Allow me to start off with a quick clarification on a few points even though this might be well understood by many readers. Defined Contribution pension plans refer to money being put away and the pension is directly linked to that pot of money, the pension will vary based on the sum of money saved and the return on the investment. The money can be put away by the employee and/or the employer. Defined Benefit pension plans primarily come from the employer and are usually determined by factors like years of employment, final salary, age of retirement and sometimes an annual increase after retirement. That annual increase can be a fixed percentage or linked to a core inflation number, for example. The problem with defined benefit plans is that there is no direct link between the assets put away and the liabilities to pay the pensioners. If you make unrealistic assumptions about expected returns and/or don't set aside enough money, you end up with an underfunded pension plan.
Based on history and human nature, defined benefit plans often run into problems as we always prefer to pay for something tomorrow rather than today. Defined benefit systems drastically decreased in the private sector a while back, at least for new policies. This change has lagged in the public sector and I aim to discuss the implications of that in this article.
Another term I will use throughout the article is the funding ratio. The formula below looks simple enough, but the main sticking point is the discount rate used for the liabilities. Because liabilities might be discounted 50+ years out into the future, even small changes to the discount rate can make a massive difference in the present value of the liabilities and consequently the funding ratio.
Funding Ratio = Assets / Present Value of Liabilities
The state and locally administered pension plans across the U.S. are seriously underfunded. I do acknowledge that the trade might be less obvious, but I do think it is important to raise the point regardless and share my takeaways. This is naturally a contentious subject, but the reality is that promises have been made and I see no way of those promises being honored, at least in real terms.
There have been a number of reports filed on this subject and the total amount of unfunded liabilities vary from low to high single-digit trillions. The expected return assumptions being used naturally have a significant impact on the numbers. One estimate puts the total figure at $6T from 299 state-administered and 5,977 locally-administered pensions across the U.S.
Most of the data I will discuss refer to state-administered pensions, because there is more and better data available. Also, state pensions are potentially a worse problem since state pension promises are more difficult to break. States are not allowed to go bankrupt under the current law. Some states have also passed laws preventing cities from negating on pension promises, but bankruptcy will likely be the route for some of the cities with excessive liabilities, when that option is available.
Figure 1 - Source: Center for Retirement Research at Boston College
The Pew Charitable Trusts reported a $1.4T deficit by the end of 2016 across the 50 states. The median return assumption for the pension funds is 7.5% and Pew applied a 6.5% return assumption. I find both 6.5% and 7.5% wildly optimistic given the current market environment, which could lead to far higher deficits than the $1.4T. Government interest rates across the curve are well below that and I don't expect the Fed will be able to get anywhere close to 6.5% without completely breaking the equity market. We are already seeing stress in the market with interest rates moving above 3%.
While equity valuations might not matter in the short term, they have shown to be good predictors for the long term. A Shiller PE of 30.6 does not bode well if history is any guide at least. John Hussman predicts negative equity returns over next 12 years based on his Margin-Adjusted CAPE ratio, which has historically had a very high correlation with future returns.
Figure 2 - Source: Shiller PE
Equity returns for 2017 were good, which likely improved the deficit situation for some states during last year. Equity returns YTD in 2018 are not that impressive after the recent sell-off and equity returns are negative for many other parts of the world, so the deficits will likely continue to grow in 2018 for most states.
Figure 3 - Source: YCharts
The below chart is illustrative for the situation with benefits payments consistently growing more than total contributions.
Figure 4 - Source: The Pew Charitable Trusts
The below table calculates the funding ratio using each state's self-reported assumed return, often in the 5-8% range and the funding ratio using a risk-free rate, which was 2.142% at the time. I do acknowledge that 2.142% is probably too low, at least in the very long term. The table does a great job of illustrating how dire the situation becomes if we have a decade of poor equity returns or a more pronounced decline, for example.
