Pension Disaster Makes States and Cities into Financial Basket Cases

Employees of US states and cities have much better pension plans than do Average Americans and this is creating some serious budgetary problems, one reason to be very careful in assessing municipal bonds, particularly general revenue ones.

A recent FT article puts some numbers on this problem:

The US public pension system faces a higher-than-expected shortfall of more than $2,000bn that will increase pressure on many states’ strained finances and crimp economic growth, according to the chairman of New Jersey’s pension fund.

The estimate by Orin Kramer will fuel investors’ concerns over the deteriorating financial health of US states after the recession. “State and local governments are correctly perceived to be in serious difficulty,” Mr Kramer told the Financial Times.

“If you factor in the reality of these unfunded promises, their deficits will rise exponentially.”

Estimates of aggregate funding requirement of the US pension system have ranged between $400bn and $500bn, but Mr Kramer’s analysis concluded that public funds would need to find more than $2,000bn to meet future pension obligations.

Under no circumstances should you believe the looming pension crisis is merely a public sector problem. Witness the recent post I wrote on the private sector pension problems and its connection to sluggish hiring. Nor is this  only a US problem.  For example, recent estimates put the aggregate defined-benefit pension hole at UK companies at £212 billion.

But, municipalities and states are tax revenue constrained due to the drop in income and property taxes. Moreover, many have balanced budget amendments in place and that means any shortfall results in cuts. The FT article points to cuts in public sector pension benefits as a potential outcome. But public sector unions will fight this tooth and nail. I see cuts in services as more likely. 

Moreover, the desire to reach for yield is immense. Orin Kramer estimated that public pension funds base their numbers on actuarial assumptions that use 8% returns – a number that is ridiculously high in a zero-rate environment but which still yields an aggregate $1 trillion deficit for public funds.

There are many investment restrictions for funds on both shorting and below investment grade bonds. This means pension funds are generally longer-term long-only investors which must reach for yield on long-term bond investments to meet nominal actuarial targets. This was done in the last bull market by buying AAA paper that turned out to be toxic. If the 70%+ returns from March 2009 lows turn into phantom profits which later revert to mean due to a double dip, you’ll have a real problem just when tax revenues are under assault.

Source

US public pensions face $2,000bn shortfall – FT


Originally published at Credit Writedowns and reproduced here with the author’s permission.