THE COST OF OUR UNLIMITED PROMISES

Today’s blog was written by Rodney Johnson, president of Dent Publishing.  It’s a story being enacted at all levels of government and a red flag of what is coming up at all levels of public enterprise.

122,000 active and retired school teachers in Kentucky have a math problem they can’t solve.  According to the latest report, their pension fund lost ground yet again in 2015, falling behind by another $3 billion.  As it stands, the fund has a mere 42% of what it needs to pay its bills.

But they can’t cry in their beer at the local watering hole to state workers.  Their pension has only 17% of what it needs, and will go broke in less than a decade!

Both pensions are controlled by the state legislature, so you’d think that state representatives would be going crazy looking for a solution.  Apparently, that’s not the case.  While they acknowledge the problem, and call it “grim,” their actions don’t match their words.

Last year state legislators contributed less state funds to pensions than required.  Every year that this happens, the funds fall farther behind.  Kentucky lawmakers have shortchanged pensions every year for a decade.

To make matters worse, they don’t eat their own cooking.  While overall state level pensions have less than 40% of what they need to pay all the benefits they owe, legislators separated their own pensions…which has 85% of the necessary funding.  They’ve conveniently put their personal retirement out of harm’s way because they know the score.

At some point, employees will have to contribute a lot more and benefits will be cut.  But that still won’t be enough.  They’ll have to get a big chunk of money from another source to balance the books, and they’ve already identified the mark.

It’s you and me.

And there’s almost nothing we can do to get out from under the burden.  Whether you know it or not, if you live in the U.S. you have a financial promise to keep…a promise without end.

By virtue of residing in a state or territory, through the government, you have promised to make good on the pensions state workers earned.  In most areas, as the courts have ruled in Oregon and Illinois, these are promises without limitation or qualification.  No matter what happens, taxpayers like you and me must pay.  Unlike most any other area of spending, these obligations can’t be reduced by legislative action, voted away, or impaired because they cause financial duress.

The only way to change the pensions is to get beneficiaries to agree to take less than they are legally entitled to receive.  As we’ve seen in recent court cases, the chances of that happening are slim to none.

The fact that previous legislators, sometimes decades ago, agreed to very generous future benefits in exchange for smaller wage increases at the time doesn’t matter.  The fact that, to this day, they continue to short-change the funds even though they know what’s going on, doesn’t matter.  The bills are coming due, and we’re legally obligated to pay any amount necessary so that beneficiaries get every nickel they were promised.  Even if we run current state legislators out of town on rails, we still owe the benefits.

On the face of it, this might not sound so bad since every state has a pension fund.  But even though there are monies set aside to meet these obligations, the liabilities far outstrip the assets that have been socked away.  The average state pension fund has only 75% of what it needs to pay all benefits, and the numbers are going the wrong direction.

We know some of the reasons for this underfunding: the sky-high assumptions about market returns that don’t come true, and the failure of state legislators to make pension contributions year after year.

But there’s another reason for why states aren’t closing the funding gap, and it’s just now coming to light.  And once again, the blame falls squarely on the legislators that we sent to state capitols to work on our behalf.

For many states, even if they contribute every cent required to their pension funds, and even if they earn their magical assumed rates of return, they will still fall farther behind.  In short, their failure is baked in the cake…and they’re doing nothing about it!

As we march toward the fiscal cliff with pensions, things will get ugly.  Right now, we’re getting a taste of what lies ahead as Puerto Rico maps out a strategy for dealing with its debt and pension mess, which typically go hand-in-hand.

The commonwealth owes roughly $48 billion in pensions, but has less than $4 billion in assets.  And yet, their preliminary plan doesn’t include cutting benefits.  They’ll direct the pain somewhere else.  As taxpayers and investors, the islanders of Puerto Rico are looking to us to bail out their mismanaged fund, not only keeping their beneficiaries whole, but also preserving benefits for public employment retirees for years to come.

In addition to reputing debts and raising taxes, state governments will redirect spending from other areas, such as education, which aren’t constitutionally protected like pensions, and already went under the knife during the Financial Crisis.