Figure 5 - Source: The American Legislative Exchange Council
It is fair to say this is a country-wide problem, but some states are far worse than others. Pew used a 6.5% return estimate and concluded that Kentucky was only funded by 31%, the same was true for New Jersey and Illinois was funded by 36%. The American Legislative Exchange Council's report estimates the average funding ratio to be 33.7% using the more pessimistic risk-free rate. Moody's recently released a report noting that adjusted net pension liabilities for Illinois reached $250B in 2017 or 601% of state revenues, which highlights how desperate the situation is.
Figure 6 - Source: Tax Foundation
There are some positive signs. We are seeing reform in some states. States are lowering living adjustment rates and moving more policies towards defined contribution models. However, the changes often deal with future pensions and not necessarily existing liabilities. Also, the cost savings are often multiples lower than what is required to make a dent in the overall liabilities. So, it will by no means resolve the situation, but it might at least prevent the problem from compounding at a higher rate. The longer it takes for real change, widespread adoptions, the more difficult the problem will be to reverse.
Another point raised by the Institute for Pension Fund Integrity is that there have been a number of politically motivated campaigns to divest from certain sectors like Energy, for example. Energy investment often offers uncorrelated returns. The sector also works as an inflation hedge which at least I think can be very important going forward. We can hope this will not get widespread traction which also has the potential to make the situation worse than it already is.
There are a number of ways this situation gets resolved and none of them is particularly pleasant. The states declare bankruptcy and the court will have to find a reasonable level of liabilities that can be honored. This is an extremely hard decision as promises to pensioners or future pensioners will be broken outright. Also, the current law does not allow for this, so the law will have to be changed. Even if this route is pursued, the decision will likely be appealed in courts, so it would take a long time to go through. I can't see any politicians willing to go down this route unless the situation gets even worse with a prolonged period of non-payments.
Another option is that the liabilities are pushed up to the federal level, but this would also be a very difficult political decision to motivate. The moral hazard argument is very prevalent: why should the rest of the country bail out fiscally irresponsible states or cities?
Taxes can be raised to fund the liabilities, but this only works to some extent as politicians will not get re-elected if other residents of the states are squeezed too hard. People are also moving away from states which lowers tax revenues and compounds the problem. This is something we have seen already in some states for a while.
Money can also be reallocated from often vital services in the states to plug the pension deficit. This is also difficult to sell from a political perspective. If crime runs rampant, schools deteriorate and there is no one to put out fires, residents that are mobile are once again unlikely to stick around and tax revenues decline.
The other option, which the states have less control over, is inflation. Some pension liabilities can have inflation protection, but far from all of them, so this might very well be the way it gets resolved. Significant inflation would constitute a default in real terms, but it's a default without the admission of guilt which politicians would likely prefer.
When looking at figures in some of the worst states, I would conclude. Promises will be broken, there is simply no way around that. If not in nominal terms, at least in real ones. From an investment perspective, the implications are less obvious. I would most certainly avoid bonds issued by some of the states with high unfunded liabilities, even if they can't default today under the law. If states run out of money, the law makes little difference and the states don't have a printing press like the U.S. Government. I highly doubt bondholders will be paid before senior citizens with a vote to cast.
When it comes to larger illiquid investments like real estate, whether the states and cities have a high amount of unfunded liabilities could also become more important over time. A fantastic location might matter less if property taxes quadruple.
It is worth pointing out that the U.S. is not the only country with these problems, it applies to many European countries as well. The demographics are better in the U.S. compared to some European countries which will have fewer taxpayers supporting retirees. That matters less from an investment perspective, though. Regardless of where one lives, I would recommend lowering expectations for anyone with defined benefit pension plans. It is certainly possible that tax changes could affect defined contribution funds as well over the longer term, but likely to a much lesser degree than defined benefit policies.
Also, in the same way federal tax revenues are linked to equity returns, high equity returns are required on the state and local level to plug the pension deficits. So, if we have another more significant drop in the equity market, the systemic effects are likely underestimated by the market.
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I enjoy my anonymity, where I write under the name Bang For The Buck. I hold a BSc and MSc in Financial Economics, but most of my value-based investment knowledge comes from independent learning where I am a perpetual student. I primarily focus on turnaround stories, with attractive valuations, in cyclical industries. I have a significant portion of my portfolio exposed to the precious metals industry due to current monetary and fiscal policies.
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