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In the same way that drivers are compelled to slow down to observe the aftermath of pileups, I find myself fascinated by the slow motion destruction of state and local government finances due to chronic underfunding of pension systems. A toxic combination of gold plated benefits, skipped pension fund contributions, and fanciful investment return projections has resulted in a looming fiscal catastrophe which was evident even before the current recession. The combination of the recession and decades of irresponsible pension policy could easily result in Federal Government bailouts of states and municipalities, bankruptcies, and municipal bond defaults.

Fortune Magazine recently published an article outlining New Jersey’s pension dilemma. Based on the information in this article, it appears that New Jersey could very well be the canary in the coalmine when it comes to the widespread pension crises that threaten to impact states and municipalities throughout the country. For additional background information on the pension crisis, I recommend reading Roger Lowenstein’s recent book While America Aged which I reviewed in February.

New Jersey had a $34 billion shortfall based on a study released in June 2008 which was before the bulk of the decline in the financial markets. Fortune estimates that the plan’s invested assets declined a further $26 billion due to market declines. Of course, pension benefits promised to retirees have not declined due to the fact that benefits are fixed by law. Let’s take a look at New Jersey’s situation and the broader implications for taxpayers, bondholders, and retirees.

Accounting Games

Public sector accounting often allows for assumptions that would not be permitted for a private sector business. The Fortune article on New Jersey outlines a few areas where the state government took actions that severely impair the solvency of the pension funds. Politicians invariably wish to reduce current year contributions to pension funds to avoid the need to cut services or raise taxes. Since benefit levels are set in stone, the only way for politicians to evade fund contributions is to play with the assumptions regarding investment returns.

Investment Practices

Fortune reports that New Jersey’s Pension Revaluation Act of 1992 lifted the projected rate of return on plan assets from 7% to 8.75% which allowed contributions to be cut by $1.5 billion in 1992 and 1993. A year later, another pension reform permitted state and local governments to reduce contributions by an additional $1.5 billion.

Even more outrageous is the fact that the state issued $2.75 billion in bonds in 1997 paying 7.6% interest and then turned around and invested these funds hoping to earn returns that beat the cost of funds. Fortune reports that the actual return on these funds worked out to less than 6%.

Demonstrating uncanny timing, the state decided to invest funds in “alternative investments” in 2006 shortly before the current bear market began. Contrary to the projections of the Wall Street professionals selling these alternative products, the diversification benefits were nowhere to be found during the bear market since the expected negative correlation between alternative investments and the stock and bond market failed to materialize.

Gold Plated Benefits

Over the past two decades, politicians have continued to provide rich benefits to the public sector workers covered by the plans. Fortune reports that New Jersey’s pension liabilities have increased by $6.8 billion over the past decade due to new benefits that have been added since 1999. Essentially, while politicians were trying to figure out ways to reduce contributions to pension plans, they were handing out ever increasing benefits to satisfy powerful public sector unions with significant political influence.

Some of the new benefits include increasing benefit levels by 9% for large groups of government workers and, more outrageously, approving a “20 and out” measure that permits firefighters and local police officers to retire after twenty years of service at 50% of final pay. This implies that workers in their early to mid 40s could be eligible for four of five decades of pension payments.

Regardless of whether one agrees with the idea of gold plated benefits for public sector employees, it should be obvious that if such promises are made, the government should set aside the funds to pay for the obligations. The corrupt aspect of the New Jersey situation is that politicians promised higher benefit levels to satisfy a political constituency while evading the responsibility to fund the promises which hid the true long term cost of the benefits from taxpayers.

Implications for Municipal Bonds

The implications for investors in municipal bonds as well as companies insuring these bonds should be readily apparent. The Federal Government could also be on the hook for municipal bond defaults if an ill advised plan for the Federal Government to insure municipal bonds is enacted into law.

In Warren Buffett’s letter to Berkshire Hathaway (NYSE:BRK.A) shareholders that accompanied the 2008 annual report, he warned about potential risks for municipal bond insurers that could arise if governments default. More details on Buffett’s comments can be found in an article I wrote at the time the letter was released. The central point of his concern is that municipalities may be more willing to default on obligations if the bonds are insured since a large insurance company would be on the hook for the losses rather than municipal bond investors who tend to be wealthy and influential residents of the state.

As a Berkshire Hathaway shareholder, the more I read about the pension crisis in this country, the more nervous I get about the implications for municipal bond insurers. The political will does not seem to exist that would be required to make the hard choices necessary to fully fund the promises made to public sector workers. New Jersey may be the most extreme current example, but it will not be the last state to face these issues.

Source: New Jersey's Pension Crisis: A Canary in the Coal Mine?