On average, state pension funding is now below 50%, but beneficiaries and the press are silent

To get an idea of ​​just how little media interest there is in the slow-moving state pension crisis, go to Twitter and search for “state pension underfunding.” I receive tweets by year: 2016, 2020, 2020, 2021, 2015, 2021, 2015, 2009, 2012, 2012.

No, sports fans, the lack of actual interest is not because the problem has gotten better. Given that the Fed is trying not only to bring down inflation, but also to put the US on a solid footing out of the ZIRP-y policy regime, the outlook for financial assets in the foreseeable future is not so bright. And that’s before we even get to the impact of climate change and resource scarcity on corporate profits. As we will discuss in more detail shortly, new Bloomberg article by Aaron Brown, a former MD and head of research at AQR, shows that the state of public pension funding is more dire than many think. For example:

The widespread failure of the public pension model calls into question the viability of the pension savings model. Neoliberalism requires labor mobility and weakens social bonds. It also adds to the strain on already fragile nuclear families. The model for retirement in the era of subsistence farming was to live with children and grandchildren or other extended family members. The elderly could still be helpful, even if they were minor players in household chores, childcare, light cooking and cleaning, and other support. In the post-World War II era, the corporate and labor elite received generous pensions while others could still save up for retirement by buying a house. The terms of the mortgage loan for 30 years corresponded to the usual work lie. The pensioner could live without a mortgage or sell his house and move to a smaller convent.

Short tenure in the workplace, expensive housing leading to much later initial home purchases, and incentivizing homeowners to raise capital through tax-advantaged second mortgages undermined the “home as a savings model.” Now people are encouraged to save and invest in financial markets.

But market advertisers forget that it took the stock market until the mid-1950s to recover from the crash of 1929. And the period after World War II was exceptional when the US initially had 50% of the world’s GDP and was able to implement a governance structure to its liking and under its control. After the stagflationary 1970s, there was a very long period of falling interest rates in the US, ending in May 2007. Lower interest rates pushed up the prices of financial assets, especially conventionally leveraged assets such as real estate and risky assets such as equities. Asset prices have been given new life by the Fed and other central banks keeping interest rates in negative real yield territory.

The problem is that investing in retirement has nothing to do with productive investing. Trading securities on the secondary market is a tiny part of the new sales of securities to finance the operations of the company. One indication of how little public companies are investing in their business is their level of share buybacks. In 2005, we pointed out that companies had become so short-term oriented that they were unwilling to invest even in projects with a one-year payback, for fear of the impact of higher spending on earnings in the next quarter. This means that many managers see the slow liquidation as the most attractive route, using cost reduction as the main driver of profit growth from existing operations.

The reason public pensions are part of the problem is that public pension managers and trustees, like many individual investors, were convinced that a long-term return on investment of 7% was perfectly reasonable. But it is unreasonable to expect investment to continue to return more than GDP growth. An indirect proof of this fallacy is the extent to which investment, like capital, involves more and more rentiers at the expense of labor. In the US, profits as a share of GDP were about 6%, a level that Warren Buffett considered unacceptably high. Over the past few years, profit compared to GDP has almost doubled. Thus, the increase in workforce fragmentation as a tailwind to stock prices is also likely to subside.

Keep in mind, not all public pension funds are in bad shape. Brown’s data looks particularly bleak compared to other surveys, but usually only covers state pension plans, while he includes municipal plans. From his work:

State and local pension funding is one of those perpetual crises that always seem to be looming, but only occasionally lead to limited real disasters in places like Detroit, Puerto Rico, or the smaller but more recent Chester, Pennsylvania. In fact, all municipal bankruptcies in the US in the 21st century are due to underfunding of pension plans. But none of the defaults has so far caused a domino to fall: skyrocketing municipal bond yields, taxpayer uprisings, or civil servants on strike. Will state and local pensions fluctuate over the next few decades, bankrupting one or three failing cities without provoking a general political or economic crisis? Or are we, in the immortal words of Jim Steinman, “living in a powder keg and emitting sparks”?

