The 99%ers: Part 5

USING PENSIONS TO ILLUSTRATE ISSUES MEASURING WEALTH

It can appear like magic, vanish like a ghost, or never show up at all. Here are some examples from people who might feel entitled to rant. I was working on the data for something else I’m doing. Here I’m using it to illustrate how important one non-traded asset is. Since mark-to-market doesn’t work on income streams, the approach is mark-to-current annuity value. It’s analogous to discounting to present value without having to generate a discount rate or longevity assumption.

In each case, I estimated the approximate value of defined benefits as if the individual retired today. They're decent estimates, but nothing more than illustrations. Given that simplifying assumptions and the approximations used to value medical benefits, they should not be used for anything beyond rough estimation of value.

The present value of Medicare and Social Security can’t be directly compared to these benefits because of differences in tax treatment. Similarly the values of their homes can’t be directly compared because of tax treatment and real estate commissions that would have to be paid before they could be converted to an annuity. I don’t have information on health coverage differences between policies: so, I just treat them all as annuities with values based on minimum cost options. There is a high probability that pre65 healthcare employers’ shares are underestimated since average employer costs were about $11,000 in 2010 for family coverage and the average employee share was between $2,000 and $3,000. I assume that none of the individuals have any debt. Spouses’ benefits are ignored totally.

Example a:
a) $2,600 starting at 62 years old - immediate annuity single life value = $441,306,
Medical coverage for an employee’s share until 65 = $28,800,
TOTAL about $470,000

Example b:
b) $2,673 starting at 60 years old – immediate joint annuity value (with wife) = $576,018
Full family medical coverage indefinitely = $156,000 for family coverage until 65 plus $342,853 post 65 for employer and employee share for total medical of $498,853
TOTAL about $1,075,000

Example c:
c) $232 starting at 65 years old - immediate annuity value = $36,565,
Medical coverage for the employee share indefinitely for two = $103,856,
TOTAL about $139,000

Example d:
d) $514 starting at 60 years old - immediate annuity value = $91,565,
No medical,
TOTAL at $92,000

I used these benefits because all were tax-free events, so they are comparable.

In these examples, the last two (“c” and “d”) have IRAs, 401(k)s, and other investments; neither “a” nor “b” chose to fund an IRA or 401(k) to a significant extent. (I don't know the exact sizes other than the assumed pension amount). The last two have interests in private businesses that aren't liquid (have no quoted price to use as a benchmark). Estimating the value of private businesses is beyond my pay grade. However, for the last two, whether they hold traditional IRAs, Roth IRAs, or taxable assets is important. It determines how much “wealth” they have to have in order to equalize the benefit that often is not considered wealth (pensions and medical benefits). (Some data relevant to the tax equalization issues will be presented later.)

These examples roughly parallel some actual cases. With minor differences, they all should be living reasonable lifestyles (no cat food consumption or going hungry). Yet, my guess is one or more of the last two would fall in the top 10% by wealth, maybe top 5% as measured by most wealth data. I’d also bet one or more knows people in that 1%. The people with the pensions probably fall near the bottom in “wealth” data if the data ignores pensions or attributes their value to the employer. The four examples include retirees, unemployed, and working stiffs. At times the individuals move between employment status categories.

They aren’t hurting in either absolute terms or relative to people their age. Yet, with a little effort and a mischievous bent, I could start a small class war among them. I could get them fighting, then go out later and collect the change that falls out of their pockets as they wrestle.

The vesting process is an interesting generational aspect to the redistribution issue. For example, Social Security and Medicare really changed the statistics on poverty and income among the aged. The generational aspect of redistribution is one where I think the young have a legitimate gripe. But, before calling it a grievance rather than just a gripe, one should perform this little exercise. Compare the wealth distribution to the income distribution, and then compare them to the consumption distribution. Across age cohorts, consumption differences can be, and at times have been, the opposite of wealth distribution.

Then do another exercise, calculate the present value of future earnings streams of the young. The young are quite wealthy, but their asset is their wage earning power. One often gets the impression that some of them didn’t expect to have to work hard. They should be out creating the jobs of the future, not bemoaning the fact that the jobs of the past are history.

Now to the issue related to taxes. I’m not a big fan of defined benefits plans, but that is totally a reflection of two things: 1) a dislike of the fact that pensions involve turning one’s savings over to Wall Street to manage (something that others may consider a plus), and 2) there are inherent conflicts of interest between all parties involved. On the other hand, one can’t dispute their three big benefits: they shift risk from the individual to the group, 2) there’s generally no “opt out,” or, worded differently, the participant has to save, and 3) what’s important for this discussion, they are incredibly tax efficient.

