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


Download PDF

Full Disclosure: Nothing on this site should ever be considered to be advice, research or an invitation to buy or sell any securities, please see my Terms & Conditions page for a full disclaimer.

  • Mark Massey

    Why should someone, anyone, receive something that is just a prediction? Predicting returns and basing pensions on those predicted returns is not fair to anyone. Pensions should not add any new participants. They should reduce annual return guarantees to a low return of 2 to 3% max.

    • How about allowing people to keep their money and manage it themselves instead of paying into an effective ponzi scheme.

  • Socrates

    Boomers. Always figuring out how to have the last laugh at the expense of the next generation.

    Something I’m not laughing about though, is all these ads on your site. Dude, it’s barely viewable on a phone anymore for all the pop ups. Do you really make that much money from ad sponsorship that it’s worth sacrificing the quality of the site?

    • Ben Shearon

      Have to agree, I’m afraid. The site’s been freezing on iPhone a lot recently. Don’t mind ads, but something has changed horribly for the worse recently.

      Big fan so hope the issue can be resolved 🙂

  • RCH

    NJ in deep trouble. Not just due to educators, but they’re a big part of it.

  • Ben Shearon

    These are defined benefit plans, right?

    I guess a lot of people are not going to get the pensions they were expecting.

    • Socrates

      True. And further to my earlier concern, another thing we don’t expect is censorship of rational, coherent, and even useful thought processes and observations – yet it occurs.

    • Ultimately, I think many municipalities follow the path of Detroit.

    • MoreFreedom2

      “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?”

      Yes, after all, government workers are the ones who promised government workers higher pensions, without providing the funds to do it, and expecting future taxpayers to provide the money.

      Carlson ignores the obvious bankruptcy option. And voters, IMHO, will go for it. Because they will essentially be voting for the government workers who put a burden on them, to take it back.

  • Mark Zoril

    By and large, this will end badly – one way or another.

    • Austerity or inflation. Those are the two outcomes that I think could occur.

  • Dev

    “This will pit younger voters against older voters.”

    This will be one of the big social trends of our time, one that is yet to rear its head in any meaningful form thus far. But it will come, and I don’t see the old voters getting a positive outcome.

    Pension plans are, by definition, disadvantageous to the young, because they are not at the negotiating table when the future beneficiaries are being promised their benefits, yet they are the ones who must bear the burden of fulfilling those payouts. As people, we have a system that consistently will destroy our young for the pleasure of the old.

  • Municipal bankruptcy has already been used in California. It resulted in significant cuts to pension benefits. State-level pension benefits are a different matter.

    Nick de Peyster

    • I think many towns and cities follow a similar demise that occurred in Detroit.

    • Only the City of Detroit took actual cuts to the pensions, small cuts. The rest did not even though they could have, but post retirement healthcare was cut in Stockton.

  • patrick k

    The pension crisis has long been discussed since the 1980’s. Extrapolating past returns of 7-8% into the endless future, guaranteeing workers pensions almost equal to their salaries. Sideways markets and zero interest rates have burst that balloon. However there is one last hope. The “secret hand” has to goose the market for a rerun of the 1980-2000 market returns all the while warning pension managers that they have to dial back returns in the future to 2-3%. It’s the ultimate hail Mary that could be coming as the market is potentially ending a 15 year plateau. As nutty as it sounds, I would remind you that if past(200 years) is prologue, the Dow will be trading at 1,000,000 plus by 2100! haha.

  • DSinden

    Might this work In a last Hurrah of QE the Fed could print the money required by the pension funds and give it to them on the basis that they would buy US Treasury Bonds and new hybrid securities designed to plug liabilities / funding and returns miss match.

    • Yea it could. This kind of already happens though, but with the Fed and government relationship – not the pensions.

  • ABro1973

    Yeah, that’s the answer — pension funds should have invested more in the stock market. Because one pyramid scheme is definitely more secure if it’s invested heavily in another pyramid scheme.

