealing a triple financial blow to the system. Other classes, such as government employees, have far more generous pensions schemes in terms of years of service and final pension payment indexes.

At my company, NAVIGATOR, we have several times attempted to calculate the actuarial costs of our healthcare and pension fund, TEBE (now under OAEE) in an effort to determine our future liabilities and what we need to do to prepare for retirement. Every time we ask TEBE how to calculate future contributions and eventual retirement levels, we receive an answer such as “TEBE doesn’t have that information – everything is changing, so we can’t give projections.”

So, we’ve tried developing our own actuarial model, which I’d like to share with you. Maybe you can spot some errors in our thinking, and help us design a better plan.

We have two partners (owners), Philip and Christine, registered in Greece under TEBE. Christine has been paying in since 1996; Philip since 2003. (Philip’s contributions in other countries are not counted in this model).

In Figure 1, I’ve charted our estimated contributions for both Philip and Christine, under the following assumptions:

a. Each partner pays in for 35 years;

b. The bi-monthly payment rises from the starting payment of EUR 250 and rises by approximately EUR 55 per year (based on contribution estimates from actual TEBE bills dating back to 1996);

c. Retirement occurs at 65 for Philip and 59 for Christine, after 35 years of contributions each.

Figure 1 shows that the cumulative contribution for both partners over 35 years is EUR 473,160, under the assumptions mentioned on annual contributions.

Let’s assume that TEBE achieves a 2% real annual interest rate by investing 100% of these contributions. This is highly unlikely, since the ratio of insured workers to retirees covered by TEBE is falling, and in fact TEBE has to use our contributions to pay for other TEBE retirees as well as hospital patients, pharmaceuticals and medical consultations.

This 2% income also assumes that TEBE has no administrative costs, but can gain maximum benefit from its tax contributions. This is obviously highly unlikely. But let’s give TEBE the benefit of the doubt and assume a 2% increase in real terms.

Figure 2 shows us that at 2% compounded annual interest, TEBE can gain EUR 664,272 by 2036 from the EUR 473,160 deposited by the two NAVIGATOR partners.

Now, let’s try to estimate pension benefits from the system. My accountant has informed me that after 35 years of payments, the two partners should be able to count on a monthly pension of EUR 1,020 in 2006 Euro (we will not adjust for inflation). According to the World Health Organisation (WHO), average life expectancy for women in Greece is 81.1 years, while for men it is 76.32 years. Let’s assume both partners live to the age of 80, and each draw down a starting pension of EUR 1,020 per month, adjusting for inflation at a rate of 3% each year.

Figure 3 shows us that the cumulative pension payments for both partners, in 2006 Euro, will be EUR 428,400, or 90.5% of own contributions, and 64.5% of accumulated capital.

So far, the TEBE pension covers pension costs costs. But what about health insurance and healthcare costs? TEBE offers cradle-to-grave healthcare insurance: nearly 100% of all pharmaceutical, surgery and medical consultation costs are free to the insured, including dependent spouses (if they are not covered by their own social insurance) and infants (up to age 18).

It’s impossible to predict such costs, but I’ve started at EUR 200 per year (total for both partners in 1996), and increased by:

- EUR 100 per year between 1996 and 2006 (2006 annual costs = EUR 1,200)
- EUR 200 per year between 2007 and 2051 (2051 annual costs = EUR 10,200)

Remember, these are for all medical costs (except teeth and eyes), including pharmaceuticals, consultations, hospitals and surgery, including family members. This represents the cost to the government for offering these services. So far, speaking empirically, the model works: between 1996 and 2007 we have spent EUR 10,700 on medical expenses, and this is without any major medical issue, i.e. it comprises only routine medical costs.

Figure 4 shows that cumulative costs to the Greek government will be EUR 268,700 for the two partners, to 2051.

