Tuesday, January 29, 2019

Are US Public Pensions Cooked?

Eric Boehm of Reason reports, Can Public Pensions Survive the Next Recession?:
A decade of consistent economic growth lifted the major stock market indices to all-time highs in 2018. But even before the recent dip, many state pension plans were struggling to get back to where they were before the last recession. Unfunded pension debt across the 50 states totals a staggering $1.6 trillion, even by the plans' own (often overly rosy) accounting.

If a decade of positive investment returns can't fix what's wrong with America's public pension systems, how much worse could things get in the event of another downturn? That's what Greg Mennis, Susan Banta, and David Draine, three researchers at the Harvard Kennedy School, set out to determine. They subjected state pension plans to a series of stress tests meant to simulate the consequences of a variety of adverse economic climates over the next two decades, including everything from another major recession to merely lower-than-expected investment growth.

What they found isn't pretty.

"Public pension systems may be more vulnerable to an economic downturn than they have ever been," the trio of researchers concluded in a paper published by the Pew Charitable Trusts in 2018. Deeply indebted pension plans in places such as Kentucky and New Jersey face insolvency if annual returns average 5 percent for the foreseeable future rather than the higher (usually around 7 percent) rates the plans assume. In other words, it won't take much to tip those systems into bankruptcy.

If a major downturn does come, states such as Colorado, Ohio, and Pennsylvania—which are closer to the national average in terms of how well-funded their pensions are—could require "contributions that may be unaffordable" to avoid insolvency.

One of the only states that seems ready to survive fiscal troubles is Wisconsin, where the combination of low existing debt and a 401(k)-style defined benefit plan means unexpected costs would be manageable and shared between employees and taxpayers.

Mennis, Banta, and Draine argue convincingly that stress tests provide a better snapshot of the health of a state pension system than more traditional methods, such as looking at aggregate unfunded liabilities or the funding ratio—that is, the percentage of future liabilities projected to be covered by a combination of future contributions, taxes, and investment earnings. Those metrics can be gamed by making unreasonable assumptions of future investment growth, but stress testing is a reminder that the good times won't keep rolling forever.

Connecticut, Hawaii, New Jersey, and Virginia have passed legislation or adopted policy changes mandating annual stress-testing of public pension plans, while California and Washington have created informal guidelines establishing similar processes. More states should do the same.
Last June, I discussed the great pension train wreck where John Mauldin alluded to the Harvard study funded by Pew Charitable Trusts using “stress test” analysis, similar to what the Federal Reserve does for large banks.

Between you, me and the lamppost, things are going to get worse -- much, much worse -- for many chronically and not-so-chronically underfunded US public pensions when the next recession hits and you don't need fancy stress tests conducted by Harvard researchers to understand why, all you need is to think clearly about the facts.

First, when will the next recession hit? Earlier today, Jeff Cox of CNBC reported, Bond King Jeffrey Gundlach says we just got ‘the most recessionary signal’ yet:
Drooping consumer sentiment is pointing the way to a substantial economic slowdown, if history is any guide.

In particular, the gap between current sentiment and future expectations has blown out wider, according to the Conference Board’s Consumer Confidence Index released Tuesday.

While confidence in the broader confidence index remains strong, falling just slightly month over month, the Expectations Index tumbled from 97.7 to 87.3 from December. Since October, the expectations reading has plunged 24 percent. Conversely, the Present Situation Index is at 169.6, a nudge lower from December’s reading.

Such wide gaps have portended sharp declines in economic activity, as pointed out by several market observers, including DoubleLine Capital’s Jeffrey Gundlach, the so-called Bond King.

“The most recessionary signal at present is consumer future expectations relative to current conditions. It’s one of the worst readings ever,” he said in a tweet.



The difference between the two readings has only been wider three times in the survey’s history going back to 1967, according to Bespoke Investment Group. Those came in January through March of 2001, the final month being the beginning of a recession.

Moreover, when the gap between the Present Situation and Expectations indexes has exceeded 50 — it is currently at 82.3 — “recessions weren’t far behind,” wrote Bespoke’s Paul Hickey (click on image).


The partial government shutdown, which ended this week, was the longest in history and likely dented sentiment.

“Shock events such as government shutdowns (i.e. 2013) tend to have sharp, but temporary, impacts on consumer confidence,” Lynn Franco, senior director of economic indicators at The Conference Board, said in a statement. “Thus, it appears that this month’s decline is more the result of a temporary shock than a precursor to a significant slowdown in the coming months.”

But Hickey said investors would be wise to watch what appears to be a fragile economy closely. He said such disparities in present and future sentiment are the last indicators of growth that is in its latter stages.

