Of all peoples, the Greeks should have seen this coming. After all, Nemesis was the ancient Greek goddess of divine retribution; an avenging deity who knocked down those mortals who dared to fly too high, live too well, or retire too young. Over the last few months, the world has witnessed the spectacle of modern Greece’s benefits-fueled financial self-immolation with a combination of horror and schadenfreude. Many feel coddled Greek workers are getting what they deserve.
Now some argue that a Greek-style meltdown is coming to America. Niall Ferguson, writing in the Financial Times (Feb. 10, 2010), intoned, “…even a casual look at the fiscal position of the federal government (not to mention the states) makes a nonsense of the phrase ‘safe haven’. US government debt is a safe haven the way Pearl Harbor was a safe haven in 1941.” Jim Jubak agrees, “The euro debt crisis is a crisis coming to a nation near you. […] [The U.S.’ debt-plus-pension-and-social-services-liability] comes to 890% of GDP. Move over Greece.” (MSN Money, “Jubak’s Journal,” May 24, 2010) Is the United States about to suffer a fiscal Pearl Harbor?
Maybe. At present the numbers look alarming. In a widely quoted article in Institutional Investor magazine (“Trillion-Dollar Crisis Looms Large Over America” March 10, 2010), Paul Ingrassia and Imogen Rose-Smith cite a variety of estimates for the U.S.’ public pension funding gap, ranging from the merely awful ($500 billion) to the terrifying ($3 trillion). The higher of these estimates includes the cost of health benefits for retirees, which is estimated to be about $1 trillion.
So when does this mountain of debt start to mean something? The answer, simply, is when investors stop lending to states and municipalities in the municipal bond market, causing a liquidity crunch. Chatter about muni default risk has been mounting in the last several months, and has only gotten louder as the Greek crisis has played out. Observers are drawing analogies to the Great Depression, when muni default rates hit 30%, and even to the early 1840s, when nine states defaulted on debts incurred to fund canal, rail, and bank infrastructure projects. Indeed, municipal-bond insurers have gotten much cagier, with the rate of municipal bonds issued with insurance falling from 55% to 11% in the last five years, according to Thomson-Reuters. No state has defaulted on debt since Arkansas during the Depression, but, nevertheless, jittery investors point to pension funding gaps to argue that many states, and perhaps the whole country, are about to face a giant comeuppance, Nemesis style.
Consider statistics cited by Mary Williams Walsh in the New York Times (“State Debt Woes Grow Too Big to Camouflage”, March 29, 2010). California, often condemned as the most profligate state, has a total bond debt load of 8% of the state’s total economy. That’s not too bad. But add in the fair value of its pension funding shortfall, and the load rises to a grim 37% of the total economy. It is these shortfalls that are alarming some municipal bond investors. But so far the ratings agencies are not factoring these deficits into state credit scores, and have even changed their muni rating methodology to align them with corporate debt, which ironically makes munis look safer just when their risks seem to be mounting. Add to this the fear that a mountain of federal government and corporate debt may crowd out the bond market over the next few years, and the notion of a liquidity squeeze or “maturity wall” starts to look less outlandish.
But wait, some with longer memories might say, what happened to the all the money held by, for example, the California Public Employees Retirement System (CalPERS), which reported that 138% of its liabilities were funded as recently as 2000 (and 101% in 2007)? To answer that question, examine what CalPERS does with the contributions made by its beneficiaries. Originally, like many retirement funds, CalPERS was only permitted to invest in bonds. In 1953, the legislature allowed the fund to invest in real estate, and in 1967 it allowed it to invest in common stock, up to a limit of 25% of the total portfolio. In 1984, however, Proposition 21 took off the handcuffs, allowing CalPERS to invest however it saw fit. As of 2007, the fund targeted an asset allocation of 20% international equities, 26% global fixed income, 6% private equity, 40% domestic equities, and 8% real estate. Not surprisingly, the fair value of CalPERS assets has been a bit volatile of late.
