Monday, June 1, 2015

Compound interest: Simple math, complicated problem

One of my favorite quotes comes from American icon Albert Einstein, who, although German born, became an American citizen in 1940. Albert observed that, “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”

I believe this quote is especially applicable in this day and age where households, college students and government agencies are being overwhelmed by debt. Evidently, not enough people paid attention to Einstein.

It’s interesting that so many disregard the math by living beyond their means and borrowing too much money. Even our lawmakers — at virtually every level — continue to try legislating the impossible. At the end of the day, no matter how you try to alter math equations, real math ultimately becomes the reality.

Our neighbors across Lake Michigan in Rockford, Illinois, serve as a good example. The city recently tried to alter their pension commitments. As we all know, it happened here in Detroit. Many city retirees were forced to take reductions in their pension payouts.

But things went differently in Illinois. The state Supreme Court ruled that such a move violated the state constitution. As a result, Moody’s, the credit rating service, immediately downgraded Illinois’ debt to junk status. In simple terms, the state of Illinois has severe pension issues and it doesn’t have any viable financial solutions.

Chicago is in an especially dire situation. The city’s pension obligations are underfunded by some $20 billion. How can such a situation be solved? Well, you can raise taxes, cut the amount pensioners receive or increase the amount they pay in. Good luck with trying to make any of those options happen.

Sadly, this situation is occurring at the city and state level all over America. It appears that Illinois and California are the two states with the most insurmountable financial issues, in both cases caused primarily by underfunded pensions liabilities.

In our own beloved Michigan, I’m a bit concerned how some government agencies are tackling their underfunded pension problems. Looking back, the city of Detroit under Kwame Kirkpatrick borrowed over $1 billion to “solve” the pension problem. We all know how that ended.

But both Oakland County and, just recently, Macomb County also borrowed money to meet some of their obligations. Macomb County recently floated 24-year bonds at 3.5 percent. Mathematically, this means they need to invest the funds at a rate greater than 3.5 percent to come out ahead.

Is that an attainable goal? Possibly. In fact, it may even be probable that the outcome is favorable. But by no means is it a risk-free scenario.

Pensions are a great example of the impossibility of outsmarting the math. When most pensions were established, life expectancies were a lot less. Social Security is a good example of how increased life expectancies can impact finances.

Dartmouth University recently concluded that Social Security will likely have final issues much sooner than the official projection date of 2033. And that’s because people are living just over one year longer than government projections.

Albert Einstein understood the importance of mathematics and compound interest. At the end of the day, two plus two will always equal four no matter how much any individual or legislative body attempts to alter the equation.

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