Jane the Actuary Retirement

Forbes post, “A Refresher Course On 401(k) and IRA Taxation – For Joe Biden’s Advisors, Too”

Originally published at Forbes.com on September 4, 2020.

 

Let’s start from scratch: what are the tax advantages of a traditional or Roth 401(k) or IRA?

In both cases, they allow savers to avoid paying taxes on their investment returns.

In the case of a traditional IRA/401(k), they also allow savers to pay their taxes, ultimately, based on their total effective tax rate during their retirement, rather than their marginal tax rate at the time of their contribution.

In the case of a Roth account, they allow savers to “lock in” their current marginal tax rate. Savers who expect their tax rate to be higher in retirement because their current income is low only temporarily, or because they have many deductions (e.g., many children!), or even because they believe that income tax rates will increase across-the-board in the future, will find a Roth to be more attractive.

There are also some differences in terms of income limits and contribution restrictions but that’s neither here nor there, as far as taxation is concerned.

Now, in my prior “actuary-splainer”, I had emphasized the first of these elements, and, in particular, the math behind it, and I’ll restate it again due to confusion in the comments/feedback I received:

Contribution x Reduction Factor for Taxes x Increase Factor for Investment Returns

is the same as

Contribution x Increase Factor for Investment Returns x Reduction Factor for Taxes

by basic mathematical principles.

And this means that the “tax savings” is not the deduction a saver receives when first contributing the money to the account. If a saver has a tax rate of 30%, he or she doesn’t “save” 30% because those taxes will be paid later. There’s not even a convenient way to quantify the tax savings because it’s a matter of removing the extra taxes that would be paid on investment earnings, and it depends on the tax rates on investment earnings and the level of investment earnings over time. (I’ll refer you again to my prior explainer.) In the same way, there’s no single number to quantify the savings due to paying taxes on post-retirement total income instead of pre-retirement marginal rates, but this is also not a matter of “saving 30%.”

Also, to add another actuarial concept: does the government “lose” money by allowing 401(k) savers to defer paying taxes until retirement? To answer that question requires making an assumption: what discount rate (actuary-speak for interest rate) do you use for the math to calculate the “present value” of the future tax payment? If you calculate based on the same rate as for investment returns, the two amounts are the same. If you calculate based on a lower rate, like the current very low government bond rates, the future deferred taxes of a traditional 401(k) are worth more to the government, as a present value, and cost more for the taxpayer, than in a Roth account.

Which all brings us back to the Biden team’s proposal for replacing the 401(k) tax deduction with a credit.

In my original August 25 article, I relied on the Biden campaign website, a Roll Call article in which a member of the campaign staff discussed the plan, past proposals by think tanks/experts, and my own knowledge and experience. On August 26, a staff member at the Tax Foundation, Garrett Watson, wrote with more confidence (whether because of confirmation from the Biden team, he doesn’t say) about the proposal:

“Biden proposes converting the current deductibility of traditional retirement contributions into matching refundabletax credits for 401(k)s, individual retirement accounts (IRAs), and other types of traditional retirement vehicles, such as SIMPLE accounts. Biden’s proposal would eliminate deductible traditional contributions and instead provide a 26 percent refundable tax credit for each $1 contributed. The tax credit would be deposited into the taxpayer’s retirement account as a matching contribution. Existing contribution limits would remain, and Roth-style tax treatment would be unaffected.”

He further links to an AARP proposal from 2012, which includes the same provisions, but also specifies that “withdrawals from the accounts would continue to be taxed as ordinary income.”

Losing the ability to use pre-tax money to make contributions in exchange for a tax credit seems reasonable enough, but maintaining the 401(k) rules of taxing everything as ordinary income, then becomes double-taxation, to the extent that the initial taxation is greater than the credit received. Perhaps, more generously, the authors and explainers of these proposals really intend for these accounts to be taxed in the entirely ordinary way that a non-retirement mutual fund is, where only the investment earnings are taxed.

But once again, as with other similar explanations, Watson says, “a taxpayer in the top marginal tax bracket receives a $37 tax benefit for every $100 contributed into a retirement account, while a taxpayer in the bottom bracket would only get a $10 tax benefit for the same $100 contribution.”

And, once again, we know that this is wrong. A taxpayer in the top tax bracket receives a tax benefit equal to the savings in not paying taxes on investment returns, and in being able to pay taxes, eventually, at total effective rather than marginal tax rates.

