Sense on Cents

Do we just need to get through the next year or two in order to regain our feet?  Really? Do not think that Fed chair Ben Bernanke is not fully aware of what lies ahead on our economic landscape as he hopes and prays for an economic revival. However, as he contemplates the perils of more quantitative easing the stranglehold of future pension obligations continues to put deflationary pressures on our economy. No surprise why Ben and most of his Fed colleagues are bound and determined to create inflation in an attempt to monetize our national debts. For greater focus on the state pension obligations, let’s review a fabulous commentary recently published by The Economist entitled, A Gold-Plated Burden,

CHUCK REED is the Democratic mayor of San Jose, California. You might expect him to be an ally of public-sector workers, a powerful lobby in the Golden State. But last month, at a hearing on pension reform held by the Little Hoover Commission, which monitors the state’s government, Mr Reed lamented his crippling public-pensions bill. “City payments for retirement benefits have tripled over the last ten years even though our workforce has declined dramatically, and we have billions of dollars in unfunded liabilities that the taxpayers must pay,” he said.

Mr Reed estimated that the average cost to his city of employing a police officer or firefighter was $180,000 a year. Not only can such workers retire at 50, but some enjoy annual pension payments greater than their salaries. They are also entitled to cost-of-living increases of 3% a year, health and dental insurance for life and lump-sum payments for unused sick leave that could reach hundreds of thousands of dollars.

Plenty of similar bills are looming in America’s public sector: in municipalities, in the federal government, and especially at state level. Defined-benefit pensions, which link retirement income to salary, are expensive promises to keep. The private sector has been switching to defined-contribution plans, in which employees bear the investment risk. But the public sector has barely begun to adjust, and has built up a huge liability to its staff. Worse, it has not funded the promises properly.

Joshua Rauh, of the Kellogg School of Management at Northwestern University, and Robert Novy-Marx, of the University of Rochester, estimate that the states’ pension shortfall may be as much as $3.4 trillion and that municipalities have a hole of $574 billion. Mr Rauh calculates that seven states will have exhausted their pension assets by 2020—even if they make a return of 8%, a common assumption that looks wildly optimistic. Half will run out of money by 2027. If pension promises are to be kept, this will place immense strain on taxes. Several have promised annual payments that will absorb more than 30% of their tax revenues after their pension funds are exhausted (see chart 1). (LD’s highlight)

The severity of states’ pension woes was disguised for years, because asset markets were so strong and because of the way states accounted for the cost of pension provision. But the 21st century has been dismal for stockmarkets, where most pension money has been put. State budgets came under huge pressure as a result of the 2008-09 recession, which caused tax revenues to plunge. Meredith Whitney, an analyst who made her name forecasting the banking crisis, believes the states could be the next source of systemic financial risk.

Now the problem is making headlines, especially in California, where taxpayer groups have been highlighting the generous pensions of some former employees. More than 9,000 beneficiaries of CalPERS, the largest state retirement plan, receive more than $100,000 a year.

The stage is set for conflict between public-sector workers and taxpayers. Because almost all states are required to balance their budgets, any extra pension contributions they make to mend a deficit will come at the expense of other citizens. Utah has calculated it will have to commit 10% of its general fund for 25 years to pay for the effects of the 2008 stockmarket crash. But attempts to reduce the cost of pensions are being challenged in court and will be opposed by trade unions, which still have plenty of members in the public sector.

“Funding the liability with risky assets doesn’t make the liability any smaller,” says Andrew Biggs, of the American Enterprise Institute, a conservative think-tank. A state pension fund may achieve the desired returns by investing in the stockmarket. But if that does not work out, the state must still pay its pensioners.

A more prudent way of measuring the liability is to regard a pension as a debt that the state owes its employees. So one possible discount rate is the state’s cost of borrowing, the yield on its municipal bonds. Some argue that pensioners have even greater rights than bondholders and that points to using a “risk-free” rate like the Treasury-bond yield. (LD’s highlight) Both rates make the present value of pensions liabilities much higher than that declared by the states.

What do you think might happen when investors holding municipal bonds are forced to restructure their investments or are compelled to take a haircut so state pension obligations can be met? How might that work? Think things may get a little U-G-L-Y?

Using Treasury bond yields as the basis for discounting, Mr Rauh and Mr Novy-Marx calculate that states’ pension liabilities are as much as $5.3 trillion. That is 68% more than reported by the states, and produces the authors’ figure of $3.4 trillion for the gap between liabilities and assets.

I have highlighted this reality previously BUT every day that states pretend that this issue is not real is one day closer to the eventual train wreck.

Navigate accordingly.

Larry Doyle

Related Sense on Cents Commentary

Sense on Cents/Pensions

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I have no affiliation or business interest with any entity referenced in this commentary. As President of Greenwich Investment Management, an SEC regulated privately held registered investment adviser, I am merely a proponent of real transparency within our markets so that investor confidence and investor protection can be achieved.

This entry was posted on Monday, October 18th, 2010 at 6:54 AM and is filed under General, pension obligations. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.