The Looming Pension Disaster

As I’ve been writing about in the Martenson Reports over time, including the last one, one of the next shoes to drop is going to be a pension disaster. This too will be more easily measured in trillions than billions.

I am expecting a public pension wreck based on “management” so flawed as to cross over into gross negligence or worse.

March 3 (Bloomberg) -- The Chicago Transit Authority retirement plan had a $1.5 billion hole in its stash of assets in 2007. At the height of a four-year bull market, it didn’t have enough cash on hand to pay its retirees through 2013, meaning it was underfunded to the tune of 62 percent.

The CTA, which manages the second-largest public transit system in the U.S., had to hope for a huge contribution from the Illinois state legislature. That wasn’t going to happen.

Then the authority found an answer.

“We’ve identified the problem and a solution,” said CTA Chairman Carole Brown on April 16, 2007. The agency decided to raise money from a bond sale.

So far so good, eh? I mean especially if you don’t think about it too hard. After all, the only way a scheme to borrow money to plug a fiscal hole can work is if you are earning more from investing that cash that you are paying out in interest. Makes sense right?

Your investment gains have to exceed your interest costs or the scheme becomes a sure-fire money loser.

Well, here’s the punch line:

In the CTA deal, the fund borrowed $1.9 billion by promising to pay bondholders a 6.8 percent return. The proceeds of the bond sale, held in a money market fund, earned 2 percent -- 70 percent less than what the fund was paying for the loan.

Wow. I am speechless. That was the "plan"?

Borrow at 6.5% and earn 2%?

This is an unfortunately accurate illustration of the type of “talent” with which many state pensions have been saddled.

New Jersey did the same thing under Governor Whitman except they borrowed money in 1997 and plowed that borrowed money into stocks with a uniquely horrible sense of timing. New Jersey residents will be paying for that fiscal nightmare for a long, long time.  From the same article as above:

New Jersey Governor Jon Corzine, a former co-chief executive officer of Goldman Sachs, has proposed allowing government pension funds to put off half their pension contributions because of the state’s growing deficit during the recession.

Corzine’s suggestion follows a recent New Jersey pension track record of mistakes. When the state’s pensions were healthy in the 1990s, the state legislature eliminated nearly all of its annual pension contributions for almost a decade, while adding $4.6 billion of benefits.

New Jersey sold $2.75 billion of pension bonds in July 1997. Then-Governor Christine Todd Whitman said at the time that the bonds would save taxpayers $47 billion and make the system fully funded. “You’d be crazy not to have done this,” Whitman said in a Bloomberg News interview in June 1997. “It’s not a gimmick. This is an ongoing benefit to taxpayers.”

Whitman’s prediction hasn’t held up. While the state pays pension bondholders a fixed 7.64 percent interest rate, the fund has earned 4.8 percent annualized since the bond sale, according to Tom Bell, spokesman for the New Jersey Treasury Department.

Now here’s the way that the pension issue gets away from the planners mighty quick. A pension takes money in and then invests it and uses actuarial assumptions (about life expectancy, etc) to estimate how much the fund needs to be “fully funded”.

What the other pensions do is they assume a “rate of return” on the funds. This means that a fund that is earning a 10% return needs a lot less cash to be put in over time than a fund that is earning 5%. As students of the exponential function you now know that even a small percentage gap over time can quickly morph into an untreatable monster.

Meet the monster

Typically, pension funds put 60 percent of their assets in stocks, 30 percent in bonds, 5 percent in real estate and the rest in riskier investments.

Yesterday, we found out that over the past 30 years, the long bond has beaten stocks

Buying 30-year Treasuries is returning more than stocks for the first time since Jimmy Carter was president.

For three decades, owning equities in developed countries earned more than “on-the-run” 30-year government bonds. The advantage reversed after $36 trillion was erased from equity markets since October 2007 amid the first simultaneous recessions in the U.S., Europe and Japan since World War II.

