This article is the fifth in a series of ten articles addressing the future of slow GDP growth, high Federal debt, and strained household finances.
(Skip this section if you're familiar with how pensions work.)
For starters, pensions are complex animals. The underlying premise is: 1) The government plan sponsor and employees contribute amounts regularly via annually budgeted government contributions and employee paycheck withholdings, respectively. 2) These funds are invested to grow, to earn more before employees begin retirement, usually working up to 30+ years or by age 60-62+, depending on the plan. 3) At any given time, pension plans are not expected to be 100% funded for the full future liabilities to be paid out. This is because employees won't retire for years, and, future investment earnings are expected to make up the difference. The general standard for a pension plan is to maintain a funding level of 80% of 'actuarially accrued benefits'. That is, what the amount needs to be now in order to earn the remainder as investment earnings before retirement. Any level over 80% is good, and the lower the funded level is below 80%, the harder it will be to fund the financial gap.
Why are some government pensions underfunded? Most likely for these three reasons:
1) Poor investment returns since year 2000, below expected levels. Two major recessions didn't help matters, despite the last 8 years of a bull market which began in 2009.
2) Past and future overestimates by governments of expected investment returns, well beyond what realistically was, and likely will be, achieved. This applies to both since 2000, and looking ahead. Governments kept the annual expected returns estimate high so that they would not have to come up with more funding, given tight budgets.
Future returns are expected to be much lower. This is mostly because a) the market, as measured using the S&P 500, is presently at a high-price level. Numerous studies have shown, including by Robert Shiller with his CAPE ratio, that when this is the case, future annual returns are much lower. Here's an explanation: U.S. Stock Market Valuations And Future Returns Of The S&P 500 Additionally, a slower GDP will dampen U.S. economic growth, meaning it's possible that business revenues and profits will not grow at the same pace as in past decades. Per a CBO report (see article 2 of 10), GDP is expected to average 1.9% annually for the next 10 years to 2027.
Historically the S&P has averaged roughly 8% returns annually. It's not expected to earn that going forward. It's beyond the scope of this blog to go into detail why, but it's primarily for the two reasons cited in the previous paragraph (market is priced highly, and slow GDP growth).
Pension plans in past years used 8% as a rate for expected annual investment returns. The more the plan investments can earn themselves, the less which has to be contributed by employees and governments. Per a study by Joshua Rauh, pension plans on average have decreased their estimated annual returns to a lower 7.6% rate. Better, but not low enough. Hidden Debt, Hidden Deficits: 2017 Edition
Realistically, pension plans need to reduce the expected rate of return much lower, as discussed in this article by Lance Roberts: The Unavoidable Pension Crisis
"In a recent note by my friend John Mauldin, he discussed an email Rob Arnott, of Research Affiliates, sent regarding this specific issue.
“Quoting from his letter (in which he assumes the typical 60% equities/40% bonds ratio that most pension funds use), here’s the math:
40% Bonds. Yield is 2% for the US aggregate bond market.
60% Stocks. Our base case is 5.4% for US stocks, but we think valuations are too high, so we trim this to 3.3% for the coming decade.
Here’s our logic:
- The yield is 2%.
- Earnings growth over the past century has been 4.5%, of which 3.1% was inflation (real growth of 1.4% … far less than most people realize).
- Inflation expectations are about 2%, so perhaps we should trim this forecast by 1.1%.
- This gives us a base-case of 5.4%.
- Valuation multiples are stretched, with the stock market priced at 25 times the 10-year average earnings, against a historical norm of 16.8x. If we’re back to historical norms in 10 years, that costs us another 4.2%. Since valuation multiples could ((a)) return to historical norms, or ((b)) remain at today’s lofty multiples, let’s split the difference, and trim our return expectations another 2.1%.
- This gives us a likely outcome of 3.3% from stocks.
If our logic is sound, we earn 0.8% from our bonds (40% allocation x 2% return) and 2% to 3.2% from our stocks (60% x 3.3%, or 60% x 5.4%). Add up the return from stocks and the return from bonds, and we get 2.8% to 4% from our balanced portfolio.
Bottom line … US public service pensions are toast."