The time to address this situation was years ago, in the mid-2000s, when the underfunding first came to light.  Back then, if our state representatives had taken their jobs seriously, they would have changed the earnings assumptions and fully funded pensions, even if it required higher taxes or budget cuts.  The painful moves would have alerted constituents to the massive issues we faced.  But it’s possible that we could have avoided the massive upheaval that lies before us today.

Now it’s too late.  There is no win-win option available, just the ugly job of picking winners and losers.

It you’re reading this, chances are you have assets and/or earn a solid income.  If you’re not covered by a state pension, then you fall in the loser category.

The winners are those covered by such pensions, since it’s likely their promised benefits will be preserved at all costs.

This is not a screed against such workers and retirees.  Through bargains cut with political representatives in the past, these teachers, policemen, firefighters, city and state administrators, etc., made deals that traded current income for retirement benefits.

The failure lies with our political leaders who agreed to such deals, and those who followed in their footsteps without providing adequate funding.  These elected officials failed in their basic duty to represent the best interests of the voters.

We can’t turn back the clock.  The best we can do is understand the situation as it stands today, and plan our way forward with an eye toward protecting our assets and limiting our financial pain.

Woefully Underfunded

At the end of June 2014, state pensions were underfunded by $934 billion.  That figure is based on each state’s estimate of their current assets, liabilities, future contributions from both employees and their own coffers, and their expected rates of return on investments.

The overall 2014 funding level was slightly higher than that of the previous year because of strong market returns, but that was then.  Equity returns were flat in fiscal years 2015 and 2016, which translates into subpar performances across pension funds.  But that’s part of the bigger problem.

In terms of the assumed rate of return, or what public pension funds must earn each year so that their assets grow as expected, “par” is a very high bar.  In fact, the assumed rates of return for public pensions are typically far above what private pension funds are allowed to use in their calculations.

We Could Be on the Hook for $4 Trillion

There was a time when earning an average of 7% to 8% on a portfolio of stocks and bonds was considered normal.  That was before the Financial Crisis.  Before central banks around the world colluded to push interest rates through the floor.  Before the developed world grew old.

Now, with productivity hovering near 1% and inflation struggling to stay between 1% and 2%, earning 7% to 8% is a lofty aspiration.  Unless you’re a public pension fund, of course.

Most of these paragons of investment knowledge assume that they’ll be able to clock such high returns so often as to make them average.  Assumed rates of return on public pension funds around the country range from a low of 6.5% in Washington, D.C., to a high of 8.5% in Houston, Texas.

Never mind that his hasn’t been the case since 2000.  Public pension funds keep up the charade of earning higher returns because it allows them to pretend that their current funding status is accurate.

The assumed rate of return, or discount rate, is used to calculate how much money is needed today to meet all the obligations of tomorrow.  This valuation is called the market value of the pension.  The higher the discount rate used, the less money needed today.

A great illustration of the difference between the valuation models recently came to light in California, which runs two large public pension systems: California State Public Employee Retirement System (CalPERS) and California State Teachers Retirement System (CalSTRS).  When determining their own funding ratio, these systems use 7.5%, although both announced last year that they would lower their assumed rate of return to 6.5% over time.

But as Citrus Pest Control District #2 found out, when determining solvency, CalPERS uses a much different discount rate.

The small pest control district serves just six retirees and employees, and felt that it would be better to withdraw from CalPERS and convert their retirement system from a pension to a defined contribution (401K) program.  Their statements from the pension system showed that their account was fully funded, but upon withdrawal, they were hit with a bill of almost $500,000.

It turns out that when calculating the district’s funding level for withdrawal, CalPERS uses a much lower discount rate, one that approximates the risk-free rate of return on U.S. Treasury securities.

CalPERS offers no reason as to why its assumed rate of return is good enough for accounting purposes, but not good enough when participating entities want to withdraw.  Or conversely, why such a low discount rate should be used for those quitting the pension system, but not for regular valuations of the larger fund.  It’s as if CalPERS trustees are telling everyone else in California, “We know more than you do, and can do this better than you can,” even though the numbers shows it’s not true!  But at this point, if CalPERS moved to the more realistic valuation method, it would immediately put the fund deep underwater,

The risk associated with using assumed rates of return higher than what could be earned on high-quality bonds is so well understood that private pensions offered by corporations can’t do it.  Instead, they must use discount rates that, while not quite risk-free, are much lower than that used by public pensions.

