Time for voters to eat their spinach

December 28, 2017

With the recent revelation that Delaware tax revenues will exceed projections, the queue of worthwhile governmental expenditures grows by the day. Unfortunately, the state's current financial obligations preclude virtually all new government initiatives until the General Assembly makes a realistic budget assessment which necessarily will involve curtailing certain state expenditures before approaching taxpayers for additional revenues.

The greatest source of concern for lawmakers should be the state's pension and benefits promises to public service employees. While the state's public employee pension program is currently among the best funded of all the states, the actuarial solvency of the program is dependent upon the state achieving a 7 percent return on investment which is at best problematic. Indeed, most renowned stock market prognosticators, including John Bogle, formerly of Vanguard and hedge fund managers, such as Jeremy Grantham and Seth Klarman, have suggested that 3.5 to 4 percent is a more realistic rate of return for stocks over the coming decade. Actuarial assumption based on such a rate of return would likely result in a significantly underfunded pension program for the state.

Secondly, in order to achieve its current rate of return, the state is relying on an asset allocation model which is almost 50 percent equities and more than 20 percent alternate investments which includes certain derivatives. With stock markets at all-time highs and the national economy approaching full capacity, the stimulative effect of the prospective Republican tax reform may prove ephemeral. In any case, the state's current yield-seeking equity exposure begs the question as to what will happen to the pension program's solvency during the next and overdue cyclical downturn? Will the existing portfolio of alternative investments provide a significant hedge during such a recession and is such a strategy really the action of a prudent fiduciary?

Lastly, there remains the issue of Other Post Employment Benefits (healthcare). The state's fund for paying healthcare benefits is significantly underfunded. In order to fulfill its healthcare promises to current and prospective retirees, the state must significantly increase contributions to this fund. Fortunately, through timely and proactive actions, lawmakers may avoid disaster.

Reality-based budgeting is the first step. The state's budget must be adjusted to account for a pension fund which achieves 3.5 percent return on investment, not a 7 percent return. This will also enable the state to reduce its portfolio risk. Next, OPEB must be more aggressively funded. Existing promises to current state employees and pensioners should be sacrosanct, but the state will likely need to move away from a defined benefits scheme to more of a defined contribution scheme for future employees with the possible exception of police officers. Where possible, other economies of scale through consolidation need to be realized. Finally, taxpayers will likely need to be approached for additional revenues. Delaware may no longer be able to afford to be the home of tax-free shopping.

For generations, Delawareans have been shielded from the true costs of their government's operation. Many existing revenue sources are contracting. Corporate franchise receipts, which account for a quarter of the state's revenues, may be static moving forward as Delaware faces increased competition from other states and nations for a piece of the franchise tax pie. Delaware's unclaimed property laws are being challenged, and legacy industries such as banking credit card operations now constitute mature industries which no longer provide the generous tax revenues they once did. Certain Silver Bullet legislation may, once again, create a cash cow for the state, but no matter how meritorious and overdue certain initiatives such as legalizing marijuana may be, turning Delaware into Napa Valley East for weed will likely not prove to be the panacea for solving the state's revenue shortfalls. Rather, a government more frugal with taxpayer dollars, along with an active and engaged citizenry prepared to share the burdens of past promises and future dreams, is more likely to preserve Delaware's reputation as the diamond state. In other words, there is precious little candy for lawmakers to distribute in the form of political largesse to their constituents. It is time for voters to eat their spinach.

Brian F. Dolan

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