US Pensions Take Big Coronavirus Hit

Aaron Brown, a former managing director and head of financial market research at AQR Capital Management and author of The Poker Face of Wall Street wrote a Bloomberg op-ed on how US pension funds will take a big coronavirus hit:
The coronavirus crisis is still unfolding, but it’s not too soon to think about lasting financial impact and how to limit the fallout. One major financial crisis that may hit later this year or early in 2021 is the ever-looming collapse in state and local employee pension funds. Although the problem has been growing for decades, the virus may have been the event that pushed it over the edge.

Declines in the financial markets may have cost the funds as much as $1 trillion in assets, or about 25% of their total, according to Moody’s Investors Service. That would bring the aggregate funding ratio—value of assets divided by actuarial value of liabilities—from 52% based on the last report by the Census Bureau down to perhaps 37%. Markets may recover, of course, but they may not. The latest aggregate numbers we have are from 2017, and for most individual funds data is available only as of mid-2018. Asset returns are usually smoothed so it could be four or five years until the full effect of the virus is reported officially.

But it’s not aggregate numbers or official reports that will trigger a crisis. It’s the big funds in the worst shape. My back-of-the-envelope calculations suggest Connecticut could be looking at a 28% funded percentage if the numbers were available now, Kentucky 25%, New Jersey 24% and Illinois 20%.

Those figures rely on optimistic assumptions about healthcare cost increases and discount rates; the true numbers are probably worse. The important statistic is more objective: how many years’ benefits do the pension assets represent? That could be no more than about four years in Illinois if true numbers were public today, five in New Jersey and Kentucky, six in Connecticut.

All benefits for active employees, plus all benefits for everyone in the near future, will have to come from employee or state contributions. But states will be strapped for cash, and looking to cut contributions, not raise them. Employees will be unwilling to contribute more since there’s little likelihood they’ll ever see that money again, especially as post-2008 reforms have denied many of them the gold-plated benefits that employees with more seniority enjoy.

Taxpayers? The least willing of the bunch. Creditors? The states need to keep borrowing money, so they have to appease creditors. Some of the money will come via defaults or restructuring of state and local debts, but this is its own crisis, and it won’t fill the gap. The federal government? Maybe, but not for full payments. A more likely scenario would be absorbing retirees into Social Security and Medicare at sharply reduced benefit levels—and those programs face similar problems as state and local plans.

It’s true that 48 states have constitutional or other legal protections for pension benefits. These will improve union bargaining power, but it won’t squeeze anywhere near the full amounts promised. Courts will both unwilling and unable to force governments to hand over money the governments don’t have and can’t get.

Will deaths tied to the Covid-19 pandemic save the day? After all, deaths will likely be concentrated among retired employees getting benefits rather than active employees paying contributions. Moreover, active employees who succumb to the virus will be replaced. If we exclude Hollywood disaster scenarios, the highest projections are U.S. death rates doubling in 2020 and remaining 2.5% higher thereafter. Using the age distribution of coronavirus deaths for which information is available, that could cause liabilities to fall by about half the amount that assets fell. But in that scenario assets would probably fall much farther. It’s hard to come up with a scenario in which additional coronavirus deaths improve pension funded ratios.

Will these events trigger Illinois or some other state to default? It’s plausible. Will that cause other states and municipalities to follow? That’s likely, mainly because creditors will stop lending to states with big unfunded pension liabilities. Will that provide the cover for every state except maybe Utah and Wisconsin from seizing the opportunity to renege on promises? I’d bet on that as well.

What we do today is start treating pensions as an issue that must be addressed rather than a can to be kicked down the road. Admit that promises to employees will not be kept, and start figuring out how to direct the cuts to where they will do the least harm: younger workers with more time to prepare and richer workers with more ability to pay. Collecting the maximum contributions possible, but in realistic forms employees can count on rather than unreliable promises about future. Releasing timely and complete data on assets and cash flows.

The basic terms of the fix are obvious. Pension payments will be capped, probably at something like the Social Security maximum of $3,011 per month for someone who retires at age 65. Tax the benefits, again probably like the rules for Social Security (50% of benefits for single filers with total income between $25,000 and $34,000, 85% of benefits for higher income individuals). Make healthcare plans more Medicare-like, with lower provider payments. Employee contributions to be directed either to Social Security/Medicare or individual retirement accounts rather than underwriting payments to retired workers.