The Ryan Labs Total Return Indices, which track bonds by continually adding the most recently sold security and removing the old one, returned 1,479 percent in 30 years. It beat MSCI’s Gross World index of buying developed market stocks and reinvesting dividends, which added 1,265 percent. “Over the last 30 years there’s been no risk premium,” said Douglas Cliggott, manager of the $81 million Dover Long/Short Sector Fund, which has beaten 92 percent of its peers this year. “It’s potentially earth shattering because the equity market hasn’t delivered the goods.”

This is actually a fairly important bit of information that deserves to be contemplated by investors everywhere separately from the issue of pensions, but it makes an important point here as well.

Namely, it means that the assumed rates of return for all pensions, public and private, have largely been flawed over the past 30 years.

This is really a staggering insight.

So what are the assumed rates of return for public pensions?

Actuaries consistently permit public pension funds to report artificially high expected rates of return -- most often 8 percent and as much as 8.75 percent. That’s more than the 6.9 percent billionaire investor Warren Buffett sets for his Omaha, Nebraska-based Berkshire Hathaway Inc.’s pension fund. “Public pension promises are huge and, in many cases, funding is woefully inadequate,” Buffett wrote in his 2008 letter to shareholders. “Because the fuse on this time bomb is long, politicians flinch from inflicting tax pain, given that the problems will only become apparent long after these officials have departed.”

Determining how much expected rates of return should be isn’t complicated, says Rowe, who oversees Texas pension funds.

“Why do they choose high expected rates of return?” he says. “The only reason is to sneak through promising a lot to pensioners -- which means worrying about it later. It’s madness.”

As long as the “perpetual growth machine” is chugging along, all of the collective assumptions about pensions more or less work out according to plan. But what happens when a model predicated on exponential expansion not only expands, but retreats?

Well, this is pretty much of an actuarial and financial disaster of biblical proportions. Here’s an example:

The nation’s largest public pension fund, California Public Employees’ Retirement System, has been reporting an expected rate of return of 7.75 percent for the past eight years, and 8 percent before that, according to Calpers spokesman Clark McKinley.

Its annual return during the decade from Dec. 31, 1998, to Dec. 31, 2008, has been 3.32 percent, and last year, when markets tanked, it lost 27 percent.

At its height in October 2007, CalPERS had $260 billion in assets and at the end of 2008 it had $186 billion. Based on the stock market performance this year, we might estimate that CalPERs is now worth somewhere in the vicinity of $140 to $150 billion.

How long would it take CalPERS to “get even”? Well, ignoring inflation, even if we use their extremely generous and woefully unmet assumed rate of return of 7.75% it would take between 8 and 9 years, and that’s assuming that cash in meets cash out the entire time.

If we use their actual 10 year performance as a rate of return, then it’s a 20 year haul to climb back to even, again ignoring inflation.

The monster is the power of compounding working in reverse instead of forward gear.

What does this mean?

Among the many wrenching adjustments that we are just now beginning to face, state legislators must now include a trillion dollar pension shortfall to the list of things that must be negotiated. A government retirement plan can’t go bankrupt, even if it’s insolvent; state treasuries must put up the money if a fund runs dry.

So we are now facing the first actual set of hard choices in several generations. Choices that increasing look like they can no longer be passed to the future. The future is here, it has arrived. Will states decide to pay their retirement obligations, pave roads, educate children, or feed the hungry? These are the choices that now sit before us and I remain skeptical that we will successfully borrow our way out of the predicament this time.

It would seem that decades of intellectually weak and fiscally negligent political leadership has finally caught up with us.

The pain of this adjustment is going to send up a mighty hue and cry from the populace and politicians alike and the response, I fear, will be the same as it always is; print more money.

That is the weak and easy road to take, and so, with history as our guide, we can be nearly 100% sure that our leadership will follow that route as certainly as water will seek a drain.