So if your eyes glazed over on this last section, the point is that future pension fund returns based on this estimate will be 2.8% - 4% annually. Compare that to Rauh's average rate for the public pension plans of 7.6%, and that leaves a gap of 3.6% - 4.8%. On a compounded basis, this shortfall impact on returns is exponential and massive. If pension plans were to lower their expected annual rate of return to, say, 3.3%, this would radically increase the level of annual contributions needed, and exponentially increase the unfunded liability. Hence, Rauh's estimate of the variance of the unfunded gap is $3.8T to $5.2T and stems from using different ranges of expected annual investment returns.
Therefore, by embracing an artificially high expected rate of return, pension administrators can easily sidestep the degree of the crisis. John Mauldin puts it this way: Angst in America, Part 5: The Crisis We Can't Muddle Through
"The fatal flaw here is that required annual pension contributions are an easily gamed number. A city council can shop around for a consultant who gives them whatever number they desire, and they frequently do just that. But the game gets harder to play as time passes and the bogus numbers get bigger and bigger."
3) Reluctance by governments to change their estimated future investment returns to reflect realistic returns. Government officials don't want to pay any more into pension plans, nor raise employee contributions, if they can avoid it. Budget pressures for spending today prevail over contributing more to pension plans whose problems won't surface until years from now.
There are some cases where governments simple don't even pay in the full amount to pension plans as actuarially required annually (IL, for one). That is, in some cases, state and local governments are already running annual operating deficit budgets (more below on this). They are permitted do so by drawing down on fund balance reserves (savings). But, by federal law, local governments cannot declare bankruptcy, and they have constitutional borrowing limits. Plus, their debt is rated by the rating agencies. Hence, the worse their financial situation becomes, the more costly the interest expense is for future borrowings. Bottom line - unlike the federal government with no constitutional borrowing limits, state and local governments can't legally borrow more to solve this: The day of reckoning is coming for some states.
WHAT'S THE OVERALL ESTIMATED UNFUNDED STATE AND LOCAL PENSION LIABILITY?
According to the link below, in a report by Joshua Rauh dated May 15, 2017, the minimum amount of the shortfall is $3.8 trillion: "... I find that as of FY 2015 accrued unfunded liabilities of U.S. state and local pension systems are at least $3.846 trillion...".
No widely followed economist that I have read has written more extensively on this topic than John Mauldin. Here's one article, with a quote regarding alternative estimates of the size of the unfunded pension gap. Promises, Promises, Pension Promises
"An April 2016 Moody’s analysis pegged the total 75-year unfunded liability for all state and local pension plans at $3.5 trillion. That’s the amount not covered by current fund assets, future expected contributions, and investment returns at assumed rates ranging from 3.7% to 4.1%. Another calculation from the American Enterprise Institute comes up with $5.2 trillion, presuming that long-term bond yields average 2.6%."
According to this article by Lance Roberts, he pegs the funding gap as follows in his article: The Unavoidable Pension Crisis
"If the numbers above are right, the unfunded obligations of approximately $4-$5.6 trillion, depending on the estimates, would have to be set aside today such that the principal and interest would cover the program’s shortfall between tax revenues and payouts over the next 75 years."
HOW MANY PEOPLE WILL THIS IMPACT?
I scanned Joshua Rauh's whitepaper linked above, but he did not cite the number of current and prospective state and local government employees enrolled in the pension plans he studied. Here's a link below to a census bureau web page on the topic, which lists 20m as the total enrolled as of 2016 (with a further breakdown between state and local numbers, plus active versus inactive). Some plans are sufficiently funded, so net of those which are, something less than 20m will be affected by insufficient pension funding. That's a lot of present and future retirees.
ITS GETTING WORSE, NOT BETTER
Per Rauh's report cited previously Hidden Debt, Hidden Deficits: 2017 Edition
"...Furthermore, while total government employer contributions to pension systems were $111 billion in 2015, or 4.9 percent of state and local government own revenue, the true annual cost of keeping pension liabilities from rising would be approximately $289 billion or 12.7 percent of revenue."
