A while back, I wrote a short article titled, "Is the Next Major Bailout the State Pension Crisis?" In light of recent news, it may be appropriate to dust off that article and follow up on some of my earlier observations.
I began that earlier piece by referring to an article written by William Baldwin in Forbes, titled "Do You Live in a Death Spiral State"? In it, Baldwin focuses on states that have more "takers" than "makers." He classifies a taker as a person who draws funds from the government as an employee, pensioner, or welfare recipient. A maker, on the other hand, is someone working in the private sector, producing a good or service. In California, Baldwin writes, there are 139 takers for every 100 makers, and in Illinois there are 103 takers for every 100 makers. Not surprisingly, Baldwin goes on, in these two states we find some of the highest tax rates in America, and Illinois has the worst credit rating of all fifty states.
When I wrote the earlier article, my concern was that the state pension plan for Illinois was 71% underfunded. Recently the state has taken a big step in the right direction, with landmark legislation attempting to right a sinking pension ship. Democratic House Speaker Michael Madigan and other leaders stated, however, that the legislation "would save the state about $160 billion over 30 years and immediately reduce the unfunded liability by at least 20 percent." If the fix covers only 20 percent, with other savings distributed across 30 years . . . that's a bandage, not a cure.
Let's look further and see how they intend to save this projected $160 billion, spread over three decades. First, in Illinois the state pension plan had a 3 percent automatic cost of living raise for all its retirees. The recent legislation trims that back to only 3 percent on the first $25,000 of retirement income. Secondly, Illinois legislators raised the retirement age for workers aged 45 and under, and also imposed a limit on pensions for the highest-paid state employees. Finally, it appears that Illinois will be implementing some kind of 401k plan to allow state employees to set aside additional retirement savings.
Such measures don't seem all that severe, considering that inflation has been running around 2.48 percent per year for the past 10 years now. A cost of living (COLA) adjustment of 3 percent each year was --- and is --- pretty generous. But, as you might imagine, public-sector unions in Illinois are having a fit, accusing state legislators of using them as a whipping boy. They also blame the legislature for allegedly borrowing against the pension plan for more than ten years, just to create the illusion of a balanced budget.
That said, the Illinois cuts are certainly not draconian, and the Speaker is correct in indicating that this is only a first step. The state legislature still has work to do. A few more years of 25% returns in the S&P would give them a boost, no doubt, but this is still just the beginning of many more cuts in state pension programs.
So much for states. Some municipalities are going to be even worse off. Cities like San Diego, Los Angeles, Atlanta, Chicago, and of course Detroit, are all going to see much deeper cuts in their pension plans. In fact, we may see a rise in the number of "makers" in these cities, since a good many pensioners will probably re-enter the work force in some capacity.
As I mentioned in my article a year ago, Detroit is a disaster. Here in the South we have an old saying --- "That dog won't hunt" --- which aptly describes Detroit's predicament at present. The state of Illinois was not in bankruptcy, remember. The city of Detroit filed for bankruptcy last July, and despite legal challenges to that filing, a federal judge has just confirmed that the city can do so.
How bad are things in Detroit? According to the U.S. Department of Labor's Bureau of Statistics, Detroit has an unemployment rate of 23.1%, at a time when 31.3% of the families in Detroit are living below the poverty level. The population has fallen from a peak of 1.8 million to 700,000. Forty percent of the street lights in Detroit are turned off, and 78,000 properties have been completely abandoned by their owners. It takes 58 minutes, on the average, for Detroit's police, fire and EMS personnel to reach their destination, more than twice the national average. Detroit has $18.5 billion in debt and 100,000 creditors. The total debt per capita is $26,428. And finally, Detroit has 23,500 pensioners.
So, how bad is Detroit? Very bad indeed. The city will need a complete restructuring of its debt, likely including a severe "haircut" for creditors . . . and the sale of all or part of the city's art collection and other properties, as well as much deeper cuts to pension plans than those made by the state of Illinois.
Chicago may well follow Detroit as the next city to face pension reform. It appears 2014 will be a year of tax increases, pension reforms, and spending cuts for the Windy City. Under Illinois law, the city must increase its contributions to its pension funds by $590 million in 2015, in order to reach a total annual contribution of $1.4 billion for each year, going forward.
That's an annual increase from $810 million to $1.4 billion. The city drafts its next municipal budget in November of 2014, and if no pension deal has been reached by that time, the city will have to raise taxes or cut services, or design a combination of both. Reaching the goal by tax increases alone would more than double property taxes.
''Should Chicago fail to get pension relief soon, we will be faced with a 2015 budget that will either double city property taxes or eliminate the vital services that people rely on,'' Mayor Emanuel said in a recent email. ''To avoid that, we need a balanced approach. We need a plan that is fair to both workers and taxpayers, and gives them both the certainty and security they are looking for.''
Naturally, unions will aggressively defend existing pensions and other legacy benefits. Angry union officials say they will sue in state court in coming days to have the new state law overturned, a process that could last more than a year --- and they argue that no further deals involving the more than 62,000 Chicago workers should be enacted until that litigation plays out. City officials say they simply cannot wait that long.
''There's a definite hole in the budget, and neither taxpayers nor employees should be expected to fill it alone,'' said Kelley Quinn, a spokeswoman for the mayor. ''The longer we delay, the worse the problem gets.''
This is just the beginning. We have many more cities and probably a few more states that face similar situations. Hard choices will lead either to restructuring debt and obligations, or, as in Detroit, to outright bankruptcy.
If you are an investor in municipal bonds, this is the environment you face. My advice to you is simple --- be very cautious where you invest, because not all cities and states are equal. And on top of the pension-related issues outlined above, the probability for rising rates is very high. Taken together, these factors could make for a very challenging bond market in the near future.