This article was published by The McAlvany Intelligence Advisor on Wednesday, April 13, 2016:
English: Devin Nunes, U.S. Representative from California (Photo credit: Wikipedia)
California Representative Devin Nunes, a middle-of-the-road Republican from the state's 22ndDistrict with a middling voting record (a Freedom Index rating of just 53), got something right: he sees the coming implosion of underfunded pension and health care plans across the country, and offered a bill to do something about it: force the states and the pension managers to tell the truth about the numbers:
It has been clear for years that many cities and states are critically underfunding their pension programs and hiding the fiscal holes with accounting tricks. When these pension funds go insolvent, they will create problems so disastrous that the fund officials assume the federal government will have to bail them out.
Underlying Nunes' proposal is that, once the truth is told, something can be done about it. Increasingly it is apparent that the assumption is false. In so many cases the liabilities are running away from government entities so rapidly that they'll never catch up. The image of Detroit is increasingly being conjured for many of them.
According to Joshua Rauh, a senior fellow at the Hoover Institute, the amount of underfunding is three times larger than that being officially reported. The Detroit bankruptcy in 2013, driven in part by underfunded pension and health plans, cost banks, insurance companies, creditors, and beneficiaries an estimated $7 billion. And that's for a city of just 700,000 population.
Other cities such as Chicago and Austin, Texas, along with states like California, Illinois, Michigan, and New Jersey are likely to follow Detroit, according to Rauh. The solution, according to the author of the study done exclusively for the Financial Times, is for cities and states to increase drastically the amount they are putting away to meet those future obligations. At present they are contributing about seven percent of their budgets; they would need to increase the amount to between 17 and 20 percent to stave off bankruptcy.
That simply isn't going to happen, even in the richest state in the union: Connecticut. According to the Wall Street Journal, that state has roughly half of what it needs to make future promised payments to its workers when they retire. Thanks to severe underfunding by the state, poor investment performance, and longer life spans of those retiring, Connecticut's unfunded pension liabilities have more than doubled in just the last ten years. Unless something drastic is done, according to State Senator Scott Frantz, “Connecticut will end up as another Detroit.”
How could this happen? Poor investment performance, beneficiaries living longer than projected, deliberate underfunding by politicians making short-term decisions in a long-term world, and overly optimistic investment assumptions, that's how. Connecticut's investment performance has fallen behind its peers for years. So far behind in fact that attempts to goose those returns by turning some of the funds over to hedge fund managers have also failed as those expected returns also disappointed.
Connecticut has done all that it was feasibly and politically possible to do to stem the tide: cutting back on hiring state workers, raising taxes, cutting benefits and COLAs, and fiddling with the investment mix. But according to Rauh the state would have to more than double its budgetary contribution – from 7 percent to over 17 percent – starting immediately, to head off the impending implosion. That's just not going to happen.
The credit ratings agencies are recognizing it. Connecticut appears to be in a death spiral so severe that the three credit rating agencies – Standard & Poor's, Fitch Ratings, and Moody's Investors Service – have been forced to cut the state's credit ratings and put Connecticut on “negative” watch for possible further downgrades.
Try hanging all of these governments' pension liabilities – present and approaching – around the neck of the federal government (as Nunes suggests could occur) and watch what happens. It'll be a case of the bailor bailing out the bailee, with what? According to Boston University professor Laurence Kotlikoff, the unfunded and unrecognized (funny numbers aren't limited just to the states) liabilities of the federal government exceed $200 trillion.
Some suggest the real problem lies with the underlying investment assumptions. The higher the assumed rate of return, the lower the obligation (and the perceived, reported “official” total future liability). At present most pension managers assume invested funds will earn between seven and eight percent annually, which, compounded over years and decades, adds significantly to the theoretical pile of funds waiting to be distributed to beneficiaries.
But what if they don't? What if pension managers aren't able to meet the performance assumptions? What happens then? It's simple: it's compound interest, only in reverse.
John Bogle, the legendary founder of the Vanguard Group of mutual funds, offers little help. In an interview with Christine Benz of Morningstar, Bogle said he expects total returns of a balanced portfolio will return 3.5 percent annually for the next decade, half of what most pension fund managers are assuming they'll be able to make.
Others suggest that pushing the responsibility of managing those funds onto the beneficiaries themselves through 401k self-directed plans will solve the problem. Will they do any better than the professionals? Not likely.
In another time and another place, Margaret Thatcher's comment about socialists (“eventually they run out of other people's money”) might apply. Here, however, it's what happens when people run out of their own money, thanks to unfunded liabilities and unfulfilled political promises.
Sources:
Financial Times: US faces ‘disastrous' $3.4tn pension funding hole
The Wall Street Journal: Connecticut, America's Richest State, Has a Huge Pension Problem
MichiganCapitolConfidential.com: State Pension Plans Are Unsustainable
MichiganCapitolConfidential.com: The Real Problem with Government Pensions
Opinion: John Bogle says you won't make much money from stocks
Background on the Detroit Bankruptcy
Margaret Thatcher's alleged quote about socialism and other peoples' money
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