| This is a long note... But it's an important topic... Read it.
Last Friday evening (27 September 2019), the government in Puerto Rico made an announcement to local retirees… Well actually, the announcement was to everyone, but retirees paid closest attention.
The announcement? Just that many of them will soon have their pensions cut.
Poof. Just like that.
The pension cut is part of a restructuring plan to help Puerto Rico emerge from the bankruptcy declared in May 2017. Bankruptcy can be a bit complicated, so let me explain.
When individuals, corporations, and even local governments load themselves up with so much debt that they can no longer make payments, they go through a legal process called bankruptcy. There's more than 1 kind of bankruptcy, but for our purposes here let's focus on what's known as a reorganization.
During the bankruptcy process, a judge temporarily relieves the bankrupt entity from making any principal or interest payments on their debt while all sides work out a solution to the problem. The bankrupt entity puts all of its assets and liabilities on the table, and then works with the debt holders to figure out a plan that everyone can accept… often painfully, but accept nonetheless.
Sometimes the bankruptcy process is successful. Occasionally you’ll hear about a big company (often an airline) ‘emerging from bankruptcy’. That means the company was able to work out a deal with its debt holders, i.e. the company agrees to sell some assets and cut costs in order to pay the bondholders, but the bondholders agree to take a loss and only recover, say, 50 cents on the dollar.
Once the deal is settled, the debt is struck from the company’s balance sheet like magic... it "emerges" and begins operating normally (hopefully prudently) again.
Sometimes, though, a deal can’t be struck. The Bankruptcy Court then appoints a special representative to liquidate the company’s assets and split up the proceeds among the bondholders.
Fortunately (unless you're a bondholder) governments can’t exactly do that. Bankruptcy courts don’t have the latitude to sell off police cars, fire trucks, roads, bridges, office buildings and elementary schools in order to repay government bondholders.
That’s why Puerto Rico’s debt negotiations have taken more than 2 years.
Puerto Rico has borrowed more than $70 billion... which is equivalent to nearly 70% of the territory’s GDP. Incidentally GDP is Gross Domestic Product which is “a monetary measure of the market value of all the final goods and services produced in a specific time period, often annually.”
Making payments on that $70 billion of debt was consuming nearly 30% of Puerto Rico's tax revenue every year.
That’s completely unsustainable, and declaring bankruptcy was inevitable.
When PR declared bankruptcy in 2017, it was the biggest bankruptcy case in US history. And also one of the most complicated. Again, the court couldn’t exactly ‘liquidate’ Puerto Rico and pay out the funds to bondholders.
So there’s been more than two years of wrangling between bondholders and all the various officials, pensions, unions, etc. Largely, about the size of the haircut that was gonna be taken by bondholders.
On Friday they announced the deal.
Bondholders will take a huge cut of more than 60%. That's like buying a single share of a $1,000 stock for "the long haul" and being told 2 years later that your stock is now only worth $400. Ouch…
Unfortunately, that's only 1 side of the pain ledger.
As part of the deal, many local retirees in Puerto Rico will also see their pensions cut. Pension payments are an enormous part of the Puerto Rico budget. And since the government doesn’t have the option of conjuring more money out of thin air, they had no choice but to cut pensions in order to free up cash to pay bondholders.
This opera is very likely coming north.
Just like Puerto Rico, the US government is heavily indebted... but much worse. Puerto Rico’s debt-to-GDP was ‘only’ 70%. The US federal government’s debt?
It exceeds 100% of GDP.
Get that? The US’ debt level exceeds the market value of all the final goods and services produced in the US annually.
And, just like Puerto Rico, the #1 most expensive item in the federal budget is retiree benefits (Social Security and Medicare) which, if you haven’t noticed is going nowhere but up.
The one difference is that the US federal government is able to kick the can a lot farther down the road. They have the ‘benefit’ of going deeper into debt because the Federal Reserve will just print more money to buy US government bonds.
But even that has limits.
Social Security is already cashflow negative, and the program’s giant trust funds are starting to deplete their cash reserves. It’s scheduled to run out of money in the next 15 years or so unless something dramatic is done to stem the tide.
There are simply too many retirees receiving benefits and not enough people paying into the system. And the spread increases daily. It’s simple arithmetic.
This isn’t just a US problem either.
A recent report from Citibank estimated that, among the world’s 20 wealthiest nations, the total pension gap is an eye-popping $78 TRILLION. And yes, that’s trillion with a T...
That makes Puerto Rico’s problem a speed bump by comparison.
And realistically there’s just no way for governments to solve a problem this large.
Their only hope is to do what Puerto Rico did: default on their promises and cut pensions… in some cases drastically.
Few people pay attention, though. It’s "too far out in the future."
Or so they think.
But just because something is far off doesn’t mean we can/should put it off.
Fortunately, there are a few things that you can do...
One of the most effective options available to you as an individual is setting up a more robust retirement structure. For example, you should have and always max out tax free (Roth IRA) and tax deferred (401k) accounts. Allowing your money to grow without the drag of taxes is one of the fastest ways to increase the size of your nest egg.
By the way, is it just me or is it weird that there’s a limit to how much you can put into your 401ks, IRAs and such each year?
If you don't have any savings to speak of and feel like you’re getting a late start, you can move up to $56,000 in qualifying income per year into the retirement type structures mentioned above. Then of course, you can use short term trading strategies to grow your accounts exponentially.
So even if you’re already 60, you could grow a ton of money for your retirement over the course of the next 5-10 years with something as simple as taking a few optimal trades each month… Not to mention any other side hustles you might have.
To be clear, this is not a fantasy… if you were to start with $1,000 in a tax free or tax deferred account next year and double the account annually for 10 years (not as hard as you think, I assure you), you would have more than $1,000,000 in the account at the end of those 10 years.
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