Michael Gentile, Johns Hopkins University:
Early last year, Dallas’ Police and Fire Pension System quoted itself $3.27 billion in unfunded liabilities. The fund has since suspended the right of pensioners to redeem their benefits after a panicked wave of retirement caused a run of $500 million during the last four months of 2016. As courtrooms and under-mattresses fill with fear, it’s important to note that the total unfunded liability of state pension plans nationwide now exceeds $5 trillion; Chicago’s stands atop the heap at $18.6 billion.
Defined benefit pension plans invest portions of employees’ incomes throughout their working lives and promise how many payments of how much they will receive after retiring. Over the past decade, most US plans have expected 7.5-8% annual returns, a sticky and outdated target from before the Great Recession; the figure also accounts for Cost of Living Adjustments that, given tepid inflation, have overshot reality. Today, with 10-year treasuries hovering below 2.5%, 60/40 stock-bond portfolios have required 10.8% growth in equities. Though the S&P 500 often outpaces this mark, the index also outpaces 90% of money managers, nonetheless retirement fund-of-funds.
That said, broad market downturns pose a grave threat to the pension system. Given the deficits these funds must close and record-low risk free rates, impending default will encourage managers to take on more risk and deepen this threat; such desperation and volatility contradict the conservative approach of pensions and account for much of their shortfall since 2008. However, these moral hazard lean against the backstop of a governmental bailout, namely in the form of transfer payments—slaps on wrists and nails on town hall chalkboards.
The municipality of Dallas pays 37.5% of Police and Fire’s employee benefits, the maximum allowed by state law. This compares to an internal funding ratio, that between assets and liabilities, of only 36%. And while plan participants account for less than 1% of the city, the city must front the remaining 64% in order to prevent fund insolvency—that is—without exceptional returns. Of course, this solution is tall order. But even partial intervention would necessitate increased tax rates or reduced public spending and ignite a vicious cycle that’s already eroded the tax base of various poor cities.
In 2013, Detroit declared bankruptcy after years of austerity and mismanagement starved the city of growth prospects and wealthy individuals. Up to 20% of benefits were lost, depopulation ensued, and property values dwindled, reducing property tax revenue. Those who can’t leave such cities, namely the old and poor, cannot escape this negative feedback loop and suffer the squeeze of pension plans that take in more and pay out less each year.
Agency costs arise not only among investment managers, but politicians as well. To them, public services and voters must take precedent; cuts can only go so far before re-election becomes impossible. Next, pension participants must supersede municipal bondholders, who reside largely outside of the state and representation. While participants in Dallas and Chicago may lose half of their promised benefits, debt-holders have experienced a much worse precedent.
As default and loss rates rise, municipal bonds may suffer losses in inverse proportion to their tax exemptions, especially at the federal level. If today’s administration does indeed slash taxes, muni bonds will become less attractive to high-income bracket investors and drag even lower. Due to their degree of labor expenditure, state and local general obligation debt with limited tax and pension liability prove the most vulnerable.
Interestingly, though municipal bondholders play second-fiddle to hemorrhaging pensioners, whose benefits rely on dismal funding ratios, credit agencies haven’t downgraded the bonds as one would expect. Why? Accounting. The assets that compose the funding ratio’s numerator already factor in their overexpected returns, compounded until the corresponding liabilities come due. The figures are inflated, idealized. Current assets hang far lower and, if compounded by the riskless rate, would warrant a painful correction from the bonds’ prices today.
Worse yet, falling funding ratios suffer from negative feedback loops in practice. For example, if I have $100 and must pay $10 each year, a constant denominator, I can earn 10% annually and maintain my principal. However, if I decrease my cash and denominator by $50 and still earn 10%, I must reduce my cash stock by $5. With $45 remaining, I’d siphon another $5.50 away and exponentially so. Municipal bonds, once investors calculate funding ratios using current returns and for themselves, fall with similar gravity.
A fall in municipal bond prices would ripple most notably in the ease of states to borrow. Inversely rates rise and render projects more costly—at a time when the federal level encourages them most. Tax revenue must either rise to accept them or shrivel as public works, like tolls, crumble without replacement. As such, downward spiral for whole municipalities waits in line after those of its pensioners, bondholders, and taxpayers.
While this is not the place to draw fine lines, incentives speak volumes. When opportunities at hand diminish, those hands seek new ones. If Dallas expects its officers to engage in sniper warfare, as it did in January, life after sacrifice requires viability. If citizens and investors expect their governments to borrow cheaply and support their assets, solvency is priority. The flow of talent to the public sector may slow further, as the perks of the job fade away—a complaint even at the highest of offices. As a country, we are short on examples of municipal bankruptcy and, if Dallas and Chicago follow as they may, our national creditworthiness may experience a correction of its own.
The $5 trillion unfunded liability of state pension funds, though not included, matches one quarter of today’s gross national debt. Bailouts will trigger a credit expansion that’s long brought dread to economists, especially in an era of rising rates—assuming that lift comes to bear. Barring such stimulus, bankruptcies will dust the backbone of our retiring populations and diminish the recruiting power of public institutions. As isolated black eyes see the light of day, first in the Windy City, the national focus we present to the world will blur. As we put out fires, growth and productivity will drag behind long enough that treasury bonds may lose their godsend status; the term ‘risk-free’ may dissolve altogether. Albeit, this development may and likely will take 15-20 years, and much can be done by then; excluding redemptions, this Dallas Pension is expected to run dry within 14 years. However, given the peaks of Treasuries today and their rigidity, as well as the negative feedback loops inherent in the crisis at hand, it’d be a painful fall down.