Watson doesn’t seem to understand this. The AARP proposal doesn’t seem to. It is possible that the individual who calculated that a 26% credit would be revenue-neutral did indeed understand this (the Tax Policy Center calculations do recognize that the expenditures change over time, but don’t model the costs past 2040 so as to properly impact the impact of workers’ tax-paying on distributions in retirement) but still unclear. And if the individual who originally calculated that 26% figure didn’t get the math right, which I suspect is the case because that number just doesn’t look right, then the actual legislation will end up increasing federal spending or disappointing many supporters.

Which means — well, readers, I hope you understand 401(k) taxation a little better.

The question is, does Joe Biden’s team?

 

December 2024 Author’s note: the terms of my affiliation with Forbes enable me to republish materials on other sites, so I am updating my personal website by duplicating a selected portion of my Forbes writing here.

Jane the Actuary Retirement

Forbes post, “Forget Pension Obligation Bonds. Two Cities Are – No Joke – Leasing Their Streets To Fund Pensions.”

Originally published at Forbes.com on September 2, 2020.

 

It sounds preposterous, and the headline of a recent article here at Forbes by Marilyn Cohen is certainly eye-catching: “The Lunacy Of Using City Streets To Collateralize New Municipal Bond Deals.” And these aren’t just any municipal bond deals — two cities in California are issuing bonds with their own city streets as collateral to pay down their unfunded pension liabilities.

In West Covina, the city council voted to do so on July 7, as reported at the San Gabriel Valley Tribune. The city, a suburb of Los Angeles with a population of 100,000, a median household income of $71,200, and nearly $200 million in pension liabilities, is using the proceeds of $205 million in debt to pay off its own debt to CalPERS.

Likewise, according to the East Bay Times, the city of Torrance, also in suburban Los Angeles, population 150,000, median household income $80,900, pension debt $500 million, will issue $350 million in bonds. (See the formal report of the recommendation and the minutes of the July 28 city council meeting.)

Now, it turns out, they’re not turning their streets into toll roads, or giving bond-buyers the ability to “foreclose” or take control either now or in the future.

They’re using a bond-issuing mechanism called “lease revenue bonds.” We’re all used to cities paying for public works, stadiums, and the like by issuing bonds which are paid off by a dedicated revenue source — sewer bills, hotel taxes, etc. But lease revenue bonds are different. Here’s the layperson’s description at Charles Schwab:

“Lease revenue bonds are a unique structure in the muni market. Instead of issuing long-term debt, like general obligation bonds do, to finance improvements on a public facility, the municipality may enter into an arrangement that uses lease revenue bonds. Often a trust, not the municipality, issues bonds and generates revenues to pay the bonds back by leasing the facility to the municipality. The municipality will generally appropriate money during each budget session to meet the lease payment.

“Bonds backed by structures with lower essentiality and limited protections for appropriating funds will usually be lower-rated and have higher yields. Our opinion is to be cautious of bonds backed by lease revenues, as these bonds should be viewed more like general government bonds, not revenue bonds.”

This means that the city of San Francisco used lease revenue bonds to buy items ranging from hospital beds to a witness protection van. And Torrance and West Covina are each using these bonds to, in principle, lease their city streets to a special Financing Authority, which will pay the city their up-front money, and “rent” the streets back to the city for the 25 year term of the agreement, in order to pay off the bonds.

Despite the fact that the streets are nominally being “leased,” the bondholders will not have any particular rights to lay claim to the streets; despite their status as “collateral,” the bondholders can’t take them over and charge tolls if either city defaults on their “rent” payments. The city will simply pay the “rent” based on their ordinary tax revenue rather than any special purpose taxes. The “lease” component then becomes little more than a gimmick, a loophole, a way to use the existing “menu” of bond choices available to them in the most advantageous way possible, especially since, at least in California, “general obligation bonds” require voter approval.

(Lease revenue bonds exist at the state level, too; and a group opposing the construction of prisons has a helpful explainer on these due to their use for that purpose.)

What, then, is the purpose of a lease revenue bond in this case? The Bond Buyer explains that these are functionally pension obligation bonds, but can be implemented more quickly, citing Mike Meyer of NHA Advisors: “Depending on the legal structure, there may be added flexibility for use of proceeds to CalPERS or more strategic timing of investing in the market. . . . These things aren’t possible under a traditional POB structure.” At the same time, there’s a trade-off, as rating agencies rate pension obligation bonds more highly than lease revenue bonds. Brian Whitworth, director of Hilltop Securities, which underwrote the West Covina bonds, further claimed, “This is the fastest form which the city would be able to use and issue bonds.”