“The stock market decline in December followed by the government shutdown undoubtedly had a negative impact on consumer sentiment in January, so the big gap in sentiment towards the present and future doesn’t guarantee that the US economy is on the cusp of a recession, but it does serve as a reminder that the economy is a lot slower now than it was a year ago,” he said in a note. “Therefore, the cushion to absorb any further weakness has worn thinner.”
No doubt, the US government shutdown did hit consumer confidence and this is a temporary shock (for now unless it closes again on February 15th). And some aren't convinced this is a good indicator to gauge whether a recession is coming:



Still, I'd heed the warning from Bespoke's Paul Hickey because the US economy is slowing and a lot more fragile going forward. The cumulative effects of nine rate hikes is taking its toll on the economy and anyone who tells you otherwise is living a fairy tale.

What else do you need to be looking at to know for sure if a major US recession is headed our way? Look for a curve steepening which will happen when the Fed begins cutting rates, sending the yield curve sharply higher (ht, Zero Hedge which didn't bother crediting Francois Trahan for these charts):



Last week, I had my annual lunch with Montreal's best bond trader, a fellow who runs his own hedge fund using his own capital and doesn't want to manage outside money. He treated me to a lunch at Milos which we both thoroughly enjoyed (best lunch special in the city by far).

Anyway, he was telling me how he was up 30% at one point last year but ended up 10%, which is still excellent but he told me flat out: "In order to make money in these markets, you need to swing trade bonds." I said the same goes for stocks (I was up 50%+ at one point last year swing trading and ended up 10% because I got greedy and didn't book my profits in September!).

He's neither bearish nor bullish on US bonds, still sees the 10-year note trading between 2% and 4% but he told me that right now his conviction trade is to go long the 5-year US bond and to short the 10-year Canadian bond. I cannot give you more details as to why but he's a sharp cookie so I'm not going to argue with him (one thing we agreed on is the Bank of Canada missed its chance to hike rates two years ago when it should have).

I told him I'm still bearish on Canada and so by extension, I'm long Canadian bonds and US bonds as I see a slowdown unfolding down south, one that will hit us hard in a year.

Anyway, I'm getting off course. Back to the topic at hand, the next US recession might hit us sooner than we think and that means rates will decline over the next two years.

By how much is anyone's guess but if the next crisis is bad, we might see a new secular low on the 10-year US Treasury note yield and that alone will hit many chronically and not-so-chronically underfunded US public pensions very hard. And if stocks and other risk assets get clobbered too, it will be a perfect storm for all pensions.

But remember, the decline in rates is much more of a factor when it comes to pension deficits for the simple reason that the duration of liabilities is a lot bigger than the duration of assets.

So, if you're going to "stress test" the funded status of US public pensions or any pension for that matter, you need to look at various scenarios where interest rates decline marginally or precipitously over the next two or three years.

I guarantee you a lot of US public pensions have not done this or if they have, they're not sharing their results because it will scare the bejesus out of their members.

What else haven't they done? Stress tests to gauge their liquidity risk if a major dislocation happens in public markets and they're forced to sell public and private market assets at the wrong time (echos of 2008!!). CPPIB's Mark Machin warned investors about this last week in Davos and he was absolutely right.

All this to say, I have serious doubts many chronically underfunded US public pensions will survive the next recession but it all depends on how bad it gets and how long it lasts.

To be sure, no pension will escape the effects of a bad recession but some are a lot more vulnerable than others because their funded status is well below the 80% that most experts consider sustainable.

In Canada, most of our large public pensions are either fully funded or close to it but they too will be hit if a bad recession strikes the US.

The big difference is Canada's large public pensions have the right governance and most have adopted the shared risk model (ex., adopted conditional inflation protection) to weather a really bad storm.

I wrote all about this last week when I went over the pros and cons of Canada's retirement system.

Malcolm Hamilton shared this with me after reading that comment:
I have one important clarification.

I did not advocate that the federal government issue 6% bonds to RRSPs, TFSAs and RPPs. I said that this is something that it could do if it wanted all Canadians to enjoy the treatment now reserved for federal public servants... i.e everyone earns a guaranteed 6% return made possible by huge risks borne by Canadian taxpayers. As you point out, this is irresponsible and unwise and the federal government should not seriously consider it. My point is that it is no more irresponsible or unwise than the DB pension plan that the federal government currently offers its employees.

DB plans are not the answer to our pension problems. Remember, a pension plan ceases to be a DB plan the minute that pensions or pension indexing depend on investment returns or funding positions.

Risk "sharing" is another dead end. Taxpayers should not be expected to share risks without sharing rewards, and employees will need to pay much more for their pensions if taxpayers are appropriately rewarded for the risks they bear.