Private pensions must use the prevailing interest rate on AA corporate bonds, which is currently 3.42%.  As the rate falls, private pension sponsors are required to add more funds to their pensions.  If rates move up, then the sponsors get a break.  This makes pension funding a bit of a moving target, but that’s the nature of the beast if a pension sponsor wants to count on investment returns to fund part of the pension.

Some companies have decided they’ve had enough.  Instead of dealing with the ups and downs of funding—and the havoc it can wreak on profitability as interest rates fall—they’ve handed off their pensions to outside insurance companies.  That’s probably a wise business decision, since it allows the company to focus on its core business.  But states haven’t gone down this road, and their funding problems continue to grow.

Failure Baked into the Cake

The last 15 years have been something of a perfect storm for pension funds.  The recession of 2001-2002 and Financial Crisis of 2008 dramatically cut investment returns at the same time that interest rates fell, which pushed up required contributions.  The economic downturns cut state revenue, and the beneficiaries retired in droves.  Essentially state pensions have more money going out, less money coming in, and falling returns.

Legislators can’t easily change state tax revenue, and they can’t tame the business cycle, but they do control the amount of money that states contribute to their pension funds each year.  On that score, they still fail to deliver.

From fiscal year 2001 through fiscal year 2013, more than half the states contributed less than the amount required.  Nine states contributed more than required over the 13 years, while another eight states and the District of Columbia contributed the full amount.  The remaining 33 states fell short of what was required, with some states, like New Jersey (38%) and Pennsylvania (41%), well below the contribution threshold.

Remember, this is what occurred over 13 years, so most states short-changed their pensions for more than a decade!

Unfortunately, that’s not the worst part.  Even if states made their required contributions, and even if they earned their lofty assumed rates of return, new research shows that 35 of them would still fall behind in funding their pensions.  For these states, failure is baked in the cake!

Even if it all Goes as Planned, They Still Lose

We know that most states aren’t contributing what they should to their pensions, and we know that they all assume rosy investment returns.  But it wasn’t obvious that many states, 35 to be precise, are planning for failure.

Using their own numbers for required contributions, employee contributions, fund balances, assumed rates of return, and expected liabilities, 35 state pensions fall further behind every year.  So even if they meet all their projections, they still lose.

It’s no surprise that many of the culprits who aren’t making their required contributions are the same ones with pensions doomed to fail.  New Jersey tops the list of bad actors at a mere 28%, with Kentucky not far behind at 35%.

I’m certain that state legislators didn’t set up pension funds to fail.  Instead, they didn’t adjust to reality.

As they contributed less to their pensions than required, and they didn’t earn their assumed rates of return, the cost of funding increased.  But if they didn’t review their plan and take appropriate action (contributing more, etc.), then the result is a plan that cannot meet its goals.  This seems like a simple concept, and yet, more than half the states in the country are on this exact path.

Again, I don’t think state legislators are blind, or somehow unaware of the problem.  It’s more likely that they understood the implication of adjusting their pension funding.  As they fell farther behind, it would take more state funds to catch up.  Those are funds that states simply didn’t have, and most likely won’t in the future…unless they take drastic measures, like raising taxes and cutting spending in other areas.

According to the Brookings Institute, states would have to immediately cut 5.7% of spending in other areas simply to keep pension funding from getting worse.  To fully fund pensions over the next 30 years, they would need more than double that amount.

The possibility of states either redirecting 10% of annual spending to pension funding or raising taxes by that amount is essentially zero.  Remember, there are no “states,” or “funds.”  These are simply organized groups of people.  And in this instance, we’re talking about state legislators and pension fund trustees who’ve proven time and again that they’re not just willing to ignore the truth, but will let things get so far out of hand that bankruptcy looms as a likely option!

What Lies Ahead

While I don’t expect the dramatic policy changes needed to better deal with this problem, I do think there will be changes at the margin.  Cities and states will spend a bit more on pensions, as well as raise taxes.  But it won’t be enough.  The worst offenders, like Illinois, Kentucky, New Jersey, and Pennsylvania, will have to find other solutions.  There are two possibilities—repudiating other debt and seeking federal aid.

