Wednesday, April 18, 2018

US Pension Fund Collapse?

Aaron Brown wrote a comment for Bloomberg View, U.S. Pension Fund Collapse Isn't a Distant Prospect. It Could Come in 5 Years:
Warnings about looming public pension disasters have regularly cropped up since the 1950s, pointing to problems 25 years or more down the line. To politicians and union leaders, the troubles were someone else's predicament. Then crisis fatigue set in as the big problem remained down the road.

Today, the hard stop is five to 10 years away, within the career plans of current officials. In the next decade, and probably within five years, some large states are going to face insolvency due to pensions, absent major changes.

There are some reassuring facts. Many states are in pretty good shape, and many others still have time and resources to fix things. There is no serious chance of retirees being impoverished. What's in doubt is whether states will pay promised benefits to retirees with large pensions or significant outside income or assets. Also, although most of the problem is created by politicians and union leaders cutting deals to promise future unfunded benefits to keep voters happy, there are also plenty of stories of politicians and union leaders risking their careers to stand up for honest pensions.

It's important to distinguish between actuarial problems (the present value of projected future benefit payments exceeds the funds set aside to pay them plus projected future contributions) and cash problems (not having the money to send out this month's checks). Actuarial problems are always debatable and usually involve the distant future. Cash shortfalls are undeniable and immediate.

New Jersey has $78 billion in its state pension fund, which is supposed to cover future payments with a present value of $280 billion. But that latter number is a projection. You can ignore it if you wish, or hope that soaring investment returns or a pandemic among retired workers will fix it. A more certain figure is that the $78 billion represents less than seven years of required cash payments.

If we extrapolate from the past, rather than use promises in the state budget, current employees plus the state will contribute about $25 billion over those seven years, which could provide another few years before the till is empty. But it will also add around $60 billion of future liabilities to current employees. The system probably breaks down before the pension fund gets to zero, for example if assets were to fall below $30 billion while projected future liabilities exceeded $300 billion. Even the most optimistic people would have to admit the situation is unsustainable. This could happen in three years in a bad stock market, or perhaps 10 with good stock returns. But fund assets are so low relative to payouts that good returns aren't that helpful.

The next phase of public pension reform will likely be touched off by a stock market decline that creates the real possibility of at least one state fund running out of cash within a couple of years. The math says that tax increases and spending cuts cannot do much. For one thing, as we learned from Detroit, at a certain point high taxes and poor services force people and businesses out. The numbers are just too big in some states to come out of the budgets. For another, voters won't stand for it. The voters in these states have refused for decades to pay the full costs of the services they were already enjoying; they're not going to have sudden conversions to paying full costs, plus the accumulated costs from the past. State constitutions will be amended if necessary and big legal battles will be fought. I cannot see any plausible scenario in which full promised benefits are paid.

I hope that the problems of the least responsible states will shock the rest of the country into more rational reforms. Actuarial problems 25 years in the future can be solved with only moderate pain today. Cash flow problems three years in the future require chainsaws, not pens. But history does not inspire confidence that warnings will be heeded.
You can read Brown's Bloomberg comment here along with his 14 footnotes which I removed above.

I share Mr. Brown's skepticism that profligate states are going to reform their public pensions any time soon. They won't. Either they'll pull an asinine Kentucky response, cutting defined-benefit plans to replace them with "cheaper" but much lousier defined-contribution plans, or they will pull an Illinois, emitting pension obligation bonds in perpetuity and become another American pension shithole.

How bad are things in Illinois? Last June, Illinois Policy cited the state's $250 billion pension debt as the main reason why Moody's Investor Service downgraded Illinois’ credit rating to Baa3, just one notch above a noninvestment-grade, or “junk,” rating.

More recently, the Herald & Review commented, Illinois has a $130 billion pension shortfall. Why aren't Gov. Bruce Rauner and J.B. Pritzker talking about it?

The simple reason is nobody wants to really slay this pension dragon. To do so requires serious compromise from the state, public-sector unions, and maybe even Illinois' taxpayers.

A big part of the problem which I alluded to in my comment on the US pension squeeze last month is the system is so corrupt on all sides that nobody wants to "fix" anything, just maintain the status quo as long as possible even though liabilities are soaring and cash flow problems will arise at one point.

It's not a matter of if but when. At one point, these chronically underfunded US public pensions will run into serious cash flow problems and either they will need to sell assets (at the wrong time) to cover pension payments or their state will need to emit pension obligation bonds and increase the contribution rate, cut benefits and increase property taxes to make up for the shortfall.

But all these measures are just prolonging the agony, placing a Band-Aid over a metastasized tumor. Unless these states adopt Canadian-style governance and more importantly, some form of a shared-risk model, these pension debts are only going to grow and constrain public finances.

In his comment above, Brown states "the next phase of public pension reform will likely be touched off by a stock market decline," but stock markets only figure into the asset side of the equation. As I keep telling my readers, pensions are all about managing assets and liabilities, and my biggest fear is when the pension storm cometh, interest rates will drop to a new secular low and liabilities will soar to unprecedented levels. And this will be the final nail in the coffin for chronically underfunded US public pensions.

But the situation isn't as dire as Brown and many others think. US public pensions may never adopt Canadian-style pension governance, separating public pensions from state governments, but they can start implementing sensible pension reforms, like implementing conditional inflation protection, a key element to Ontario Teachers' Pension Plan's success, making it young again.

Again, to do so requires compromise on all sides, including public-sector unions, but the alternative remains Kentucky or Illinois and that's a road to pension hell.

Lastly, MoneyStrong's Danielle DiMartino Booth put out a comment on Public Pensions & the Trolley Problem — The Impossibly Immoral Choices the Future Holds:


Take the time to read Danielle's comment, she understands the problem and that there are no easy solutions to the ongoing US public pension saga.

Will US public pension funds collapse? Of course not but the time for action is now and the solutions require some compromise from all sides because if these pensions do collapse, it not only spells doom for hardworking workers and pensioners who were promised a pension for life, it will significantly impact the US economy in a very negative way over the long run.

Below, Goldman Sachs's CEO Lloyd Blankfein told CNBC on Wednesday that "central banks all around the world are buying risky assets." This confirms my belief that another Black Swan event like 2008 is highly unlikely and that the Fed and other central banks are not even contemplating quantitative tightening in any serious way.

My only question is how long before central banks all over the world start buying pension obligation bonds? If you think it can never happen, I remind you that global bonds remain in the Twilight Zone and if things get really bad, central banks will continue buying risky assets to reflate the economy.

Update: After reading this comment, Lew Andrews of the Yankee Institute for Public Policy sent me this email response:
In response to your post, I wanted to make you aware of a study that Dr. Marty Lueken and I did for Connecticut’s Yankee Institute. It shows how a modest school choice policy generates enough annual savings ($385 million) to bail out our state’s underfunded teacher pensions. A group of us here in CT are pushing for a grand compromise with the public unions: allow school choice in return for a securely financed retirement.
You can find the study he is referring to here.  I note the following on page 4:
The state’s fiscal problems are especially aggravated by public pension plans which, in 2016, the American Legislative Exchange Council determined to be the most underfunded in America. The teacher ’s retirement system alone is only 59 percent funded, with pension debt exceeding $10.8 billion, or $19,000 for each student in the state.
Clearly, something needs to  be done in Connecticut and other states where underfunded public pensions are sapping public finances. Is a modest school choice policy the answer? Maybe not but it's an option worth considering. Still, I'd like to see structural changes at the pension level, including the adoption of conditional inflation protection.

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