  • Barry Sharer

    I have been involved with large plans that are underfunded. In most cases there is no one at fault. Two factors have exasperated this problem in the past 10 years or so. People are living longer and interest rates are very low. One is good and one is temporary. When interest rates normalize this will dramatically lower plans underfunded amounts. I look at this like a 30-year mortgage on a home. It’s something that has to be addressed over decades by chipping away at it. Don’t panic. I think this problem will resolve over time.

    • Ben

      I wish it were that easy. The math behind it doesn’t really allow it though. See here:

      Many of these plans will be fine but many are in deep trouble.

    • People are living longer and interest rates are very low.
      Neither are the meat of the problem. Pension funds are mostly invested in equities today so interest rates have little impact… and if the fund is upside down after the third longest bull market in US history then it it simply a matter of not properly funding the system, because true funding would be enormous. Living longer is a small part of the problem, but a far bigger problems is allowing public safety employees to “retire” at age 50-55 and then earn more from their pensions than when they were actually working, you simply cannot afford to have people in “retirement” for 30-50 years, far longer then when they were actually working. Raise the retirement age to 62-67, and hike the contributions, problem solved.

  • LPL Advisor

    It is called Denial – Ben, you hit it on the head.. The solution is a combination of higher taxes and lower benefit payouts… And like health – it is a combination of eating better and diet. Complaining prolongs getting well – true with both..

    It is ironic to hear them blame investments – and even more ironic as the “Smart (Pension) Money” that moves their assets out of equities in 2008 into “Alternatives and Hedge Funds – because the had performed so well the previous couple of years (when pricing is… well let’s say not very transparent)… so all that “Smart Money” moved out of the S&P 500 at 670, into Hedge Funds/Alternatives, you name it… and guess what – they made the Classic Mistake: Chasing Performance, trying to buy what happened yesterday. “Dumb Money” is what it is… Bad Behavior… Humans – go figure… Good thing we do what we do… Help people make wise choices with their money… Plenty of raw material out there to help…


    Spends a trillion dollars destroying Iraq. Gives a billion dollars in physical cash to Iranian dictators.

    Can’t fund pensions.

  • Fabian

    I don’t think the problem results from an asset allocation issue. It’s pretty difficult for a pension fund to allocate unpredictable return (stocks) to predictable disbursements, particularly after two major crashes. Another problem pension funds will face is a potential rise in interest rates that’s going to drop the value of the bonds they hold, increasing the shortfall. Furthermore, a lot of these pensions have their benefits protected by the state constitution. The only way out is tax increase and reducing services to the population. If the population is OK with it…

  • Elgangster

    New fan here. I have a question:
    How in the world with the stock market at all time high can pensions be out of money? Have the politicians stolen so much? can they be accused of fraud? thanks for your website, very good!!!

    • Ben

      Not fraud but just poor planning (meaning they haven’t been putting enough money in to cover future obligations)

  • Nathan Zebrowski

    First, you have to separate out the relatively healthy systems from the seriously sick systems. The seriously systems became that way because payments were not made. That should have been criminal. States need laws that require the payments. Boards need regularly to adjust payments based on estimated income and needs. No one has a solution for states that have not made payments for many years. In some states, unilateral retroactive reneging on contracts is illegal–and employment agreements are considered contractual. I agree with that approach myself. The old folks kept their part of the bargain, and they should be paid. Now clean the system up and make it honest. But keep contracts and the rule of law.

    Many systems are relatively healthy. The actuarial liability figures can be a little misleading here. A solid system varies from around 80% funding to over 100%. Some systems that look underfunded today were overfunded 15 years ago. This is retirement investing, after all, and the long term is what’s important. Those states and systems should absolutely keep to their agreements.

    Making retirement payments always hurts–whether you take the money out of your income yourself or whether the states see all that money going into a pension fund. Everyone would rather do something else with it. Some companies and unions and some states have done something different with it. It’s important to keep discipline all around. Make payments. Keep agreements. Keep contracts protected by law. It will always be a sacrifice, but there’s no better form of society than one that follows this discipline.