So surely, then, if the drop in pension plan asset values is due to the financial crisis, and the pension obligations come due gradually over the course of the next 30 or more years, recovering asset values will eventually eliminate the funding gap. In that case, is the talk of a pension crisis so much hot air? Not necessarily. If the municipal bond market dries up, or begins to demand much higher interest rates for loaning money, cash-strapped states (and localities) may be tempted to lower their contributions to pension funds, thus worsening the shortfall caused by reduced stock prices. Indeed, the Government Accountability Office (GAO) estimated that in 2006, when stock and other asset prices were still rising, states were making smaller contributions to their pension funds than would be required to maintain long-term viability and thus public pension funds were increasingly falling below the 80% funded threshold experts consider prudent (GAO Report “State and Local Government Retiree Benefits” Published Jan. 2008). The effects of the recent deep recession, for which we do not yet have a comprehensive array of statistics, are likely to have made the situation far worse.
This highlights the crux of the pension funding crisis: the desire to increase pension assets by higher investment returns rather than by other means. Part of the issue is that outsized investment returns during bull markets, which by their nature tend to be impermanent, have encouraged benefit increases for plan beneficiaries, which by their nature tend to be permanent. Consider again the case of CalPERS. In 1999, at the very height of dot-com stock sugar high, total plan assets had grown 77% in four years. Flush with cash, the state raised pension benefits for retired police, firefighters, and prison guards, then 2% of their pay for each year worked with a cap of 60% of salary, to 3% and 90%, respectively. Similar increases occurred in other places. It was as if a 55-year old retiree holding $1,000,000 worth of Priceline stock at 1999 values decided to buy a house in West Palm Beach, pledging the stock as collateral.
The recent news that CalPERS is considering lowering its projected rate of return from 7.75% is the first sign that large pension funds may be recognizing the danger of pushing for ever-larger returns. That danger is the risk of increased benefit demands in years of outsized investment returns, as well as increased risk of large losses such as those experienced in 2000-2002 and 2008-2009. This is the key point: the appetite for equity risk among pension managers or those setting policy for pension managers has driven both the ever-increasing benefit demands of pension beneficiaries and undermined the funding base for those very benefits.
The foolishness of pension managers chasing market returns is well illustrated by the experience of the Pension Benefit Guarantee Corporation (PBGC), a government agency established to insure private pension plans of companies that either go bankrupt or otherwise abandon their defined benefit plans. In an attempt to address funding shortfalls in 2006-2007, the new head of the PBGC, Charles Millard, announced a more aggressive investment strategy, raising its equity asset allocation to 45% from 15%-25%. After the policy was announced in February, 2008, the PBGC’s net funding gap ballooned from $11 billion to nearly $22 billion. Although clearly cursed by bad timing, the PBGC’s new policy was questionable at best. The stress on the PBGC has made it less capable of coping with what are sure to be increasing private pension insurance obligations over the next several years as the effects of the recession slowly burn their way through the economy. Indeed, rumors are swirling now of a federal bailout of so-called “multi-employer” pension plans, those run jointly by companies and unions.
Interestingly, former PBGC director Millard took to the editorial pages of the Wall Street Journal (“Washington and Your Retirement” June 9, 2010) to decry the suspension of his asset allocation transition to equities. Millard is right to point out the funding gaps at the PBGC and certainly right to exhort the senate to confirm a new permanent director for the agency. But his argument that the solution to the PBGC’s funding gap is to restart his plunge into riskier investments is completely backward. It is rather like that 55-year old retiree arguing that his Priceline stock is sure to go back up to its 1999 levels and cover his debts.
The likelihood of default by the federal government, or even a state, remains exceedingly minimal. Instead, we are likely to see continued bailouts and payment transfers from federal coffers to shore up state and municipal budgets (and probably PBGC’s as well). The hope is that wretched experience of the last 24 months induces pension plan managers to adopt more conservative projected rates of return and to pursue those in more risk-averse ways. As any ancient Greek would tell you, humility is the best way to avoid the grim deity Nemesis.