And why are the cities in such a hurry to issue these bonds? In one respect, it’s the same rationalization as appears every time pension obligation bonds pop up, the notion that they are “refinancing” a debt at a lower interest rate, because of the difference in rates between the bond rate, and the interest being accrued on the books, at the higher actuarial valuation rate — so, for example, a 7% rate appears to be dropped to a 4% rate due to the “savings” of “refinancing.” (See my explainer from 2019, when this was a hot topic in Chicago.) This is a mirage, though — since it’s all just a matter of how liabilities are accounted for; their true cost is the payment of pension benefits in the future, regardless of what the plan account is now. And the nature of a pension obligation bond, the hope to get a higher asset return for the money you’ve borrowed at a low bond rate, remains the same.

Now, to be sure, there is a further wrinkle in California. The state agency CalPERS manages their pensions, and prescribes a required annual contribution. This makes it all the more difficult to perceive that pension bonds’ “savings” come solely from the hope of higher asset returns than bond interest rates (which are, incidentally, fully-taxable rather than offering the investors the benefit being of tax-free).

And what are those annual contributions? The most up-to-date reports on the CalPERS website are from July 2019, based on June 30, 2018 and calculating the required contributions for the 2020 – 2021 plan year. The city of West Covina pension plan is 71% funded, but to pay down its underfunding and fund new accruals, must pay 44% of payroll. The West Covina public safety plan is 62% funded and requires a contribution of 74% of payroll to fund new accruals and pay down underfunding. The Torrance city pension is 79% funded with 24%-of-payroll contributions; the Torrance fire pension, 65% funded, 68%-of-payroll contributions; and the Torrance police pension, 62% funded, 78% of payroll contributions. What’s also important to know is that these high contributions are not the result of having to make up underfunding in an unreasonably-short period of time; the underfunding level as of 2008 was set at a 30 year amortization, and gains and losses since then are likewise given 30 years to be paid off. This means that the high contributions are simply a reflection of the high cost of the pensions themselves, and the tremendous impact of even marginally-poor funding levels.

 

December 2024 Author’s note: the terms of my affiliation with Forbes enable me to republish materials on other sites, so I am updating my personal website by duplicating a selected portion of my Forbes writing here.

Jane the Actuary General Interest

Don’t be fooled by “fair tax” ads!

https://media.defense.gov/2019/Feb/12/2002088973/-1/-1/0/181206-A-UM169-0001.JPG; https://www.dover.af.mil/News/Article/1755127/what-you-should-know-about-filing-2018-taxes/ (public domain/US gov)

Oh, the irony:  back in 2015, before Trumpism, long before the Illinois General Assembly placed on this November’s ballot a measure to enable a graduated income tax, I supported such a tax at my Patheos blog.  I called it “the Jane Tax Plan” and advocated for lots of tax brackets, with moderate increases from one to the next, so that there was never a point at which a jump from one bracket to the next felt punitive.  Separately, I wrote that, with respect to graduated income tax rates, ” is that it is most reasonable and appropriate to ask those who are most able to, to pay a disproportionate share of the total income tax burden.”

Which means that I might appear, were I to say, “vote no on the fair tax!” to be a hypocrite.

In reality, well, it’s a mess.

In principle, a graduated income tax is reasonable and appropriate, and, what’s more, it’s not appropriate for the state’s constitution to spell out what sorts of taxes are and aren’t permitted and, in particular, to mandate that any income tax be flat across all income levels.

In reality, I have serious doubts as to whether Illinois politicians can handle the responsibility that comes with this increased power.

It is, after all, well-established that states that succumb to temptation, end up with marginal tax rates on higher income levels so high that, first, they drive residents away, and, second, they are highly susceptible to swings in revenue, as the highest earners’ income fluctuates so much from year to year (bonuses, sales of stocks, etc.).  And the fact that the tax rates stay low(er) for low(er) earners creates a mindset that the possible tax revenue from higher earners is “free” money for the legislators’ spending wishes.

Of course, plenty of states manage to be responsible about their tax-rate-setting abilities.  But I simply don’t believe that Illinois is.

And with that in mind, let’s look at the message of the ads in support of this amendment, via the website “Vote Yes for Fairness.”