Assuming these forecasts are correct, TEBE will receive a total income (compounded at 2% real interest) of EUR 664,272 from the two NAVIGATOR partners between 1996 and 2036. This assumes that it has no expenses, does not use this income to pay for the pensions and healthcare costs of other retirees or workers, and that the investment performance of 2% per year is stable. Yet between 1996 and 2051, it will pay out EUR 697,100 in benefits to the two partners. This presents an immediate lifetime deficit of EUR 32,828. This is seen in Figure 5, below.

Let’s not forget that these forecasts present an optimal case: that both partners are gainfully employed, that they pay their contributions on time, and that each partner can afford to pay an end-of-term annual TEBE payment of about EUR 12,200 each per year.

This case proves my initial claim: that the Greek social insurance system is remarkably generous, since clearly it will have to pay much more to each insured person that it is taking in. Let’s not forget that many beneficiaries of the system have retired far earlier, while others have not yet worked at all, but are claiming the pension of their deceased spouse.

This is a main reason why the OECD estimated – before the latest round of pension reforms – that Greece’s unfunded pension liabilities may be 200% of GDP, or over EUR 400 billion, in the pessimistic case. Given current demographic trends, with Greece’s population shrinking after 2012 and the ratio of workers to retirees falling below 2.0, conditions are almost certainly going to become worse.

So what to do? On the one hand, it’s clear that the government has to save more to cover future liabilities. On the other hand, it’s also clear that companies and individuals have to prepare for their retirement, using private funds to complement public funds. I’ll get into recommendations in another post. In the meantime, if anyone can spot any calculation errors, please let me know.

"Yes we can" or "No, we can't afford it?"

A number of articles has come out in recent weeks challenging the financial plans of the Democratic and Republican candidates for President. I'm glad to see this is finally getting some mainstream attention, because much of their platform appears divorced from the reality of the longer-term, structural problems affecting the economy.

Let's looks at some of these articles:

Paul Krugman's Op-Ed piece in the June 16th New York Times Fiscal Poison Pill looks at the Tax Policy Center's analysis of the two candidate's tax platform, and comes to the conclusion that $ 700 billion in added revenue over the next 10 years won't be enough to introduce universal healthcare.

The Economist ran an article entitled The battle of the pockets is joined in the June 14th edition quoting the same report. It offers a starker conclusion on the proposals: "The figures are debatable, but there is one clear difference. Mr. Obama's plan would redistribute cash to lower- and middle-income Americans, while Mr. McCain's would skew benefits towards the wealthy. That's something voters may find it easy to take a view on."

Lori Montgomery wrote a cogent article in the Washintgon Post entitled Big Promises Bump Into Budget Realities which offered a pointed reminder that even if the projections are correct, the rising deficit and total public debt will make major reforms difficult to implement. As she writes: "Good luck. Because, back in Washington, tax collections are slowing, the budget deficit is rising, and the national debt is approaching $10 trillion. Whoever wins the White House this fall, fiscal experts say, is likely to have a tough time enacting expensive new initiatives, be they tax cuts or health care reform."

All three articles are excellent and deserve attention. Yet I can't help thinking that we continue to look at very short term effects. We know that in the global market, the United States is facing declining manufacturing and service sector competitiveness, at least in relative terms. Why is offshoring taking place? Because it's cheaper and more effective to run insurance processing in Bangalore, India, or manufacture clothes in Zheijiang, China. That's also why the United States has a massive deficit in international trade in merchandise. Although the declining dollar will help manufactured product exports in the short term, this is a cyclical factor which betrays the longer-term decline in the American economy and public finance, and is not a welcome event.

We know that in terms of educational standards and attainment, the situation continues to be challenging, to say the least. The 2006 PISA study on educational performance shows that the United States scores significantly below other OECD countries in science knowledge at the secondary level. In higher education, the continually rising costs of a university degree are a major barrier to educational achievement. The tremendous regional variation in educational achievement and the method of financing public education at the state level (which relies extensively on property taxes in many areas) is a generator of inequality: rich neighbourhoods have rich schools; poor neighbourhoods have poor schools.

