Orlando's Outlook: Can we talk about entitlement reform?

As of 09-18-2012

Philip J. Orlando, chief equity market strategist, examines why it’s so hard for us to tackle the tough issue of entitlement reform, and why it’s so important for us to overcome our reluctance.

El•e•phant in the room (phrase): An obvious major problem or issue people avoid discussing or acknowledging. (See also: “Entitlement reform”)

We’re going through an election year. It’s a time when the major players in Washington take great pains to ensure that they say exactly what they think the voters want to hear. More importantly, though, they avoid talking about any subject that might make people uncomfortable. And topping the taboo list is any substantive discussion of what needs to be done to deal with our growing national debt, and especially entitlement reform.

The numbers don’t lie
It’s been said that financial disagreements are the leading cause of divorce in the United States. That’s because people find it hard to talk about money, and find it even harder to compromise on common goals when it comes to spending. What started as a civil discussion at the kitchen table ends up as a messy fight in civil court. And the country as a whole is not much different.

Much of the noise out of Washington comes from the debate between those who want to cut spending and those who think that we need to raise taxes to solve our debt problems. Both sides have their arguments, but a historical analysis of the numbers shows the real problem is we’re spending too much. The Congressional Budget Office is projecting that if we continue on this path, by 2022, federal spending will equal approximately 24% of Gross Domestic Product (GDP), and revenues will be approximately 19% of GDP.

The accepted range for both spending and revenues over the last half century has been in the 18-20% of GDP range. That means projected revenues in 10 years—at 19% of GDP—will have rebounded back into the middle of that range, from a trough of about 15% in 2008 at the depths of the Great Recession. Spending, however, at a projected 24% of GDP by 2022, is well above the upper end of the normal range, although slightly lower than the peak of 25.2% established in 2009. To balance our federal budget, then, we need to generate a little more revenue, coupled with a lot of spending cuts.

The automatic cutoff valve
Rather than dealing directly with this issue, Congress has put in place an economic automatic cutoff valve, known as the “sequester,” which will automatically make the cuts if lawmakers don’t do it themselves. Under the Budget Control Act approved in 2011 as a compromise to raise the debt ceiling, if Congress cannot agree on $1.2 trillion in spending cuts before Jan. 1, 2013 the country would be forced into mandatory spending cuts, with across-the-board reductions to be split evenly between defense and nondefense discretionary spending. Of the total amount of U.S. government spending this year, approximately 17% is allocated to non-defense discretionary spending, from which fully half of the spending cuts mandated under the bill will come. Defense spending accounts for approximately 19% percent of the federal budget this year, from which the other half of the mandated cuts will come.

The automatic cuts, however, will not touch such entitlements as Social Security, Medicare and Medicaid even though they account for 58% of the federal budget. In our view, that’s an unbalanced way for the president to trim the budget. The only equitable way to cut spending on that order of magnitude without draconian cuts to vital programs involves the daunting prospect of including entitlements in the cutbacks.

Simply put, we have to accept the fact that entitlements are on a demographically unsustainable trajectory. The baby-boom generation is getting older and starting to retire, which is creating an increasingly larger draw on Social Security, Medicare and Medicaid, and the federal budget was not designed to handle that incremental strain.

Why not? When President Franklin Roosevelt started Social Security in the mid-1930s, an individual received full retirement benefits at age 65, but the average American died at age 62, not long enough to reap the benefits. Back then, for each person receiving Social Security benefits, 40 others contributed payroll taxes into the system, for a robust worker-to-retiree ratio of 40:1. But fast forward three generations, and because of advances in medicine, nutrition and exercise, the average American today lives to an age closer to 80 than 62. So the worker-to-beneficiary ratio is now 3:1, and in the next generation, it could shrink to 2:1. The system was never designed for a country in which so many people lived to be 80-years-old.

The situation with Medicare is much the same. When President Lyndon Johnson started Medicare in 1965, an individual received full health-care benefits at age 65, but the average American then died at age 69, so the system was designed to provide an average of four years of health benefits. Today, Medicare is providing 15 years—and counting—of health-care benefits. No wonder the system’s going bust.