This will provoke fierce fights. First to accept the inevitable and second to set the precise terms. How will police officers be treated versus teachers versus Division of Motor Vehicle clerks? Will all state and local plans be put in one bucket, or will employees from more prudent states do better than employees from profligate ones? How will scarce funds be directed to pensions versus health benefits? How much will taxpayers and creditors kick in? These fights will take place in legislatures, courtrooms and union elections. It won’t be pretty or fun. But the sooner we admit the problem and start to solve it, the sooner it’s behind us.
James Comtois of Pensions & Investments also reports on how public plans to face major losses in fiscal 2020, according to Moody's:
U.S. public pension plans are facing investment losses approaching $1 trillion because of the economic fallout from the coronavirus, according to a report from Moody's Investors Service.

The losses could exacerbate the pension liability challenges that many state and local governments are already facing. Plus, the economic setback is reducing revenue levels and threatening the ability of municipal governments to afford these higher pension costs.

U.S. public plans are generally on pace for an average investment loss of about 21% for the fiscal year ending June 30, Moody's estimates.

"Without a dramatic bounce back of investment markets, 2020 pension investment losses will mark a significant turning point where the downside exposure of some state and local governments' credit quality to pension risk comes to fruition because of already heightened liabilities and lower capacity to defer costs," said Tom Aaron, vice president at Moody's, in a news release announcing the report.

"The credit impact from 2020 pension investment losses will depend on many factors, including the ultimate magnitude of asset declines, the unique funding and cash flow position of governments' pension systems, and their ability to absorb cost hikes in their budgets while continuing to provide services and pay debt service," Mr. Aaron added.

Reflecting an annual investment return target in the range of 6% to 7.5%, plan assets are heavily allocated to equities and alternatives.

Falling market interest rates are also increasing adjusted net pension liabilities. On average, adjusted net pension liabilities are generally on pace to rise by nearly 50%. Investment losses are pushing down the value of pension assets and falling interest rates are pushing up adjusted net pension liabilities further by causing the market value of total pension liabilities to rise, the report said.

If steep investment losses are not reversed, the annual costs that governments face to keep up with their unfunded liabilities will spike, the report stated. The cost for governments to make the minimum contributions required to prevent unfunded liabilities from growing is likely to rise nearly 60% in fiscal 2021. If governments' revenue performance also deteriorates, then pension affordability ratios will get significantly worse for some plans due to the combination of increased costs and decreased revenue.

Moody's based its estimates on a sample of 56 large U.S. public pension plans.
On Monday, I discussed the next retirement crisis and shared an email a former senior pension fund manager sent me after reading my recent comment on whether Canada's top ten pensions are in trouble, sharing this:
I think that the big Canadian pension plans will be fine, they are well managed and came into this situation in very good financial shape. However this is going to be a disaster for US states and municipal plans. It was just a matter of time for many of them as their pension plans were so poorly funded, even when using completely unrealistic return expectation. 

Now these governments are having to pile on debt to bail out their economies. This may give them political cover to break their pension promises.

One thing that could hurt Canadian pension plans is longer term effects of the coronavirus on the assets they own. Two things come to mind - real estate and some types of infrastructure. This crisis may just hasten the demise of the retail sector and commercial office space. For example, OTPP owns about 17% of Macerich which is a publicly traded US REIT. It is down 92% from the end of 2015. The office sector has been booming in some parts of Canada but that may change if companies decide to take less space in the future as they find that employees can work efficiently from home.

Airports and toll roads are taking a HUGE hit in the short term. Will traffic volumes come all the way back? Did anyone do a worst case scenario for Hwy 407 that saw traffic down 90% for a month or more? These assets may need equity injections to stay viable, and their long term valuations may shrink as globablization reverses and the flight volumes at airports decreases.

I also think that long term equity markets will do less well due to (1) lower long term earnings, and (2) lower P/E multiples. Taxes are going to have to go up to pay for these bailouts and that will have to come from somewhere. Companies, and society, will now focus more on resiliency than efficiency which will hurt profits. Will the Eurozone survive this crisis? And this crisis is showing us that there are a lot of unseen risks in the world and you can't be pricing markets for perfection at a 20 P/E multiple. That just won't work over the long run.

The other risk that I am worried about in the long term is inflation. How are governments going to pay back all of the debt being issued? Do they inflate their way out of this problem?

I have more questions than answers but I think the future will look very different than the last 25 years, and I think we are going back to valuation ratios that we saw from 1880-1995 rather than what we have seen for the last 25 years. And note that we are STILL at high ratios in the US - to get to a P/E10 ratio of 10 markets have to fall by another 50%+. I don't think that will happen but I don't think we are going to see a snap back to an S&P500 of 3300 any time soon.

If you haven't already heard this I suggest you listen to this Recode/Decode podcast featuring Chamath Palihapitiya from last week (click here or here to listen to it).
Again, this person is extremely knowledgeable, has tremendous experience and he is providing my readers with excellent food for thought.