Note that one of the reasons the day of reckoning seems slow is because retirees in defined benefit plans, thanks to recent rulings by the Court of Appeal and the Supreme Court, cannot sue plan sponsors or trustees for breach of fiduciary duties and others. Misconduct until they literally do so. t get all its benefits. The fund must be so depleted that it cannot make mandatory payments before the beneficiaries have legal capacity. This is completely different from defined contribution land, where the reduction in the balance of beneficiaries, which may be due to poor performance by the fund manager, does confer status.

In addition to making the whole “invest to retire” scheme questionable, many government pensions have self-inflicted wounds. Kristin Todd Whitman, as governor of New Jersey in the early 1990s, started a fashion for deliberate underfunding, based on the foolish idea that fancy market work would fill any deficit. New Jersey has been awarded one of the most underfunded systems in the US.

Brown points out that public pensions in general made a big mistake by cutting contributions when the stock market was strong; CalPERS has announced a celebration of donations in the dot-com era. Again from Brown:

I think we can get more information by looking at what engineers call “phase space”. Instead of plotting funding levels over time, let’s look at them versus cyclically adjusted price-to-earnings (CAPE) ratios. This is a measure developed by Yale University professor Robert Shiller that divides current stock prices by average inflation-adjusted earnings over the past 10 years. I consider it the best standard price-to-earnings ratio….

Admittedly, phase space diagrams take a little more effort to understand than time series diagrams, but I think this work rewards the effort. You can see that between 1991 and 2000, stock prices nearly tripled while pension funding levels barely changed. Reminds me of a bumper sticker seen in Silicon Valley in 2000: “God give me another Internet boom, I promise not to waste it” (sticker from the recycled oil boom of the 1980s). State and local pension administrators and politicians have squandered the Internet boom by using rising stock prices and low interest rates to cut pension funding and increase promised benefits. They did not add reserves as CAPE soared to 44.20, well above the 1929 peak of 32.56, which is a strong case to expect either a crash in stocks or a decade of mediocre real returns.

Over the next decade, as CAPE dropped to 1991 levels, pension funding fell along with the stock markets. There was a brief reversal during the 2003-2006 housing bubble—fund administrators didn’t waste it—but the subsequent housing crash and economic crisis reversed those gains and continued the downward trajectory.

What followed was the longest bull market in history from 2009 to 2022, and like the bubble of the 1990s, it was wasted. Despite wide-ranging reforms to cut benefits and increase new employee contributions, increase government contributions, and adopt increasingly aggressive investment strategies, aggregate funding levels in February 2023 are likely to be similar to the 2009 low.

It’s three decades of history to argue that state and local pension administrators and politicians will spend profits from successful investment years, allowing losses from bad investment years to undermine funding levels. When valuations rise, they are seen as a permanent economic benefit. When they fall, they are treated as temporary losses at current market prices that do not affect long-term economic fundamentals. If this continues, disaster is inevitable, regardless of whether future investment returns are generally better or worse than historical averages.

Note that Brown did not mention the pet horse that public pension funds, by increasing their contributions to supposedly more profitable “alternatives” as in alternative investments such as private equity, have worsened returns compared to simpler and cheaper strategies for almost all public pension funds and donations. And CalPERS is one of the biggest sinners, as are the biggest “negative alpha” generators.

This sad story reinforces the idea that pensions should be primarily the responsibility of the federal government. The US creates its own currency and can always afford the costs. And if we had better governance, stronger pension rights would lead to more growth-oriented spending policies. None other than arch-neoliberal Larry Summers pointed out that spending on infrastructure could be expected to generate $3 of GDP for every dollar spent. How about an economic think tank rank spending in terms of returns to growth? It’s funny that we don’t take such analyzes for granted.

Similarly, if we had better leaders, we might also see more programs to better serve retirees. One reader described how social workers visit older people’s homes twice a week, even bringing portable bathtubs to bathe them, as well as shopping and other tasks to help them live independently. But now that nursing homes have become big business in America, we can never get there from here.

Unfortunately, as is the case with our foreign policy, it looks like on the public pensions front we will have to see a real hiccup before we get real change.

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