We know that the US is a very litigious society. The legal costs of doing business for companies and individual entrepreneurs continues to rise. One contact, a fund manager for a German investment firm, told me that he would not consider any investment in the United States below $ 10 million in value, because the legal compliance and due diligence costs were too high. Legal costs in certain sectors, such as healthcare, are a major driver not only of overall costs, but in corporate policy on providing treatment to certain categories of patients.

And finally, we know that the US may look like a single market, but the patchwork of state taxes, payroll taxes and federal taxes, as well as hundreds if not thousands of tax loopholes and special provisions, complicate the situation still further.

Yet if we look at the policy platforms of both candidates, we see a range of hollow promises which treat the symptoms, not the root causes of these problems:

a. "Tax reform" is usually code for tax breaks to supporters, rather than an objective look at international tax competitiveness and, more relevant, how tax income is used, and whether it is efficient or not. Right now, it is clearly not efficient, judging from the huge industry of accountants and offshore companies that exists to help Americans avoid taxes, sorry, I meant to say "file tax returns."

b. To reform the education system, we need a commitment on an objective measure for school funding (usually per student enrolled) as well as operating costs per location (a school in Manhattan costs more than a school in Duluth), and a system of getting that funding to the school. We need to remove property taxes from the equation, and ensure that in public education, every community receives the funding needed. The only way to do this is in the short term is to expand the role of Federal funding for primary, secondary and tertiary education. At present, the Federal allocation for education is $ 68.6 billion per year, which is only a fraction of state spending. Over the long term, the public funding system will need a paradigm change rather than short-term tinkering. Such a system change is possible over a 4-year administration (which is needed simply to build consensus and credibility), but then will require 10-15 years to implement. This must be a nonpartisan priority, because it is literally the future of the country. The Department of Education has made some good policy choices in this area, but funding for education must be increased, at least for the less well-resourced schools and universities - if results are to be seen.

c. Some type of legal liability cap needs to be introduced, although I am not at all aware of what this should be. Clearly, this conflicts with a range of Constitutional rights. On the other hand, the situation today is a parody of what a legal system should look like. Proposals on legal reform often hinge around (that is, founder) the ability of lawyers to contribute to political candidates, which shows you how broken the system has become.

d. In terms of manufacturing and general economic competitiveness, we have a big problems. America signed on to NAFTA and GATT (the precursor to the WTO) thinking that it's economic advantage would last into the future. Since then, competition has increased to unimaginable levels. South Korea, Japan, China - even Mexico and Canada - are now better manufacturers than the United States in key areas. In the last 10 years, US manufacturing has made quantum shifts in effectiveness: using lean manufacturing, automation and ERP systems, productivity is up and its share of GDP has remained important. However, it is losing competitiveness in two areas:

- Low value merchandise products, particularly those where high labour customisation is needed. The main factors here are vast manufacturing capacities established in China, Taiwan, and other countries.

- Higher-value products, where competitors are mastering the production value chain, and establishing dominance in key areas such as semi-conductors, consumer electronics, appliances and the automotive sector.

The situation is mixed, because part of the US merchandise deficit is attributed to US companies who are manufacturing offshore, and exporting to the United States. On the other hand, if we look at what's going on in China, South Korea, Taiwan and other powerhouses, it's clear that this is turning into a very one-sided race. The trade picture is complicated by the fact that at present, the US is leading in terms of complex, high value products, such as Boeing jets or General Dynamics vehicles. How long can this last?

We urgently need a long-term manufacturing scenario, a strategy/policy and real resources allocated to competitiveness. I don't mean necessarily mean subsidies, which I think in some cases would only worsen the situation. But we need to provide a competitive framework in the United States which makes it more profitable to produce (and employ) at home rather than export jobs, capacity and competencies. This is obviously a very complex area, and I don't have all the solutions ready to pull out of a hat.

Yet neither candidate mentions manufacturing competitiveness. There's a lot on trade competitiveness, but it's all about symptoms, not addressing the causes of the decline.

As I've said before, we should not be surprised if Barack Obama is not able to deliver what he has promised. This doesn't mean we shouldn't vote for him, but we do need to be aware of the painful economic reality that transcends political dogma and will be with us whoever wins the November 4th election.