Something I’m Worried About

Predicting crashes, recessions, black swans and such has become fetishized by many in the investment world since the Great Financial Crisis. Those who predicted trouble prior to 2008 have had a hard time letting go of that one right call and plenty of those who missed it have been trying to make up for lost time by finding canaries in every coal mine imaginable ever since.

After stating this opinion to someone recently I was asked to share something I am truly worried about.

The coming pension crisis is something I’m worried about.

The New York Times had a crazy story this past week about the looming pension crisis in the city of Dallas because of some very poor planning and highly illogical decisions in the past. Here’s a short excerpt from the piece:

What is happening in Dallas is an extreme example of what’s happening in many other places around the country. Elected officials promised workers solid pensions years ago, on the basis of wishful thinking rather than realistic expectations. Dallas’s troubles have become more urgent because its plan rules let some retirees take big withdrawals.

Now, the Dallas Police and Fire Pension System has asked the city for a one-time infusion of $1.1 billion, an amount roughly equal to Dallas’s entire general fund budget but not even close to what the pension fund needs to be fully funded. Nothing would be left for fighting endemic poverty south of the Trinity River, for public libraries, or for giving current police officers and firefighters a raise.

The headline for the article reads ‘Dallas Stares Down a Texas-Size Threat of Bankruptcy’ but really should have read ‘Dallas Stares Down a Texas-Size Threat of Higher Taxes and/or Deprived Government Services.’

I’ve been reading similar examples of pension funds in huge trouble over the past few years. There was a story in the Wall Street Journal last year on how Connecticut, America’s richest state, got itself into so much trouble:

Connecticut’s pension gap developed as a result of decisions made over decades to scrimp on payments when the economy sputtered and to cut taxes, according to state leaders and public-finance experts. And there is a quirk: Connecticut officials contributed almost no money to the state’s various public pensions from the late 1930s until the early 1980s, meaning little had been saved up because the state had chosen not to prefund the retirement system for future payouts.

Here’s another one from the WSJ about pension costs in Pennsylvania:

In Erie, Pa., schools are struggling to afford the basics because pension costs have nearly tripled in the past five years, said city schools Superintendent Jay Badams.

Students in Erie receive stapled copies of “Everyday Mathematics” rather than the hardcover textbook. Two winters ago, 21 buckets were needed to catch all the leaks from the ceiling of a second-grade classroom following a snowstorm. Since 2011, one-fifth of the workforce has been eliminated and three schools have closed.

“Our pension costs have been a major expense that force us to spend less on students and more on employee benefits,” Mr. Badams said.

These are extreme examples, but there are many states, cities and municipalities who are going to have trouble meeting the promises they’ve made to their beneficiaries over the years.

A paper by Robert Novy-Marx and Joshua Rauh written a few years ago pegged the total amount of state employee pension liabilities at $3.2 to $4.5 trillion (numbers that will rise with higher salaries and inflation rates into the future). The average funded status of the 50 state pension plans was 43%-61%, depending on the discount rate used to calculate the present value of the liabilities.

Regardless of the actual numbers, there are going to be many, many pension plans that run into trouble in the years ahead. It’s simple math.

Many of the largest pensions are blaming low interest rates for their troubles. If one of the greatest stock bull markets couldn’t get these funds into better shape I don’t know what will (this tells you that recent troubles have been more of an asset allocation issue than an interest rate issue, but I digress…).

I see a few potential outcomes from these problems.

The obvious one is that many municipalities are going to need help in terms of meeting their future payouts. This will likely come from a combination of higher contributions or lower payouts to their beneficiaries. Neither is very appealing to lawmakers looking to get reelected, because it means raising taxes, breaking promises or diverting spending that could be used elsewhere.

This will pit younger voters against older voters.

Is it really fair to saddle younger voters with higher taxes and see lower spending on infrastructure or government services just to pay for the retirement of their elders? On the other hand, is it really fair to older government workers to expect them to accept lower pension payouts than they were promised a number of years ago?

There really aren’t any simple solutions to this problem.

Many plans will play games with their expected return numbers and discount rates to buy more time, but these are accounting tricks that will only work for so long.

Winston Churchill once said, “You can always count on the Americans to do the right thing after they have tried everything else.”

My guess would be this is how this pension ordeal will play out, as well. There will be many patchwork short-term solutions and can-kicking by the elected officials who oversee these plan assets. The “right” thing will mean different things to different plans.

I don’t really know what the right thing to do here is and I’m not smart enough to offer a simple solution.

The only real positive here is that this crisis will be more of a process than an event. It’s not going to happen overnight.

I hope my fears are overdone about this but I don’t see many clear paths forward.

Difficult decisions will have to be made eventually because there’s no way to make everyone happy here.

Further Reading:
How Return Assumptions Affect Investment Behavior

 

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