That's a difference and one which will be painful if not improbable for governments to begin funding. It would require substantial service or capital improvement budget cuts, or higher taxes. Realistically, government officials will have a hard time politically justifying service cuts, or raising taxes, to fund pension benefits funding for their employees. If for no other reason, the plans which are significantly underfunded have little hope to ever be sufficiently funded, and that means retirement income cuts for such current and future retirees are likely.
WHICH STATES' PENSION PLANS ARE IN THE WORST FINANCIAL CONDITION?
-Per the cool map of the US per Bloomberg article dated August 29, 2017 (link below) NJ, KY, and IL are in the worst shape under 40% of funded levels. If you are current or future retiree depending on a pension from these three states, you had better watch this very closely (to put it mildly). It is important to note that this is overall statistics by state and does not address a given specific plan within each state. State Pension Funding Worsens for 43 States
-Five states are under 50% funded. Here's a quote from a John Mauldin article on the pension crisis: "Yet most pension experts will tell you that there is no bouncing back, no restoring the ratio to a healthy level once it has dropped below 50%." Angst in America, Part 5: The Crisis We Can't Muddle Through
-Seventeen states are between 50%-69% funded. That means twenty-two states under the 70% funding threshold face future serious difficulty.
-Thirteen states are between 70%-80%, and 15 states, plus the District of Columbia, are above 80%. Any state at 80% or above is in decent shape, and between 70-80%, close enough to return to the target 80% within the 30-year standard industry time frame, albeit with some changes such as lowered COLAs or increased contributions.
WHICH STATE IS THE CURRENT POSTER-CHILD FOR THE PENSION PLAN FUNDING CRISIS?
New Jersey, Kentucky, Illinois, Connecticut, and Colorado public pensions are in poor shape, as all states are under 50% funded. Let's look at IL: Per a June 30th 2016 version of the Bloomberg article linked above, this quote: "As of the 2015 fiscal year, Illinois had promised its employees $199 billion in retirement benefits. Right now, it’s $119.1 billion short."
Per an article dated June 20, 2017 per this IBD link: Illinois Financial Crisis Looks Ever More Dire
"'We are now reaching a new phase of crisis,'" State Comptroller Susana Mendoza said..." pertaining to a court order that the State's unpaid Medicaid bills must be paid. "In a separate, but related bit of financial trauma, Chicago public schools are now paying an exorbitant (and tax free) rate of 9% on its adjustable-rate bonds."
"Moody’s did acknowledge that with a budget in place and $5 billion in higher income taxes approved, the state can begin to pay down its $15 billion bill backlog." (And you think you have bills to pay?) Moody's questions Illinois' ability to pay bills
It can't be ruled out that Moody's could lower Illinois' bond rating to junk status. Eventually the clock may run out on IL, increasing the possibility of eventual of bond defaults.
HOW ABOUT OTHER STATES?
Not much better according to this article: Public Pension Crisis Reaching A Tipping Point
However, "the granddaddy of them all is California," McQuillan said. "We have anywhere up to $750 billion unfunded public pension debt at the state and local government level... It's a massive problem here."
"The reality is, it's likely to take a crisis to get the public to notice and force change. The problem is so bad in some places that money is being siphoned from police, fire, schools, roads and other funds to bridge the gap."
Minnesota has its share of issues as well: New Math Deals Minnesota's Pensions the Biggest Hit in the U.S.
The Puerto Rico fiscal crisis is the canary in the coal mine. Essentially, P.R. bondholders may ultimately take a massive haircut, receiving much less on the dollar than expected, once it's all resolved. Despite an appeal to the Federal Government, no bailout was provided. It's possible that congressional members realized states are heading in the same direction, and sent a message with the P.R. decision - no Federal bailouts. The P.R. population has decreased due to migration to the states by residents (they are U.S. citizens), abandoning the territory for a better life. What You Need to Know About Puerto Rico's Debt Crisis - Law Street (NYSE:TM)
WHY HASN'T SOME PENSION REGULATOR DONE SOMETHING TO PREVENT THE UNDERFUNDING?
The answer is because there is no regulator with the power to enforce a lower expected estimated investment rate and mandate that annual pension payments by the government must be paid first. Both are subject to the priorities of the governing elected officials.
