The Pension Crisis: The Case Against Municipal Bonds

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Summary

Investors are ignoring public pension plan liabilities.

Bankruptcies await a significant number of municipalities regardless of interest rate levels.

Municipalities can avert this by converting their pensions to defined contribution pension plans.

Note: Everything below applies only to municipalities and states. The federal government and Social Security's solvency is a different beast (in worse condition) and will be covered on another day.

I believe a third, and likely even more, of all municipalities and perhaps states in the U.S. will go bankrupt or significantly cut their pension promises within 15-20 years. The interest rate (price of risk) on muni bonds (NYSEARCA:MUB) do not reflect this. States are not legally allowed to file for bankruptcy so they will have to make some tough decisions outlined below. I believe this will take place regardless of interest rate levels; this has nothing to do with the Fed. Everything varies on a case by case basis; some states and cities are in better shape than others. The purpose of this article is to compel investors to pay attention to the overlooked pension liabilities that are piling up because they will eventually be transferred to bondholders if the state chooses to guarantee them.

HOW DO PENSIONS WORK?

There are two main types of Pensions:

Defined Contribution Pension

In a defined contribution (alias 401k) pension scheme, the employee makes a contribution to a retirement account and then the employer matches a portion of the contribution. The sum of the contributions is invested in the financial markets. The employee usually has a say in how he/she wants the pension invested albeit the potential pool of investments is usually limited to mutual funds. The employee gets to keep whatever the value of the pension is at retirement. Defined Contribution pension schemes have become very common in the private sector over the past few decades as a result of the 1974 Employee Retirement Income Security Act (ERISA) law which increased reporting requirements amongst other regulations, but most notably required employers that offered pension plans (defined benefit at the time) to be fully transparent about the plan's funded status with the plan participants. But as is so often the case, excludes governments from complying. Here is a paper from the Boston Fed describing the impact of ERISA.

Defined Benefit Pension

In a defined benefit pension scheme, an employee contributes a percentage of his or her income or a specified dollar amount and the employer also contributes a specified figure to the scheme. The employer then invests the money (with no employee input) into the financial markets and subsequently guarantees the employee a fixed amount of payments in retirement usually coupled with a Cost Of Living Adjustment (COLA) to compensate for inflation. COLA laws vary by state but have no limits on the federal level.

If the employer can invest the money at a return higher than what is needed to pay the promised benefits, then they keep the balance. If the employer is not able to invest the money at a higher rate than is needed to make benefit payments, then they have to figure out a way to make up for the owed balance. An easy way to differentiate the two types of pensions is to think of the defined benefit (note the emphasis on "defined") as a fixed (defined) income retirement. The payments in retirement will not change, unless when adjusted for inflation, whereas defined contribution will vary based on stocks, bonds, and other financial market fluctuations.

Comparing Both

In a nutshell, both pension schemes do the same thing: they invest in the financial markets. The startling difference between the two, however, is that the defined contribution retiree bears market risk while the defined benefit retiree is insulated from market risk because their pension is insured by the plan administrator (employer). If the stock market crashes, the defined benefit employer, and not the employee, feels the pinch since his/her employer guarantees the pension whereas the defined contribution employee would watch their retirement account decline in value. The catch on the defined benefit side is that the insurance only remains valid for as long as the insurer (employer) is solvent.

The rest of this post will focus on defined benefit.

DEFINED BENEFIT PENSION VOCABULARY

I want to start by defining two important terms so you can refer to this section:

Funded Ratio - The funded ratio is the ratio of a pension's assets to its liabilities at a given period inclusive of the concept of time value of money. So - say you borrowed $1,000 last year, and you have to pay it back today, but you only have $600 today, your funded ratio would be 60% ($600/$1,000). The funded ratio is essentially how much money you have relative to how much you owe the day the bill is due.

Discount Rate - The rate of return a pension assumes it will earn over the long run (this is not always the case, but we will run with this to keep it simple). Expanding on the funded ratio example, say that $1,000 is due one year from today and not tomorrow. If you could invest the $600 that you have today at 10% rate of return over the next year, you would have $660 ($600 + ($600*10%)) when the loan is due, a year from today. Your funded ratio today would be 66% ($660/$1,000) because you will be able to meet 66% of your liabilities when the bill is due in a year if you save the $600 today.

APPLYING THE FUNDED RATIO AND DISCOUNT RATE TO THE PENSION CRISIS

Data Source: Public Plans Data, Federal Reserve

The median expected rate of return (discount rate) for pensions nationwide as of the end of fiscal year (FY) 2016 according to Moody's was 7.5%, but the median return (what they earned) in FY 2016 was 0.52%. What the above chart shows is that even if the state and municipal pensions earn the 7.5% projected perpetual returns which they are expecting, they will only be able to meet 65.4% of their promised defined benefit pension obligations. At this pace, however, they will need to be cut for the state or city to stay solvent. The severity of the cut will depend on what % they earn on the investments since it is based on a 7.5% 'expected' return.