In the first place, of course, the label “fair tax” is so loaded as to be itself untrustworthy.  Why is a graduated income tax “fairer” than a flat tax?  As it happens, until Pritzker began his campaign, another group was using the “fair tax” moniker for a type of tax that Pritzker would surely label extremely unfair:  the swapping out of our existing national income tax and its replacement by a national consumption tax.  The website FairTax.org is still active, with the organization Americans for Fair Taxation, and the left-leaning Tax Policy Center, in 2015, wrote “The Trouble with the Fair Tax,” which rejects the tax because it would disproportionately impact lower-income workers.

But beyond that, here are that site’ promises, which are the same as in ads everywhere:

  • Bring our tax system up-to-date with the one used by a majority of states and the federal government
  • Lift the burden off of lower and middle-income Illinoisans by asking the wealthiest to pay their fair share
  • Require only individuals making over $250,000 a year to pay more
  • Ensure at least 97% of Illinoisans see their taxes cut or remain the same
  • Keep taxes the same or less for all small business owners making less than $250,000 a year in profit
  • Generate additional revenue to fund our schools and lower the property tax burden
  • Address Illinois’ structural budget deficit and put the state on the path toward fiscal sustainability
  • Make sure essential workers aren’t forced to pay the same tax rate as millionaires and billionaires

Are these claims legitimate?

In the last session of the General Assembly, they passed a law which sets new tax rates if the voters approve the graduated tax amendment.  These rates — which, incidentally, at the top level are not marginal tax rates at all but a jump to a new tax rate on all income — include a 0.05% drop in rate for taxpayers earning less than $100,000, allowing supporters to claim that their taxes will “drop” without acknowledging how little the drop will be.  Then, for those with incomes of $250,000 or over, rates increase from 4.95% to 7.75%, and then further to 7.9% for millionaires.  (Note that there is no differentiation between singles and couples.)

But these rates are not locked into the amendment.  Once authorized, the legislature can make any changes it likes, so that making promises such as “only individuals making over $250,000 per year [would] pay more” is extremely misleading.

In addition, that a graduated tax system may be more common than a flat tax is one thing — but that’s only one characteristic of tax systems.  As the Illinois Policy Institute reports, of those states with graduated income tax rates, it is actually a more common approach to use the marginal tax rate structure to reduce taxes on the lowest-income taxpayers than it is to “as the wealthiest to pay their fair share,” as the pro-amendment ads say.  10 states’ highest tax rate is for income of $20,000 or less.  8 states’ highest rates are at “middle class” income levels, between $30,000 – $73,710.  Only 15 states’ highest tax brackets start at upper-middle income levels, ranging from Oregon’s $125,000 to New York’s $1,077,550 bracket.  And, of course, if you’ve done the math, that leaves 18 states with flat rates.

Which means that “bring our tax system up-to-date with the one used by a majority of states and the federal government” is not really true.  A tax system in which the “wealthy” pay higher rates than most others is, generously, used by only 30% of states, or only 22% if you discard the states with top brackets in the $100,000’s range (4 states).

What’s it boil down to?

It boils down to, really, the fact that the untrustworthiness of Gov. Pritzker, House Speaker Mike Madigan, and everyone promoting the graduated income tax using this rhetoric and these misleading claims, makes a proposal that would otherwise be reasonable and appropriate, highly suspect indeed.

Jane the Actuary Retirement

Forbes post, “Can The Dutch Example Help Us Improve Long-Term Care And Manage Its Costs? Maybe.”

Originally published at Forbes.com on September 1, 2020.

 

Yes, the Netherlands! Some time ago (almost exactly a year ago, in fact), I started researching what eldercare looks like in other countries, and had put this article together but waited to publish it until I could provide a series of such articles. At the time, my interest was in eldercare per se, and especially how it fits into broader issues of “Medicare for all”/universal health care. But, in light of Trump’s (barely thought through and soundly attacked) proposal to pay for Social Security through general tax revenues, I’m looking at this in a new light, because it really addresses bigger questions of what the right way is to fund social insurance programs in general.

The Netherlands, as it happens, ranks tops in long-term care provision among developed countries — if your metric is total spending level, where it ranks first at 3.7% of GDP or projected future spending, or total projected spending in 2070, where it comes out at 6% of GDP, second only to Norway (7.1%). But are they getting their money’s worth from that spending, and are they protecting elders from the impoverishing effects of out-of-pocket spending, and their children from the burdens of caregiving? Let’s do a deeper dive.