The GASB (Government Acconting Standards Board) has regulatory authority over financial reporting for governments. Beginning with financial statements for years ending after June 30, 2015, governments are now required to report the following: http://www.gasb.org/cs/BlobServer?blobkey=id&blobnocache=true&blobwhere=1175828264598&blobheader=application%2Fpdf&blobheadername2=Content-Length&blobheadername1=Content-Disposition&blobheadervalue2=145542&blobheadervalue1=filename%3DGASB_New_Pension_Statements_article_12-13.pdf&blobcol=urldata&blobtable=MungoBlobs
1) "Nevertheless, a government has a present obligation to pay these deferred benefits in the future—a total pension liabilty—once they have been earned. When the total pension liability exceeds the pension plan’s net assets (now referred to as plan net position) available for paying benefits, there is a net pension liability. Governments will now be required to report that amount as a liability in their accrual-based financial statements (for example, the government-wide statement of net position)."
2) "If there comes a point in the projections when plan net position and contributions related to active and inactive employees is no longer projected to be greater than or equal to projected benefit payments related to those employees and administrative expenses, then from that point forward a government would be required to discount the projected benefit payments using a municipal borrowing rate—a tax-exempt, high-quality (an average rating of AA/Aa or higher, including equivalent ratings) 20-year general obligation bond index rate."
This accounting gobbledygook language requires two changes: report the unfunded liability on the balance sheet, and, a recalculation of the liability using a much lower fixed income rate if conditions meet the criteria of the GASB pronouncement. While this certainly results in a more realistic reporting of financial condition of government liabilities for pension plans, it doesn't require the governments to pay those much larger, more realistic, unfunded liabilities.
WHAT IS THE MOST LIKELY OUTCOME HERE?
States with funded levels between 70%-80% can resolve this by increasing the state and employee contributions, if they act to do so. It will be painful, but, it can be fixed. Ohio's OPERS is currently considering reductions of its COLA, among other options. OPERS - COLA Update
In a some instances, for states which have not already done so, where retiree medical benefits are part of the retirement package, states may make changes to alter or discontinue the medical plan and shift the contributions to the pension plan. Usually retirement benefits are constitutionally protected, but retiree medical benefits are not. I'm a retiree with a pension plan from the state of Ohio. In Ohio, for the OPERS plan (state and local governments), they will drop spouse retiree health care coverage after 2018, and the retiree coverage after 2019. Instead, they will advise reireees on obtaining coverage through the marketplace 'exchanges'. They will also provide a monthly stipend into a retiree's HSA of up to the mid-$300s per month (dependent on length of service and other factors). This is in lieu of providing medical coverage.
For states between 50%-70% of underfunded levels, it's going to be more much more difficult to bridge the funding gap. More contributions will be likely required by current employees and governments. It's likely there will be continued changes in plans in the form of reductions of initially planned payments for retirees so that current funds and expected payments can help bridge the funding gap.
And its not as if this is going to be a walk in the park for states to merely start contributing more to their pension plans. They are dealing with serious budgetary challenges. Most states are facing budgetary deficits, that is, where receipts are short of expenditures. They are relying on reserves to make up the difference, until they ultimately balance the budget. States can offer a lesson as GOP proposes deep cut taxes
"A recent Associated Press survey found that more than half of the states — 33 — are currently dealing with a budget shortfall or expect to confront one in the coming fiscal year. Experts say state economic growth has been slower than expected, with revenue in some places failing to meet projections or keep up with rising spending needs."
Furthermore, the Republican House and Senate plans will reduce the rate of future Medicaid funding to states in an effort to send less to shore up the underfunded Medicaid underfunded condition. (If you are reading this at a much later date, perhaps the resolution of these proposals will be known). Per the same article above:
"A House tax plan would reduce federal revenue by $3 trillion in the first 10 years, while Trump’s plan would cut revenue by $9.5 trillion over the same period, according to the nonpartisan Tax Policy Center. Trump has disputed the analysis." As of the date of this writing, it remains an uncertainty what will happen with the future Federal budget and Medicaid funding.