No lack of proposals

Over the past two years, Congress has vetted five different tax and entitlement reform proposals, each of which could cut between $4 trillion to $6 trillion from the federal budget over a period of nine to 12 years, with the bulk of those savings coming through entitlement reform:

The Simpson-Bowles Deficit Reduction Commission Commissioned by President Obama in 2010, this 18-member bipartisan group proposed cutting federal spending to 20-21% of GDP by reforming Medicare and Social Security, cutting Defense spending and enhancing revenues to achieve $4 trillion in deficit reductions over 10 years.
Corker-McCaskill CAP Act The bipartisan Commitment to American Prosperity Act (CAP) was introduced by the Sens. Bob Corker (R-Tenn.) and Claire McCaskill (D-Mo.) to force Congress to dramatically cut spending by capping it at 20.6% of GDP over the next 10 years.
The Domenici-Rivlin Plan A bipartisan group chaired by former Senate Budget Committee Chairman Pete Domenici (R-N.M.) and former Clinton White House Budget Director Alice Rivlin proposed a 60-40 mix between spending cuts and tax increases to cut nearly $6 trillion from the deficit over the next nine years.
The Paul Ryan Plan Vice Presidential nominee and House Budget Committee Chairman Rep. Paul Ryan’s (R-Wis.) “Path to Prosperity” looks to simplify the personal and corporate tax code, reform entitlement spending and cap federal spending at 19-20% of GDP, thus cutting some $6 trillion from the deficit over the next decade.
The Senate’s Bipartisan Gang of Six Plan Democrats Dick Durbin (Ill.), Kent Conrad (N.D.), and Mark Warner (Va.) joined Republicans Saxby Chambliss (Ga.), Mike Crapo (Idaho) and Tom Coburn (Okla.) and proposed $3.7 trillion in balanced deficit reduction over the next decade.

Can we at least do something?
Our leaders have been presented with a number of plans (see accompanying sidebar to your right), but they’ve chosen to do nothing. Here are six common-sense measures we can take now to help us get a hold on our finances:

First, we have to accept the fact that Americans are living longer, and increase the retirement age to 70, and then index that figure even further if advancements in health and nutrition push life expectancy higher.
Second, we should establish means testing for benefits, so that those who have no need for benefits don’t end up getting them by default, which would allow the social safety net to support those who truly need it. Billionaire investor Warren Buffet, for instance, receives Social Security and Medicare benefits.
Third, over the last 60 years, cost-of-living adjustments (COLA) have been generously based on higher wage inflation, as opposed to more modest price inflation. By basing future increases on costs rather than wages, payroll tax receipts won’t keep falling behind benefit increases.
Fourth, the federal government can do a much better job of managing its money. The government generates an historical investment return of 1% to 2% managing cash. But a mix of Treasury securities and blue-chip stocks over the last 60 years—even given the bursting of the tech and housing bubbles over the past 12 years—would have generated annual returns of about 5% to 6%.
Fifth, the tax base from which we are drawing money to fund Social Security caps out at the first $110,000 of wages. If we increase that threshold to, say, $150,000, and then index it further for inflation, we could bring more money into the system.
Sixth, the IRA, 401(k) and 529 programs, for example, have been successful, tax-advantaged vehicles created over the past 40 years to encourage savings for retirement and college. We should expand these programs—and create new ones dedicated to health care—to help people generate more wealth, which would allow the government to means-test them out of the system, thus freeing up assets for the government to assist the truly needy.

These six common-sense measures would go a long way toward fixing the budget problem, and we believe there’s 80% bipartisan approval on most of these ideas in Congress right now. But no one has the spine to talk about these issues ahead of the election, for fear of upsetting an important group of voters. While President Obama seems to be indicating entitlement reform is an issue that he would consider discussing in a second term, he clearly wanted no part of the proposed “Grand Bargain” with House Speaker John Boehner last July or the Congressional Super Committee last Thanksgiving, when entitlement and tax reform could have easily become a reality. Gov. Romney, for his part, has stated that entitlement reform would be on his agenda if elected. It might be a good idea not to hold your breath, however. Nobody talks about the elephant in the room because there’s no easy way to get it out the door.