To adjust for potential differences in taxes, the closest equivalent would be wealth in a traditional IRA and/or 401(k) if contributions to both were deductible. (Note that other than tax treatment all other aspects of differences, even who made the contributions, are being ignored). The focus is on wealth that could then be annuitized with the same tax treatment.

Interestingly, those that rage against the rich sometimes confuse wealth and income. Neither the recipient of “a” nor “b” thinks of themselves as rich, but in the year in which the benefits begin, either individual would fall in the 1% by income if one includes increases in wealth in the income calculation. (The 1% income cut off is somewhere in the $350,000 and $500,000 range depending on the year used). However, as mentioned, the value of pensions is not generally attributed to the individual in wealth data, nor is its increase in value or vesting included in income statistics.

This is important because a lot of people who say tax the rich, actually mean tax those with high incomes in a given year. The 99%ers flip back and forth. The individual with high incomes (top 1%) have a limited overlap with the 1% by wealth. Many none wealthy are high income: they spend it all (big hats; no cattle is the saying in Texas, but a lot of the high income are in very high cost of living areas like northern New Jersey, NYC, etc.). The wealthy not in the high income group tend to be small business owners, franchise owners, and farmer.

The problem is if one wants to rage against the rich, it’s easy to change assumptions and come up with different numbers. For example in a resent liberal rant they used these figures: Membership in the 1 percent can be measured by wealth or by income. By household wealth, the cutoff point would be a projected $9 million in 2010, according to an analysis of the Federal Reserve Board’s Survey of Consumer Finances by Edward Wolff, an economist at New York University. The cutoff for annual household income would be about $700,000, Mr. Wolff said. (Using Internal Revenue Service figures, which count earnings differently, the Congressional Budget Office puts the earnings cutoff at $350,000 for the 1 percent in 2007. Conservative rants come up with figures that are lower than these projections for either wealth or income.

Interestingly, figures used to assist organizations plan marketing campaigns fall in between. The most interesting figures often focus on “liquid wealth.” Not surprisingly, since they exclude real estate and “private businesses, they are lower than either.

These are just numbers. To provide a way to give them more meaning, consider this: If an individual contributed the maximum allowed under IRA restrictions every year from when the IRA began in 1975 through 2010, the return would have to be greater than a compound annual rate of 8% in order to have $400,000 to annuitize. So, replicating “a”, “c”, or “d” is possible under ideal conditions for using an IRA. Not be eligible to contribute to an IRA one year, skip a year’s contribution, or start later than 1975, and “d” or “c” could still be replicated with a reasonable return assumption.

To replicate “b,” one would have to have been lucky enough to work for employers who offered a 401(k) for the entire period since the program began in1982, and been qualified and able to make the maximum contribution every year. (Note that the maximum contribution assumption is based on IRS guidelines on deductibility which can be more generous than individual plans). The return would have to have been slightly better than 8%. Miss a year, start late, work for a business that doesn’t offer a 401(k), change jobs, have a year where one couldn’t make the maximum deductible contribution, and the result will be less. Employer contribution would help. (Technically during the early year of the program there was a way to structure a 401(k) so that larger contributions were possible, but it was so rarely used as to be irrelevant).

The 401(k) program started in 1982 with very few employers; program restrictions preclude the maximum contribution by most employees; most small employers can’t afford the administrative cost of a 401(k); job changes are common and even if the new employer offers a 401(k), new employees usually have to wait to participate; and most importantly, the program is voluntary. So, it isn’t surprising that IRA and 401(k) data indicate balances well short of these theoretical maximums.

But, that only illustrates the point. If wealth data ignores pensions, attributes the wealth to the employer, or measures the pension by assets rather than benefits, the wealth data is very questionable. When viewed from individuals’ perspectives, even under ideal assumptions, the benefits often exceed the wealth most participants accumulate in programs that are somewhat comparable in terms of tax treatment (IRAs or 401(k)s).

The calculations above are based on the laws as they existed historically. Why start from the beginning of the IRA and 401(k) programs? Why not build the calculations from current more liberal rules? Two reason justify looking backward.