WHY IS THE FUNDED RATIO FALLING?

1.) Employers are not contributing the required amount to fund the pension.

Governments do this primarily to shift that expenditure to a different part of the budget and also give off a pretentious appearance of their financial health, which lowers their cost of capital (cost of borrowing or raising money).

Corporations do it also because it not only decreases their cost of capital (cost of borrowing) but also because it increases their perceived profitability. When companies contribute less money towards their pension, the extra money that does not go towards the pension scheme inflates their net income and thus, increases their stock price. Private executives are showered with stock options, so they are incentivized to keep the stock price as high as possible.

2.) They are not meeting their projected expected returns or because they have reduced their expected future returns.

If the investment does not meet the expected return, then the funded ratio also falls. The 10-Year Treasury yield peaked at 15.3% in 1981 and fell to 6% at the end of 1999, and the S&P 500 (NYSEARCA:SPY) returned an astounding 17% a year from January 1981 to December 1999 (dividends reinvested). Because recency bias almost always blinds market participants and government officials, a 9.6% expected perpetual rate of return for the pensions seemed plausible at the time. From January 2000 to September 2016, however, S&P returned just 4.47%, dividends included. Pension funds have also continued to revise their "expected returns" lower to reasonable rates which pushes the funded ratio lower.

MARKET RATE ASSUMPTIONS

When one adjusts the expected rate of return to reasonable levels from 7.5%, the numbers are frightening. Here is a study by ALEC using market rate assumptions (market rates are usually the 30-year Treasury "safe" rate):

Source: ALEC

The study was conducted using a "risk-free" rate of 2.344%. Wisconsin is the only state that comes in above 50%. Once again, this means that assuming they earn the 2.344% return, the states will only be able to meet the funded ratio percent (above) of their pension obligations. Arizona retirees, for example, would only get 31.2% of their promised pension payments. Understanding the sleight of hand is imperative here because accounting fiction comes into play. The stroke of a pen creates and erases imaginary pension wealth; government accounting is as suspect as it gets. Subtract the numbers above from 100% to arrive at the percentage that the states will be forced to cut their pensions by to stay solvent if they earn the Treasury rate of return.

What Happens When the Pension Assets Run Out?

When pension assets run out, the states and municipalities will be forced to either cut the payments or fund them via their operating budgets. The problem, however, is that neither the states nor the cities have the capacity to fund this which is why we are in this predicament in the first place. So the pension funds are paying retirees with the principal that is being contributed by current employees and not the investment returns, as it should be. The structure is similar to that of a Ponzi scheme - the longer it goes on for, the more unsustainable it becomes. The fewer the number of workers available to fund the payouts (new money coming into the Ponzi), the faster it crumbles.

The cost of borrowing (interest rates) is also at all-time lows, making this the cheapest period in centuries to borrow, so future interest rate increases will make it that much more difficult for the governments to balance their budgets. The Cost of Living Adjustments (COLA) eliminates the 'inflate it away' option. If the governments are not able to fund it from their operating budget, they have to sell bonds to investors. If investors say no, then they push up property taxes, and then income taxes if needed. Property tax increases depress real estate valuations because it is a transfer of wealth from investors or citizens to the government. If those fail, then they will be forced to cut the pensions. States are currently not legally allowed to file for bankruptcy and so will be forced to take other maneuvers which will likely be via property taxes or pension cuts.

REAL WORLD EXAMPLES

California Public Employees' Retirement System (CalPERS) And The City of Loyalton

The city of Loyalton, a former member of CalPERS, recently terminated their contract with CalPERS. The pension was underfunded at the time of the termination, so CalPERS requested the outstanding liability (a lump sum) to fund the pension fully. Loyalton could not make the $1.66 million liability payment. The liability was derived from a 2% market rate assumption by CalPERS. CalPERS made the decision to cut the pension payments by 60.5% because the scheme was only 39.5% funded. Those employees will only receive 39.5 cents on the dollar or 39.5% of what the city of Loyalton promised them.

CalPERS assumes that it will earn 7.5% but assumes a market rate (U.S long-term Treasury) rate when people want to leave the scheme. So the higher "expected" rate increases the scheme's perceived stability, but when people choose to take a lump sum, the deviation between their perception and the stern reality is severe. CalPERS' board explains the legal process of the cuts and how the board made the decision to make them here and the New York Times also profiled one the city of Loyalton's retirees here.

