Image: iStock.com/Samuel Jörg
A decade ago I pointed out that public pension funds were $2 trillion underfunded and getting worse. More than one person told me that couldn’t be right.
They were correct: It was actually much worse. It has gotten to $2 trillion and much worse in just a few years.
Note that we are talking here about a specific kind of pension: defined benefit plans. They are usually sponsored by state and local governments, labor unions, and a number of private businesses.
Many sponsors haven’t set aside the assets needed to pay the benefits they’ve promised to current and future retirees. They can delay the inevitable for a long time but not forever. And “forever” is just around the corner.
The numbers are large enough to make this a problem for everyone, even those without affected pensions. The underfunded pensions could also be one of the triggers to the unprecedented credit crisis I see coming in the next five years.
The problem is “solvable”… but the solutions will be problems in themselves.
The Funding Gap Is Actually Much Bigger than Reported
A defined benefit pension plan knows it owes a certain number of retirees certain monthly benefits for life. Their lifespans are quite predictable when the pool is large enough.
From that, it’s simple math to calculate how much money the plan should have right now in order to pay those benefits when they are due. But then the assumptions start.
The plan must presume a future rate of return on the invested portfolio, an inflation rate, and in some cases future health care costs (medical benefits are part of many plans).
So, when we say a plan is “fully funded,” it may not be so if the assumptions are wrong.
Almost all public pension funds assume investment returns somewhere around 7% (and some as high as 8%+). That’s highly unlikely due to the debt we’ve accumulated, and debt is a drag on future growth.
If you make more realistic assumptions on future returns the unfunded liability becomes $6 trillion according to the American Legislative Exchange Council.
A more conservative and realistic approach would force the state and local governments to fund those pension plans at a much higher level. They have only two ways to do that: either raise taxes or reduce services.
That may be the reason policymakers have turned a blind eye to this.
Pension Fund Underfunding Is Also a Local Problem
Another problem is that the taxpayers who might have to cover these amounts are mobile. They can move to other states with lower tax burdens.
And to make it even more interesting, the beneficiaries often no longer live in the states that pay them. Retired public employees from the Northeast might live in Florida now, for instance. They can’t even vote for the people who govern their incomes.
The broader point: As with the federal debt, some portion of this unfunded pension debt is going to get liquidated in some way. Any way we do it will hurt either the pensioners or taxpayers.
The Future Looks Grim
The most common solution to this problem so far has been cutting services in the hope no one notices.
It is happening nationwide but California takes the lead, thanks to its massive pension debt. This is from a recent Brookings Institution note.
Pension and health-benefit costs are bending education finances in California to their will. The sheer magnitude of the rising costs is staggering. Large numbers of school board officials who participated in our survey indicate that the rising costs are meaningfully affecting educational services. For example, many report making cost-saving changes to district budgets that include deferred maintenance, larger class sizes, and fewer enrichment opportunities for students in response to rising pension and health benefit costs.
So in effect, today’s students are paying to keep benefits flowing to retired teachers and administrators.
Meanwhile, the Berkeley city council is taking criticism for prioritizing pension payments ahead of public works projects.
Voters approved bond issues supposedly dedicated to infrastructure but the city is apparently not doing the work.
Nor is it just California.
Bank of America analysts found an inverse relationship between infrastructure investment and pension fund contributions. Each additional $1 billion in plan contributions takes away about $2.5 billion from state and local government investment.
We have multiple parties fighting over pieces of the same pie, all hoping that Uncle Sam will step in and save them. Uncle Sam may well do it, too, but it won’t remove the pain.
It will just redistribute the burden, perhaps more widely, but the aggregate amount won’t change.
I see this leading to some kind of Japan-like deflationary recession or debt monetization. If we’re lucky, it will be mild and long. It won’t be fun but the alternatives would be worse.
The Great Reset: The Collapse of the Biggest Bubble in History
New York Times best seller and renowned financial expert John Mauldin predicts an unprecedented financial crisis that could be triggered in the next five years. Most investors seem completely unaware of the relentless pressure that’s building right now. Learn more here.