The Pension Storm Cometh?

The American Interest put out a warning, The Pension Storm Cometh:

Last April, we highlighted research from Joshua Rauh, a professor at Stanford’s Graduate School of Business, placing America’s state and local pension shortfall at an eye-popping $3.4 trillion. This year, Rauh has crunched the numbers again—and, despite a growing stock market, the situation has not improved. The Financial Times reports:

US cities and states face a “looming crisis” after the collective funding hole in the public pension system jumped by $434bn in just one year, raising fears of further Detroit-style bankruptcies.

According to academic research shared exclusively with FTfm, US public pension funds lack $3.85tn that they need to pay the retirement benefits of current and retired workers. […]

Big pension deficits have already contributed to the bankruptcy of several US cities, including Detroit. Puerto Rico, the US territory, this month declared a form of bankruptcy after amassing debt and pension obligations of $123bn.

The numbers are so grim that it is hard to see how America gets through the next recession and its aftermath without a wave of municipal bankruptcies. Public employee unions have managed to extract promises from state and local governments that are simply impossible to keep. And those governments have been papering over the extent of their obligations with accounting assumptions that are so overly-optimistic as to be deceptive.

Before the bankruptcies, however, there will be pain. School budgets will be cut, civil servant salaries will stagnate, welfare services will atrophy, new fines will be imposed, and infrastructure will be neglected as state legislatures and city councils try to make room in their budget for ballooning pension contributions.

If the governing class had shown more backbone, accounted for pensions more responsibly, imposed reasonable restrictions on union power, and distributed cutbacks more gradually, the situation might not be as dire as it is today. But now the pension vise is tightening fast, and it looks like decades of elite shortsightedness will come at a great cost, especially for the most vulnerable Americans.

Quite a scathing rebuke of America's governing class and I can't say I disagree with this comment except for one important point, the pension storm isn't coming, it's been here for years and will only get worse.

You can read professor Rauh's latest study, Hidden Debt, Hidden Deficits: 2017 Edition, to get informed on what is going on in terms of US public pension deficits. Below are the main findings of his study:

Despite the introduction of new accounting standards, the vast majority of state and local governments continue to understate their pension costs and liabilities by relying on investment return assumptions of 7-8 percent per year. This report applies market valuation to pension liabilities for 649 state and local pension funds. Considering only already-earned benefits and treating those liabilities as the guaranteed government debt that they are, I find that as of FY 2015 accrued unfunded liabilities of U.S. state and local pension systems are at least $3.846 trillion, or 2.8 times more than the value reflected in government disclosures. Furthermore, while total government employer contributions to pension systems were $111 billion in 2015, or 4.9 percent of state and local government own revenue, the true annual cost of keeping pension liabilities from rising would be approximately $289 billion or 12.7 percent of revenue. Applying the principles of financial economics reveals that states have large hidden unfunded liabilities and continue to run substantial hidden deficits by means of their pension systems.

The origins of this pension crisis can be traced back to the tech boom and bust of 1999-2002. Sure, the financial crisis of 2008 exacerbated pension deficits and exposed the severity of the crisis, but if you talk to smart people in the industry, like HOOPP's CEO Jim Keohane, they will tell you everything starting unraveling after the tech crash of 2000.

Whenever people talk about pensions, they typically focus on assets, not liabilities. This is a fundamental mistake because pensions are all about managing assets and liabilities. In short, it's about the funded status, stupid, not bragging about how much money your pension plan makes in any given year.

This is especially true in the US where you have mature, chronically underfunded pensions which are poorly governed. No matter what they do, they will never be able to invest their way back to fully-funded status.

Earlier this week, I discussed how New Jersey will divert lottery revenues from its state lottery to shore up its underfunded pensions. In my opinion, this is a dumb idea, a short-term fix which reminds me of cutting taxes to stimulate spending. Once those tax cuts dissipate and the stimulus wears off, the deficit gets larger and addressing it will require major cuts in fiscal spending.

Importantly, diverting state lottery revenues into an ailing, chronically underfunded state pension system without addressing the structural flaws of such a system is madness but it allows Gov. Christie to claim a major victory on tackling New Jersey's growing pension deficits while he simply kicks the can down the road.

What storm are pensions facing right now? It looks like the reflation trade is doomed, the next economic shoe is dropping in the US and the big picture is looking awfully scary with each passing day. Moreover, capitalists are scared, realizing they can't afford a trumped recovery.

And as if things can't get worse, look at this chart of US inflation expectations (5-year-5-year forward breakevens) that Bloomberg's Lisa Abramowicz tweeted earlier today (click on image):

Inflation? Reflation? The Fed will hike three times this year? Get real folks, global deflation is alive and well and rates are headed much lower in the second half of the year.

And the lower rates go, the higher pension liabilities go, which is why I keep warning pensions, deflation will decimate them (liabilities will soar and assets will plunge).

As far as these crazy markets, given my views on the reflation chimera and a potential US dollar crisis later this year or next year despite the recent selloff, I would be actively shorting emerging markets (EEM), Chinese (FXI), Industrials (XLI), Metal & Mining (XME), Energy (XLE) and Financial (XLF) shares. The only sector I like and trade now, and it's very volatile, is biotech (XBI) but technology (XLK) is also doing well, for now.

But as I stated plenty of times before, if you want to sleep well, buy US long bonds (TLT) and thank me later this year. In this environment, US bonds are still the ultimate diversifier and will save your portfolio from huge losses.

Despite the James Comey selloff today, I foresee very choppy markets this summer. Still, the risks of a reversal are high, so be prepared for a downturn and hedge your portfolio accordingly.

Of course, if quant funds have their way, we will see another melt-up like 1999-2000 where stock prices go parabolic. If that happens, the risks of a bigger downturn down the road will be magnified.

Bottom line: prepare for much lower returns ahead. The pension storm isn't coming, it's already here, gathering force and when the full hurricane strikes, many hard working people are going to see their pension benefits slashed. I'd rather people be prepared, not shocked and angry like Greek pensioners were when it happened to them.

Below, an older (2013) clip where Joshua Rauh, professor of finance at the Stanford Graduate School of Business, predicted a national crisis in public sector pensions within the next decade that will leave state and local governments bankrupt and taxpayers on the hook for trillions of dollars.

And while everyone in Washington is making a big stink on President Trump, the "Comey memo" and passing classified information to Russia, you should all watch this Tucker Carlson interview with professor Stephen Cohen that took place last night on FOX News.

Professor Cohen, an expert on Russia, claims there is an assault on President Trump from a "fourth branch of government" designed to undermine a US-Russia alliance against international terrorism.

I'm not a Trump supporter, think he's making plenty of dumb mistakes (like firing James Comey), but this interview is the only sensible thing I've seen on the television lately and decided to share it here.

In another recent interview, professor Cohen explained why going back to a Cold War with Russia is not a hot idea, and stated this as to why people don't want him on their TV and radio talk shows these days:

What passes for an intellectual class in America these days has decided to go into a state of panic about Russia reminiscent of the Cold War era. But unlike that era, we're not having a spirited debate of the issue, he said.

All this to say, everyone needs to look past Russian hysteria and think before accusing the President of the United States of being a Kremlin agent. This political storm will pass, the pension storm won't.