The Trillion Dollar State Funding Gap?

Mandi Woodruff of Yahoo Finance reports, State pension funds face $1 trillion funding gap:
More depressing news for workers who depend on a pension to fund their retirement: State-run pension funds faced a $968 billion shortfall in 2013, up $54 billion from the year prior, according to a new report by The Pew Charitable Trusts. When local pension fund shortfalls are factored in, the total pension funding gap surpasses $1 trillion.

"Policy makers are going to need to find a way to address [this funding gap] and it’s going to have to come down to some kind of plan to pay it down in an orderly fashion," said David Draine, a senior researcher at Pew Charitable Trusts.

On average, state pension plans were only 74% funded. The implications for workers are huge. If states don’t find a way to fully fund pension plans, many workers who have dutifully paid into pension plans may not get back what they’ve put in and young workers may not get to participate at all.

Fewer than half of states were able to meet their required annual contributions to pension funds in 2013. New Jersey and Pennsylvania were the furthest behind— each was only able to make only half its annual funding contribution. As a result, more than one-third of their state pension funds were unfunded.

Overall funding rates were the worst in Illinois (with just 39% funded) and Kentucky (44%), where pension funding levels have declined for three years in a row. Just two states managed to finish the year with 100%-funded pensions: South Dakota and Wisconsin.

It should be noted that Pew’s report only looks at funding rates for 2013 and does not factor in the significant investment gains of 2014 (the S&P 500 index rose around 11% last year, according to data from FactSet). But even if it had, the budget shortfall would still likely exceed $900 billion, the report says.

They probably aren’t wrong on this point. In a recent analysis by Boston College’s Center for Retirement Research (CRR), researchers predicted that the pension funding rate would be 74% for 2014, the same rate as Pew’s report, which looked at 2013. If the market continues to improve, however, that funding level could reach 81% by the year 2018, CRR said.

To close the funding gap, like anyone who’s ever been overwhelmed by credit debt knows, states need to step up, Pew argues.

States have adopted pension funding standards that allow them to drag out their pension debts over a longer period of time (a maximum of 30 years) -- similar to homeowners who want to stretch out their mortgage payments as long as possible. The result is smaller payments that are easier to swallow but don’t actually put a significant dent in the principal debt.

“This is similar to the negative amortization loans some homeowners used in the run-up to the financial crisis,” the Pew report says. “Initial payments on those loans failed to pay down any principal, and homeowners fell deeper into debt as a result.”

To see how your state ranked, check out the report here.
In June 2012, I wrote an extensive comment on the pathetic state of state pension funds. Back then, the funding gap for U.S. state public employee retirement benefits climbed by $120 billion to $1.38 trillion in fiscal 2010, which was understandable given the 2008 crisis hit pensions' assets and liabilities as investments took a huge hit and bond yields tumbled to record lows.

Three years later we see that the situation hasn't drastically improved even though U.S. stocks are soaring to record highs. What gives? A few things. First and foremost, states have failed to top up public pensions for years which is why the situation has consistently deteriorated.

Second, the main driver of pension funding gaps is interest rates and with rates still hovering around historic lows, it's hard to see any significant improvement in state pension funding gaps. Worse, if another financial crisis hits markets, rates will go even lower and deflation will decimate all pensions.

Third, U.S. public pension funds are delusional, stubbornly clinging to their the pension rate-of-return fantasy which will force them to take greater risks in illiquid alternative investments to make their 7.5%-8% bogey. But illiquid alternatives are no panacea and I would heed the wise advice of Ron Mock, Ontario Teachers' President and CEO, and start scaling back on them at this time.

Interestingly, over in the Netherlands, Dutch regulators just lowered the average return pension funds are allowed to assume over the long run, forcing them to hike premiums to build up capital due to persistent low interest rates. The Dutch take their pensions seriously which is why they monitor pension funding gaps very closely to make sure the assumptions being used reflect current market conditions.

But in the United States, regulators pretty much turn a blind eye to public pension funding gaps and the assumed rate-of-return used to discount future liabilities. Instead, state politicians enact stupid policies like shifting employees to defined-contribution plans, further exacerbating pension poverty, or they "extend and pretend" by emitting pension obligation bonds, something which can turn out to be the next bigger short.

Finally, in my opinion, the problem with U.S. public pensions is they lack the proper governance to bring assets internally to lower costs. I wrote about this in the New York Times, arguing that until U.S. policymakers get the governance right and introduce risk-sharing in their plans (just like the Dutch do), state pensions are doomed for failure. 

Below, Bloomberg’s Betty Liu reports on Blackstone Group unloading real estate assets. Why is Blackstone selling real estate? Because they have smart managers which know when to buy and when to unload. It's that simple.