Source: CALPERS

Dallas Police and Fire

Dallas Police and Fire Pension Scheme was forced to write down a series of abysmal real estate investments and their funded ratio fell from 64% to 45%. Meaning that even if the Dallas Police and Fire meets its overly optimistic 7.25% "expected" future returns, they will only have enough money to pay out 45% of what they promised to the Pension participants who are expecting their full retirement benefits. There is now a run on the pension where police and firemen are retiring to get lump sums because of the uncertainty surrounding the pension's solvency. The city just recently eliminated the lump-sum option to prolong the solvency of the scheme.

Detroit

There is also the Detroit pension plan which the city was forced to cut in its prolific bankruptcy. Detroit opened a city run savings plan for its citizens where it guaranteed them an unsustainable 7.9% investment return. When the city realized how tough it would be to hit these returns, it was forced to make cuts as well as clawbacks - asking the citizens to pay the interest back. Bloomberg profiled a Detroit resident here who was forced to pay the city a $75,000 interest lump sum while also taking a 6.7% reduction in his monthly pension payments. The Detroit City Pension is still underfunded today even after pension cuts and restructuring.

AVERTING OR DELAYING BANKRUPTCY

Pension plan administrators can delay or avert bankruptcy in a few ways:

  1. Abolish lump sums - Abolishing lump sums will not fix the issue, it will cause a severe loss of confidence in the pension scheme, but will also buy the city or state time. The longer the lump sum run for, and they make full payouts to retirees, the faster the pension scheme will run out of money and drive the city into bankruptcy. If they only have $0.45 but pay out $1 to each lump sum request, they'll run out of money if 45% of the pool requests a lump sum.
  2. Make payouts based on zero or negative percent (%) returns - The scheme will essentially be paying something less than 10 cents (depending on what rate is used) on the dollar to those that request lump sums which will improve the funded ratio because the plan has $0.45 cents for each person, but only pays them <$0.10. The more people requesting lump sums in this case, the higher the funded ratio goes. Moreover, once everyone is done redeeming their lump sums, the retirees will realize that they have made a mistake but it will be too late, and they will no longer have the option of receiving payments. For this to work, the city will have to change its pension lump sum payment assumptions to a calculated return which will vary depending on the funded %.
  3. Convert the scheme to a defined contribution plan - At today's asset balance, they could convert the current pension assets and every other future employee's pension plan to a defined contributions scheme thereby taking the risk off their books. It will be a difficult transition, and the retirees will be forced to take cuts, but this will put the scheme on a sustainable path and ensure that the city or states never make pension promises that they cannot cash.

There are much more examples of these around the country like the city of Chicago, or perhaps, the entire state of Illinois, which is on the brink of bankruptcy because of both mismanagement and pension liabilities; Kentucky, etc. The Supreme Court of the State of Illinois ruled against Mayor Rahm Emanuel's proposed Chicago pension reforms. I cannot cover them all, but it is important to be aware of and to take the pension liabilities into account when making decisions to diversify into municipal bonds. Obscenely high "expected" future returns decrease the net liability that investors see which leads them to lend at a lower rate.

Pension funds, in the aggregate, will always underperform their general market benchmarks because:

  1. Hedge Funds, Private Equity funds and other Alternative Investments - Pension funds are increasingly flocking to the aforementioned with the flawed idea that they have to take 'high risks' to generate 'high returns.' So the hedge funds and PE firms collectively underperform their benchmarks while charging exorbitant fees to the Pension funds. I love the finance industry, but facts are facts. New York has recently been criticized for paying these alternative investors $3.8 billion while they produced abysmal investment returns.
  2. The funds are just too big to generate better than market returns - The larger an investment portfolio becomes, the more difficult it becomes to actively post better returns than the general stock market because the fund becomes limited by what it can buy.

So how does this eventually play out?

Post the dot-com bubble, once investors started paying attention to the business models of tech companies, they elaborately scrutinize the rest of them. When they started paying attention to banks in 2007, they got skeptical of all the banks. And when they start paying attention to state and municipal pension liabilities, expect investors to pay attention to all pension schemes nationwide.

It is only a matter of time until the masses realize that the promises their employer (the government) made to them will not be kept and they will likely rush to collect lump sums, as they have done in Dallas. In this case, the states/municipalities will be forced to step in to guarantee pensions or prohibit lump sums. This is when I believe markets will start paying attention to their operating budgets and then appropriately price their bonds for the pension risks, increasing their cost of capital, which the state/cities cannot afford.

Disclaimer: Nothing in this article is investment advice. The views expressed in this article should not be taken as advice to buy, sell, or hold any security.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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