The answer is to prospectively convert public sector DB plans and JSPPs (jointly sponsored pension plans) to Target Benefit Plans, where members bear all of the risks, including the risks that taxpayers now bear for free. The pension boards and pension managers can then sit down with unions and plan members and decide how much investment risk the plan should take now that members bear all of the risks as adjustments to their contributions and/or to their pensions. No more free lunch. Public sector employees and public sector pension plans would then enter the real world... the one where you can't solve all your problems by punting them to taxpayers.
I obviously disagree with him on target benefit plans as the way forward because I see them as glorified defined-contribution plans which I'm not fond of and stick to my proposal of  'more well-governed DB plans'.

Malcolm kept insisting:
So here's the problem with your position. You compare Target Benefit Plans to Defined Benefit Plans that cost twice as much. It's like comparing a Pontiac to a Porsche (I'm dating myself).

Properly priced, a public sector DB plan costs 40% of pay. By changing the guaranteed benefit to a target benefit that will be adjusted as circumstances require (by changing the level of the benefit or the indexing), we reduce the cost of the pension plan to 20% of pay. So yes, the DB pension is much more valuable. But it is much more valuable because it is much more expensive, not because it is a better plan design. I see no evidence that members will voluntarily pay the extra 20% of pay. I believe that most public sector employees would rather pay 20% of pay for the Target Benefit Plan than pay 40% of pay for the Defined Benefit Plan. In other words, the Target Benefit Plan is better value.

In support of my position, I draw your attention to the behavior of employees in DC plans that allow them to choose between safe investments (long term government bonds) and more risky ones. Virtually no retirement saver voluntarily invests all of their money, or even half of their money, in government bonds. When employees retire, few decide to buy annuities. They prefer to take investment risk and, by so doing, to strive for higher returns and, eventually, higher incomes. They could save twice as much and take less risk, but they choose not to do so.

I believe that the same will happen in Target Benefit Plans. The plans will invest in balanced portfolios that will typically deliver good returns and good pensions, but with no guarantees. The plans will take less risk than today's public sector DB plans because employees will no longer be able to pocket the reward for risks borne by the public - hence risk-taking will be less advantageous to plan members.

You may not understand this. You may not want to understand it. But this is how things work. If you feel differently, explain how the public is now rewarded for the investment risks it bears. Or perhaps you think that public employees deserve a free ride? As I wrote earlier, the federal government's DB plan is no different than telling federal employees that they can use 20% of their compensation to buy long term RRBs with 4% real interest rate while offering other Canadians a 1% real interest rate on the bonds they buy.
It's not that I 'don't understand or want to understand' but I can easily accuse Malcolm of the same, he doesn't want to understand my proposal of creating new, well-governed public DB plans with a shared-risk model so that private-sector workers can enjoy the same defined-benefit pension as the public sector employees.

Also, I sent Malcolm's comments to Jim Keohane, President and CEO of HOOPP, who shared this with me:
This is a bit of a “glass half empty “ view. You could also view it that prudent risk-taking, scale, good governance and good management allow Canadian model plans to provide good pensions for 20% of pay which would otherwise cost 40% of pay thus saving taxpayers 20% of pay.

The Federal Public service plan is unique in Canada in that the employer assumes all of the downside risk. Virtually every other public sector plan is a shared risk plan with contingent benefits. In the case of HOOPP, neither the employers or the province guarantee the pension. The only obligation the employer has is to pay their share of the annual contributions as long as they remain members of the plan (which is voluntary). When you consider that COLA (cost-of-living) is not guaranteed and can be reduced or eliminated should plan funding be insufficient, employees accept most of the risk of underfunding. The notion that taxpayers are taking all the risk and that plan members are getting all the benefit is simply not true.

What we should be focusing on is the efficiency of the conversion of pension savings into pension payments. Our recent research paper “The Value of a Good Pension” shows the efficiency of moving from individual savings plans to collective plans. If more Canadians were fortunate enough to be members of Canada model plans there would be a much larger pool of savings to pay pensions which would benefit all of Canadian society and taxpayers.
I completely agree with Jim on the value of a good pension and opening up the Canada model to more Canadians (ergo my proposal!) and I think his rebuttal to Malcolm is legitimate and very succinct.

Anyway, one thing is for sure, and both Malcolm and Jim will agree with me on this, Canada's large public pensions are in much better shape to weather the next storm relative to their US counterparts. I don't think that's up for debate.

Below, once again, CPPIB's CEO Mark Machin in Davos last week discussing where he thinks the institutional investor belongs in the Davos conversation, company sustainability, investment themes and his investment strategy with Bloomberg's Erik Schatzker.

Mark ends by expressing his concerns about what happens the next time there's a major dislocation in public markets and investors who hold too much private markets are forced to sell at the wrong time to meet their obligations (ie. Mind your liquidity risk!! Truth be told, this will present excellent opportunities for CPPIB if it happens).

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