Puerto Rico is a real-time example of how things might unfold…

The commonwealth issued bonds in the spring of 2014 that were backed by the full faith and credit of the government, adding to its existing mountain of debt.  At the time, their finances were so precarious that they had to pay over 8% interest on their tax-free bonds.

Investors scooped them up, placing so many orders that Puerto Rico was able to sell even more bonds than it had originally planned, bringing the offering to $3.5 billion.

In less than a year, it was obvious that the investors would not get all their money back.

It’s as if Puerto Rican administrators were playing a game of poker, bluffing the others as the table (investors) about how they would abide by the law…right up until they didn’t.

This doesn’t mean that Puerto Rico hasn’t inflicted pain on its own constituents.  The sales tax just jumped to 11.5% and fees of all sorts have jumped.  The government even tried to pass a business tax that would have applied only to companies with more than $2.75 billion in annual revenue…a tax that would only hit Walmart!

This is exactly what will happen elsewhere.

As citizens and businesses in Chicago know all too well, the city plans to increase taxes to pay for pensions.  Unfortunately, it won’t be enough, because the pensions still use unrealistic earnings expectations and have pushed out making full contributions for at least five years—these are the same bad habits that led to the pension underfunding in the process.

Eventually Chicago, Illinois, and countless other municipalities and states around the country will grapple with their underfunding, and will make the same calculation that Puerto Rico did.  It would be unconscionable to pay bondholders ahead of paying salaries and retirement benefits to everyday citizens.

Donald Trump’s election could make the process even easier.  While the president doesn’t have direct say over courts and laws, he does have a bully pulpit and sway in Congress.  Given his previous use of the bankruptcy code for his own purposes, it would follow that he sees it as a logical way to solve issues involving a mismatch of debt and revenue.

This sets off warning bells in my head.  In the private sector, investors put up their money and place their bets.  In the public sector, legislators are making “bets” with our money.  It’s a different world that calls for, and has, a different set of rules.  But who knows how his process will be affected by the next administration?

In other words, buyer beware.

If this occurs, it would be just like Greece and the European lenders.  The borrower still wouldn’t have the ability to meet all repayment demands, so the process just lets the charade continue for a few more years until there’s another bailout…and then another.  Eventually, this ends with no repayment, just as it will in Greece, leaving the lender on the hook.

That lender would be you and me, the American taxpayer.

Steps to Take

As this pension snowball rolls downhill, getting bigger and gaining speed, we should be what we can to get out of the way.

As I’ve cautioned before, all investors must review their portfolios, looking for exposure to cities and states that could have pension payment issues.  Typically this means owning general obligation municipal bonds issued by those cities and states, either directly or inside of a bond fund.

It takes work to perform such a review, but as holders of Puerto Rico debt will tell you, it is well worth the effort.  Do it now, before it’s too late!

Notice that I specified general obligation bonds.  Typically revenue bonds, such as those backed by water and sewer payments or toll roads, aren’t endangered by the paying ability of the city or state.  These bonds usually have identified revenue flow, and if it is sufficient to make all required payments, then those bondholders will be spared.  This is exactly what happened in Detroit, where the Detroit Water bonds paid off as anticipated, but Detroit general obligation bond payments were slashed.

Away from bondholders, all citizens should take a few minutes to review the finances of their city, school district, county, state, and any other territorial body that has jurisdiction.

1 Comment

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One response to “THE COST OF OUR UNLIMITED PROMISES

  1. I wonder if Senator McConnell, the majority leader of the U.S. Senate could lend a hand to his constituents? I know he’s federal and you’re describing state stuff; but isn’t this just another way a representative should be involved to protect the people he’s elected to serve?

    Several years ago I was battling a major bank over a mortgage modification and was being strung along for more than a year. I won’t go into the daily details of dealing with all levels of bank employees INCLUDING the CEO located in Georgia. At on point I was so frustrated, I cried while talking to one of the senior executives.

    A mortgage broker in my Rotary club suggested I call then U.S. Senator Barbara Boxer’s office and talk to the staff person involved with the committee that oversees banking and financial matters. Long story short, I got a call within a couple days from the bank, my modification was approved and my modification was issued at 2% adjustable capping at 4%. Believe it or not, those elected officials do have influence. The trick is to get the ones elected that use it for us rather than “them.”

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