First, there is no reason to believe the current rules won’t be changed to restrict the programs again. After all, the reason the rules were restrictive in the past was because the rich might use the programs (take advantage of the loophole was the expression used). It isn’t at all clear that the same logic won’t be applied retrospectively, especially since the programs have been successful at letting working people accumulate wealth. Once some politicians realize people who take advantage of IRAs and 401(k)s have become “rich,” they may well decide that they don’t deserve the programs. Closing loopholes is so fashionable, there’s no guarantee these programs won’t be targeted.

Second, a substantial portion of the changes to IRA and 401(k) rules reflect adjustments to inflation and income levels. Projecting that they won’t be changed in the future implies an assumption about future economic performance (e.g., it won’t change enough to necessitate program changes). Since we’re talking about a 35 year time span, it seems better to just assume that in the future the programs will be changed in response to the economy similarly to how they were adjusted in the past. So, the past seems as good a guide as any alternative.

Given that many people in 401(k)s or contributing to IRAs can’t legally contribute the maximum amount each year, some tax adjustment consideration should be useful. What happens if one assumes one or more of the people in this example is one of the many Americans who never had access to a 401(k)? To simplify the discussion, assume they also couldn’t have an IRA (a situation that was common when the program was first enacted, but is now fairly rare).

The first thing to note is that once taxes are introduced, things get more complicated because one is forced to use the government’s arbitrary tax cycle. Nevertheless, one thing is clear. All the benefits vest over time and become wealth when they kick in. The vesting over time is analogous to capital gains. So, using the current capital gains rules, the wealth required as capital gains would have to be 15% larger. Then the wealth could be “realized” and converted into an equivalent income steam (i.e., annuitized). Here’s the complication, annuitizing creates a tax benefit (return of principal isn’t taxed). The benefits also have different tax characteristics depending on whether it’s a pension or medical coverage. Nevertheless, it provides an interesting comparison for those who get animated by differences in “wealth.”

If one ignores the vesting process for benefits and the accumulation process for capital gains, the benefits appear as a one year increase in wealth equivalent to fairly substantial income relative to the tax rate structure. Here are the 2011 tax tables. The table makes it easy to see which marginal tax bracket would apply to equivalent annual flows:

Tax Bracket/ Head of Household
10% Bracket = $0 – $12,150
15% Bracket = $12,150 – $46,250
25% Bracket = $46,250 – $119,400
28% Bracket = $119,400 – $193,350
33% Bracket = $193,350 – $379,150
35% Bracket = $379,150+

Since the tax issues only provide perspective, I haven’t bothered to show average tax rates. Average rates would be lower than marginal rate. This should, however, make clear why I referenced tax efficiency as a benefit of defined benefits programs.

Even ignoring tax efficiency, measuring wealth as an income stream has major implications for one’s perception of the wealth distribution. One’s assumptions about ownership of benefit streams, such as pensions, Medicare, and Social Security, have to be explicit. Unfortunately, they often aren’t. Worse yet, they often are intentionally ignored in order to score political points. The figures involved should also make one thing clear: How benefits are treated isn’t a trivial matter for data about either income or wealth distributions.

Count benefits as income in the year they begin (or capital gains in the year they’re realized, for that matter) and one gets one income distribution as well as wealth distribution. Count them as they vest (or appreciate) and the income distribution is different as is the wealth distribution. Ignore them as income or wealth and, not surprisingly, one gets a third set of distributions.

Keep in mind that I used pensions simply for convenience. It would be equally possible to do the same analysis with the same conclusion using Social Security or Medicare. It just would have been a lot more complicated.

As explained earlier in this posting, tax treatment, COLA indexing, and all the complexities associated with any government program make clean calculations of annuity values impossible. That presents problems since in aggregate Social Security provides more than half the income of people over 65 years old. In other words, half of the wealth of people over 65 is ignored in wealth distribution data. However, given almost universal coverage of Social Security and Medicare, wealth that isn’t counted as wealth is important to most Americans.

The 99%ers and many liberals who focus on redistributing income think they are responding to an important social development. In fact, to a large extent, they are just reacting to a tax code that recognizes some forms of income and wealth, but not others. To support their rant they’re ignoring Social Security, Medicare, Medicaid, etc. and misallocating the wealth of pensions.


In America, nothing is more indicative of this phenomenon than the intergenerational shift in poverty. Poverty used to be a concentrated among the aged. Now children living in poverty should be a greater concern. Does that sound political? It’s not. Given that children in poverty can’t vote, chasing erroneous impressions generated by the tax code has far greater political appeal. So, don’t expect the real issues to even make the political radar.