IT MAY BE WORSE THAN IT SEEMS - IT MAY BECOME A CRISIS FOR SOME PENSION PLANS AND THEIR PENSIONERS
For the states with the worst funding ratios, it's highly likely there will be cuts to pensioners, as the only alternative. When the money is not there, it simply cannot be paid out. States can't borrow their way out of this mess. Per this article: Public Pension Crisis Reaching A Tipping Point
"Though contributions have increased in recent years to make up for the shortfall, public pension liabilities are still climbing at a much faster rate and are unlikely to be reversed even under the rosiest scenarios, notes Bloomberg, based on a recent study by Moody's:
The optimistic "best case" of cumulative 25% investment return would reduce net pension liabilities by just 1% through 2019 year-end because of past bad investment returns and weak contributions. Meanwhile, the "base case" scenario of 19% returns would see net pension liabilities rise by 15%."
"These funds work on the assumption that they're going to generate returns 25 percent higher than Warren Buffett every single year into perpetuity, McQuillan noted. That's an insanely optimistic rate, but it allows politicians to low-ball contributions and use that money for other politically expedient ends."
For some states, we may see a continuation of lowered bond ratings, and in some cases, perhaps to junk bond status. At that juncture, such states will have reached the point of no return - no more kicking the can - where borrowing costs will become prohibitive. Ultimately, the bond market will likely drive the states to address the problem by refusing to commit to buy their bonds except at exhorbitantly high interest rates. The Pension Crisis and the Muni Bond Market - Articles - Advisor Perspectives
It's going to be simply too late for some states (and, some city governments which have their own pension plans, rather than participating in state-sponsored plans). Their current pensioners will take a haircut, and future retirees will contribute more, be required to retire later to qualify for a pension, perhaps face reduced or no health care benefits, and, receive less than expected when they retire. For states such as IL, KY, and CT and others, retirees may take a cut in pension income.
From the Mauldin article mentioned above Angst in America, Part 5: The Crisis We Can't Muddle Through
"'We are promised...' is the haphazard refrain often encountered when the reduction of pension claims is mentioned. Promised or not, one distinguishing feature of non-federal government spending commitments stands out: Only the United States has a printing press. States cannot print money. They can earn returns on their pensions’ invested assets, they can sell city hall, lay off the public works department, and tax, but an underfunded pension plan can only pay claims with dollars that exist."
[One personal note: I spent 21 years as a finance director, advising management and elected officials on policy for local governments. Despite all rightful claims by pensioners that 'they were promised' benefits, if the cash is not there, it cannot be paid out, period. Also note that I take no pleasure in saying this whatsoever, and, also as an OPERS pension member facing a very probable reduction in my future annual COLAs.]
1) Per the quote above from the Mauldin article: "...an underfunded pension plan can only pay claims with dollars that exist." While some states' pension plans are in good financial condition, many others are not. Those retirees in states with the worst unfunded levels will take a cut in pension pay. (I'll reference this in another article in this series on the status on individuals and their retirement preparation).
2) Some states facing pension shortfalls will become handcuffed by future increases necessary to restore funding. This will result in great difficulties in funding other priorities, with many cuts expected to normal services, higher fees (licenses, etc), and deferral of capital maintenance and improvements.
3) How will the states in the worst condition resolve the issue? States might consider imposing higher employee and employer contributions, and even more income taxes. If they risk the latter, states could risk a possible exodus of population, accelerating the situation into a continued viscious downward spiral. At the worst level of fiscal crisis, the only realistic workout pattern is well known. Pensioners will incur retirement payment cuts. The states may face junk bond ratings, and we can't rule out eventual bond defaults, where investors will get less than their full investment. For the very worse - a major debt restructuring may be unavoidable.
1) Setting aside the well-funded plans, state and local government pension plans are presently underfunded by between $3.8-$5.2T, a financial gap which needs to be set aside today.
2) This may affect a figure of something under 20 million public pension employees and retirees, many of whom may face future pension income cuts because of the magnitude of this funding deficit.
Disclosure: I am/we are long EQIX COR CONE MSFT O STWD JCAP HASI UNIT HD LOW.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.