CalPERS recently disclosed it lost about $67 billion in market value since January as the coronavirus pandemic roiled global financial markets.

But when it comes to US public pensions, I worry a lot more about chronically underfunded state and municipal plans that will be unable to meet their pension obligations.

Keep in mind, pensions are all about managing assets and liabilities. The perfect storm is when assets get clobbered and liabilities explode as long bond rates approach zero (like now). It's actually the drop in rates which causes many pensions to sink further and further into underfunded territory, and even when assets recover, as long as rates stay ultra low, pensions remain in big trouble.

A long time ago, Jim Leech, the former CEO of Ontario Teachers' Pension Plan and author of The Third Rail, told me something I never forgot: "Pension deficits are path dependent," meaning the starting point matters a lot.

If you're starting point is 69 or 70% funded status like a CalPERS or CalSTRS, you will get hit hard but won't succumb to pension hell.

If, on the other hand, your funded status is 30% or less like Kentucky, Illinois, and many municipal plans, you're pretty much screwed because there is no realistic way you will climb out of that pension hole.

Jim Leech was recently interviewed on Real Vision. The entire interview is available here for subscribers but I provide below two clips which were posted on Twitter:

Notice what he says about the governance of US public pensions where there is "undue political pressure".

The governance at Canada's large public pensions is a big reason why they are successful. There is zero (or extremely limited) political interference, our pensions focus exclusively on how to invest over the long run in the best interests of their members and beneficiaries.

What else? Canada's large public pensions use much lower discount rates to mark their liabilities, use leverage intelligently, and they share the costs of the plan equally among sponsors and members (typically by adopting conditional inflation protection).

This is why Canada's large public pensions were fully funded (or overfunded) going into this coranavirus crisis and they are in a better position to ride out this storm (they will all get hit but are in better shape to come out ahead).

In the US, I have openly been worried about the next retirement crisis and its ripple effects on the economy and society.

Real Vision recently did a short documentary called Reversal of Fortune: Inside Pensions and the Erosion of Retirement, featuring yours truly, Jim Leech, Ed Siedle, Teresa Ghilarducci, Roger Lowenstein and others.

You can watch it here (subscription required). Below, a tweet which features the trailer:

I feel for that teacher who saw his benefits slashed.

At the end of that trailer, I said the ripple effects of the US public pension crisis will be felt everywhere and it "will affect everyone in material ways".

Here is exactly what I said at the end of the documentary:
"It can be anything from paving roads to other services, and that will have effects on everyone. When you run out of all options, the only other option is to go to Uncle Sam and say, hey, we need a massive bailout on our pension system. We can't do anything about it, and we're contractually obligated to meet those pension payments. It will bail these pensions out not because they're particularly worried about pensions and retirees, they will bail them out because they want to bail out Wall Street, private equity funds and hedge funds and make sure that they get money in perpetuity over the long run so that they can grow richer and richer and pay these politicians more and more money for their campaigns. I am being cynical, but that's the reality of the situation, but notice, they will never change anything structurally."
It's really important to remember all bailouts are typically done with a single purpose of keeping the financial system afloat so elite capitalists can keep prospering.

The same goes for these "rescue packages" governments are doing now in response to the pandemic. The money isn't going directly to banks (for political reasons) but once people get it, they will pay the mortgage, pay down their credit cards, car leases, student loans, and rent. So, in effect, it's a dead (indirect) giveaway to big banks.

This is why I keep telling people, if things really get bad and many US public pensions become insolvent, they will be bailed out but the real reason will be to bail out Wall Street (big banks and their big hedge fund and private equity clients), not to bail out Main Street.

Lastly, while some people think we are heading for a pensions apartheid, I worry we are heading into something a lot more painful, a complete pension and social albatross:

On that grim note, stay safe everyone, it's going to be a long, tough slug ahead, we need to prepare for a long war against this virus (and I mean mentally and physically prepare not just for the virus and the tragic deaths but also for the economic fallout which will likely linger long after the virus is vanquished).

Below, Jim Keohane who just retired from HOOPP, spoke to Real Vision's Ed Harrison in February and explained why once pensions get to a certain level of "underfunded-ness" (60-70% funded), it’s extremely hard to dig out of the hole, because they have to earn way more just to catch up.

Many underfunded and chronically underfunded US public pensions are about to find out exactly what Jim Keohane is explaining in this clip. Unfortunately, for most of them, it's already too late.

And Jim Chanos, Kynikos Associates founder, joins 'Fast Money Halftime Report' to discuss how to watch the stocks amid the coronavirus pandemic, how the gig economy will not scrape by unharmed from the outbreak and some of his stock picks. Listen to Chanos, he offers incredible insights.