U.S. State Pensions Need a Miracle?

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

Frank McGuire of Newsmax Finance reports, Former Fed Adviser: ‘Some Miracle’ Needed to Defuse $1.3 Trillion Pensions Time Bomb:

America will need “some miracle” to survive the looming economic disaster of $1.3 trillion worth of underfunded government pensions, a former Federal Reserve adviser has warned.

“The average state pension in the last fiscal year returned something south of 1%. You cannot fill that gap with a bulldozer, impossible,” Danielle DiMartino Booth told Real Vision TV.

The median state pension had 74.5 percent of assets needed to meet promised benefits, down from 75.6 percent the prior year. The decline followed two years of gains. The shortfall for states overall was $1.1 trillion in 2015 and has continued to grow.

“Anyone who knows their compounding tables knows you don’t make that up. You don’t get that back unless you get some miracle,” Business Insider quoted the president of Money Strong as saying.

“The baby boomers are no longer an actuarial theory,” she said. “They’re a reality. The checks are being written.”

Pressure on governments to increase pension contributions has mounted because of investment losses during the recession that ended in 2009, benefit increases, rising retirements and flat or declining public payrolls that have cut the number of workers paying in. U.S. state and local government pensions logged median increases of 3.4 percent for the 12 months ended June 30, 2015, according to data from Wilshire Associates.

State and local pensions count on annual gains of 7 percent to 8 percent to pay retirement benefits for teachers, police officers and other civil employees. The funds are being forced to re-evaluate projected investment gains that determine how much money taxpayers need to put into them, given the recent run of lackluster returns.

And while many aging Americans have accepted the “new reality” that they would be retiring at 70 instead of 65, any additional extension won’t be welcome. “They’re turning 71. And the physiological decision to stay in the workforce won’t work for much longer. And that means that these pensions are going to come under tremendous amounts of pressure,” she said.

“And the idea that we can escape what’s to come, given demographically what we’re staring at is naive at best. And it’s reckless at worst,” DiMartino Booth said. “And when you throw private equity and all of the dry powder that they have — that they’re sitting on — still waiting to deploy on pensions’ behalf, at really egregious valuations, yeah, it’s hard to sleep at night,” she said.

DiMartino Booth cited Dallas as an example of the pensions crisis, where returns for the $2.27 billion Police and Fire Pension System have suffered due to risky investments in real estate.

“We’re seeing this surge of people trying to retire early and take the money. Because they see it’s not going to be there. And if that dynamic and that belief spreads– forget all the other problems,” DiMartino Booth said. “The pension fund — underfunding is Ground Zero.”

DiMartino Booth warned of public violence if her pensions predictions come to fruition. Large pension shortfalls may lead to cuts in services as governments face pressure to pump more cash into the retirement systems.

“This is where the smile comes off my face. We are an angry country. We’re an angry world. The wealth effect is dead. The inequality divide is unlike anything we’ve seen since the years that preceded the Great Depression,” she said.

To be sure, New Jersey became the state with the worst-funded public pension system in the U.S. in 2015, followed closely by Kentucky and Illinois, Bloomberg recently reported.

The Garden State had $135.7 billion less than it needs to cover all the benefits that have been promised, a $22.6 billion increase over the prior year, according to data compiled by Bloomberg. Illinois’s unfunded pension liabilities rose to $119.1 billion from $111.5 billion.

The two were among states whose retirement systems slipped further behind as rock-bottom bond yields and lackluster stock-market gains caused investment returns to fall short of targets.

Danielle DiMartino Booth, president of Money Strong, is one smart lady. I’ve heard her speak a few times on CNBC and she understands Fed policy and the economy.

In this interview, she highlights a lot of the issues I’ve been warning of for years, namely, state pensions are delusional, reality will hit them all hard which effectively means higher contributions, lower benefits, higher property taxes and a slower economy as baby boomers retire with little to no savings.

I’ve also been warning my readers that the global pension crisis isn’t getting better, it’s deflationary and it will exacerbate rising inequality which is itself very deflationary.

I discussed all this in my recent comment on CalPERS getting real on future returns:

So, CalPERS is getting real on future returns? It’s about time. I’ve long argued that US public pensions are delusional when it comes to their investment return assumptions and that if they used the discount rates most Canadian public pensions use, they’d be insolvent.

And J.J. Jelincic is right, taking too little risk in public equities is walking away from upside but he’s not being completely honest because when a mature pension plan with negative cash flows the size of CalPERS is underfunded, taking more risk in public equities can also spell doom because it introduces a lot more volatility in the asset mix (ie. downside risk).

When it comes to pensions, it’s not just about taking more risk, it’s about taking smarter risks, it’s about delivering high risk-adjusted returns over the long run to minimize the volatility in contribution risk.

Sure, CalPERS can allocate 60% of its portfolio to MSCI global stocks and hope for the best but can it then live through the volatility or worse still, a prolonged recession and bear market?

This too has huge implications because pension plans are path dependent which means the starting point matters and if the plan is underfunded or severely underfunded, taking more risk can put it in a deeper hole, one that it might never get out of.

The main reason why US public pensions don’t like lowering their return assumptions is because it effectively means public sector workers and state and local governments will need to contribute more to shore up these pensions. And this isn’t always feasible, which means property taxes might need to rise too to shore up these public pensions.

This is why I keep stating the pension crisis is deflationary. The shift from defined-benefit to defined-contribution plans shifts the retirement risk entirely on to employees which will eventually succumb to pension poverty once they outlive their meager savings (forcing higher social welfare costs for governments) and public sector pension deficits will only be met by lowering return assumptions, hiking the contributions, cutting benefits or raising property taxes, all of which take money out of the system and impact aggregate demand in a negative way.

This is why it’s a huge deal if CalPERS goes ahead and lowers its investment return assumptions. The ripple effects will be felt throughout the economy especially if other US public pensions follow suit.

The point is CalPERS is a mature plan with negative cash flows and it’s underfunded so it needs to get real on its return assumptions as do plenty of other US state pensions that are in the same or much worse situation (most are far worse).

Now, to be fair, the situation isn’t dire as the article above states the median state pension has had 74.5 percent of assets needed to meet promised benefits, down from 75.6 percent the prior year. Typically any figure close to 80% is considered fine to pension actuaries who smooth things out over a long period.

But as DiMartino Booth correctly points out, the structural headwinds pensions face, driven primarily by demographics but other factors too, are unlike anything in the past and looking ahead, the environment is very grim for US state pensions.

Maybe the Trump reflation rally will continue for the next four years and interest rates will normalize at 5-6% — the best scenario for pensions. But if I were advising US state pensions, I’d say this is a pipe dream scenario and they are all better off getting real on future returns, just like CalPERS is currently doing.

Defusing America’s pensions time bomb will require some serious structural reforms to the governance of these plans and adopting a shared-risk model so that the risk of these plans doesn’t just fall on sponsors and taxpayers. Beneficiaries need to accept that when times are tough, their benefits will necessarily be lower until these plans get back to fully funded status.

Share This Post

Recent Articles

Leave a Reply

Privacy Policy | © 2017 Pension360 and © 2014 Policy Data Institute | Site Admin · Entries RSS ·