It is not hard to find articles praising the Dutch approach to eldercare. Its “Dementia Village” has received considerable press (for example, at The Atlantic in 2014) for its patient-friendly approach of creating a secure, Truman Show-style community in which residents can spend time at the town square or the grocery store as well as individual homes styled in the manner of their youth. Likewise, an expert on eldercare at Access Health International described her experiences in a visit to the country in glowing terms:

“I visited a number of different care homes, homecare organizations, academic institutions, and eHealth providers, as well as the University Medical Center in Groningen. Throughout my time in the Netherlands, I noticed that innovative groups all shared fundamental ideas upon which they centered the delivery of care. The organizations I visited focused on wellbeing, wellness, and lifestyle choices. They focused less on the medical aspects of chronic and long term care. These groups did not consider themselves to be part of the curative branch of the healthcare system. These healthcare professionals wanted to focus on patients’ individual capabilities, freedom, autonomy, and wellness.

“For example, the care homes wanted to provide a nice home environment, with home cooked meals, small groups, interior design choices, and a personalized care routine. The care homes focused on providing tasty food, the freedom to go to bed and wake up at will, and an exterior environment that feels just like the environment in any city neighborhood. The homecare organizations strove to provide assistance, but only when individuals could not manage on their own. The nurses look first at a person’s capability to care for him or herself. Next, the nurses look to the neighborhood and what help neighbors might provide. Then the nurses reach out to relatives to see if they can be of assistance. As a final step, the nurses provide care.”

But it’s not quite that simple.

Here’s a brief overview of the FICA-equivalent taxes in the Netherlands, courtesy Social Security Programs Throughout the World, at the Social Security website.

  • For old age, disability, and survivor’s benefits (American Social Security-equivalent), the Dutch contribute 20% of pay up to a ceiling of EUR 33,994 (about USD 37,700). Employers pay 6.27% of pay up to EUR 54,614 (USD 60,600).
  • For medical, the system is a hybrid one and workers purchase private insurance. Employers pay 6.90% of covered payroll (no ceiling), and the government subsidizes benefits.
  • And for long-term care, workers pay 9.65% of earnings up to EUR 33,994 (about USD 37,700).

 

(Yes, that ceiling puts the American debates about the unfairness of the Social Security ceiling into perspective.)

Are you ready to pay nearly 10% of your paycheck up to a ceiling, to fund long-term care?

World Bank consultant Laurie Joshua provides a more detailed review of the Dutch system in her 2017 paper “Aging and Long Term Care Systems: A Review of Finance and Governance Arrangements in Europe, North America and Asia-Pacific” (yes, that’s a mouthful, and a handy source for information on other countries, too). The first social insurance benefit for long-term care, the Exceptional Medical Expenses Act (or AWBZ in its Dutch initialism) was implemented in 1968 and, in 2014, 5% of Dutch people received benefits through the program. However, the cost of the system had escalated, which the government initially attempted to control with budget caps until a 1999 ruling prohibited these, and costs grew from EUR 15.9 billion in 2001 to EUR 27.8 in 2014, despite cost-control efforts such as increases in copays required from middle- and upper-income families and tightening of eligibility criteria.

In 2015, the government wholly reformed the system through the Long-term Care Act (WLZ in its Dutch initialism), with a new administrative structure, shifts in which levels of government pay for which services, a move to home support rather than nursing homes wherever possible, and general cuts/freezes in reimbursement rates. One consequence? The English-language site Dutch News reported in 2017 that

“At least 40% of Dutch nursing homes and home nursing organisations are making a loss and overall profitability across the healthcare sector has more than halved, according to accountancy group EY,”

as reimbursement rates drop and (since the less-frail elderly are more often being cared for at home) nursing home residents need more help.

Separately, municipalities are required to provide care services, either directly or through a “personal budget” as well as providing support and coordination.

Finally, elder care is not free of charge, though its rates are based on income and, at a maximum, still considerably lower than American private-pay nursing home or home care costs, at EUR 2,301.40 (USD 2,500) per month. As a result, copayments by families amount to 8.7% of total spending.

So, on the one hand, taxes are higher but the direct out-of-pocket costs of care in the Netherlands are substantially lower than in the United States, and its systematized provision of home care and the efforts put into home-like nursing homes are appealing. On the other hand, the jury is still out whether its 2015 reform has managed to control costs to ensure its programs are sustainable in the long run — and the very fact that this reform was needed confirms that an expansive government program isn’t as simple as its proponents would like it to be.

 

December 2024 Author’s note: the terms of my affiliation with Forbes enable me to republish materials on other sites, so I am updating my personal website by duplicating a selected portion of my Forbes writing here.