    • Ben

      Corporations are fine for the most part. I’m more worried about municipalities. I agree the LT is important but the numbers just don’t seem to work w/o some serious re-thinking. Many will be fine but many will have tough decisions to make See here:

      • Shawn

        Zebriwski is exactly correct. I can tell you after almost a decade of managing a $3 billion municipal DB plan in Texas (that is 90% funded) that failure of municipalities to make their required contributions over the years is the major issue facing the
        “sick systems”. When Governor Chris Christy was asked about NJ failing to make payments to the state plan for almost 10 years, as he explained his austerity measures, his response was that it was before his administration. He failed to acknowledge the state’s role in eroding the retirement security of thousands of state workers. Most municipal workers and teachers do not participate in social
        security (which requires the employer to match the employee’s contributions). Essentially these municipalities have given their workforce an IOU for so many years that they are now realizing they spent the money on other projects and cannot catch up. Keep in mind that the employees have been contributing all this time since it is a
        condition for them to be eligible to receive a pension. Politicians have shifted projects up in their timelines (so they can get re-elected) and crowded out pension payments of the past. Future projects may be the cost that has to eventually be paid. Gov. Christy negotiated an increase in contributions from both the state of NJ and state workers to fix the underfunding issue created by the State. Workers agreed at the risk
        of losing their entire retirement savings. Once it was implemented into law and the workers started contributing more to the plan, the State declared it did not have enough left in the budget and they would not be making the newly negotiated contributions. He effectively shifted some of the State’s past debt onto the workers. The concept of pooling longevity risk in DB pension plans is valid only if all parties meet their obligations. Imagine paying into your company’s 401K for 30 years only to be told “sorry but you are not going to get it all back in retirement because we were not able to make the match we promised you”

        Municipalities and states have used incentives like DB pensions to offset the lower than market salaries theiremployees agree to at the onset of their employment. Governments cannot pay bonuses or provide ESOPs that are a common component of compensation in the corporate world. To ensure that we have adequate individuals who are willing to be police officers, firefighters, and teachers; we must demand that our elected officials make reasonable compensation agreements and then honor those agreements. This is a wakeup call that the citizenry is responsible to make sure our agents are making good decisions with our tax dollars because we eventually pay the cost of their failures.

        Dallas’ pension issues are a case of mismanagement by the pension staff that approached the point of fraud. It was a case of making too many illiquid alternative investments and then carrying them at cost on the books through the financial crisis.
        Most (I would assume all) municipal sponsors of DB plans have seats on the boards of trustees. My experience is that the elected officials who are appointed to these boards fail to attend meetings with any regularity. This is how municipalities and beneficiaries provide oversight on the activities of their pension plans. Dallas elected
        officials are finally getting involved in the management of their plan and taking steps to correct the actions of the previous Executive Director. Just as I would not judge the entire investment industry based on the actions of Madolff, I would not judge the actions of all pension funds based on the example of Dallas. The Dallas citizens will pay a higher cost based on the failure of their elected officials to provide adequate oversight.

        I agree that tough decisions will need to be made to fix the “sick systems”. Making the required contributions when they are due (so a rate of return can be used to reduce costs) should be a basic requirement that we demand. I just do not want to see the baby thrown out with the bath water. Municipal workers who provide us essential services for many decades should not be the ones who take the blame for the actions
        of shortsighted politicians.

  • MG

    Ben, I agree with this article, but my question for you is how do we make this thesis actionable? More specifically, is there anywhere municipal bond buyers (like myself) can go to find out what municipalities will be in trouble, and when, so that we can avoid buying their bonds? I note that most GO bond prospectus’ never mention the municipality’s pension funding situation.

  • dormand

    Managing a pension fund requires a highest level of expertise that is generally available only through a superlative business education and solid experience.

    Why anyone felt that the Dallas Police & Fire Pension Fund could survive by naming a person whose sole business experience was from running a Baskin & Robbins franchise is beyond comprehension.

    That said, it is time for Dallas to stop kicking the can down the road and face the very painful choices.

    Everyone is going to have to endure significant pain for this gross negligence driven fiasco to be resolved.

    Until it is addressed and resolved, the City of Dallas will be be avoided like a leper by two vital constituencies: corporate headquarters relocation site selection teams and well qualified new potential employees for the vast number of public safety vacancies.