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No Garden-Variety Public Pension Crisis?

Leo Kolivakis's picture




 

Via Pension Pulse.

Andrew
G. Biggs of the American Enterprise Institute
writes, No
Garden-Variety Public Pension Crisis
(HT: Bill Tufts):

I've
been thinking about New Jersey's troubled public pension funds lately,
as part of collaboration with the Mercatus Center's Eileen Norcross
for a new
working paper
on potential pension reforms in the Garden
State. The June 25 New York Times mentioned
our principal finding: using the accounting rules required for
private-sector plans, which economists almost universally think are
superior to current public-pension accounting, New Jersey's unfunded
pension liabilities would rise from a reported level of $46 billion to
around $170 billion.

 

But a recent discussion of the working paper
with some New Jersey lawmakers raised a question we didn't investigate
closely in the paper: When will New Jersey's pension funds run out of
money? Our paper cited figures
from Northwestern University's Joshua Rauh that New Jersey's funds
could go under as soon as 2019, a figure at least one lawmaker found
implausible. I found no reason to doubt Rauh’s figures, but being an
inquisitive sort I offered to try replicating Rauh's numbers.

 

The short story is that a 2019 go-broke date
for New Jersey pensions seems very reasonable. While Rauh assumed that
funds earned an 8 percent return going forward, which is typical of
most public plans' projections, New Jersey projects an 8.25 percent
average return, which I adopted. Using this, New Jersey's funds would
run out of gas in 2021. Given the uncertainties involved in these kinds
of estimates, that's close enough for me.

 

But I tried to go one
step further: New Jersey's public-sector plans, like pensions around
the country, are investing in increasingly risky assets—first it was a
shift toward stocks, from less than 40 percent of their total
portfolios in 1990 to around 60 percent today, followed by moves into
"alternative investments" such as hedge funds and private equity. New
Jersey leads in this regard, with $11 billion of their $67 billion in
total assets held in alternative investments. The point is that these
investments are risky, yet public-sector pensions totally ignore this
risk and the cost it imposes on taxpayers.

 

I simulated the risk of New Jersey's investments through a simple
"Monte Carlo" simulation, where annual investment returns vary from year
to year in a manner consistent with New Jersey's investments. I
simulated New Jersey's pension investments 500 times this way; the chart
above reports the results.

 

All the simulations begin with the
$68 billion in assets that the New Jersey trust fund holds today. The
bright red center line represents the median result of the
simulation—that is, the distribution’s center. Other lines show the
interquartile range (that is, from the 25th to 75th percentiles) and
give the most likely range of outcomes, the 10th and 90th percentiles,
and the 5th and 95th percentiles. These latter are the extreme ends of
what might happen.

 

The median outcome of these simulations is fund
insolvency in 2021. If returns are higher than projected, the fund
could last longer—25 percent of the time projections show it lasting
beyond 2023, 10 percent of the time it lasts beyond 2027, and there's a
5 percent chance of solvency through 2031. Of course, things could be
worse than expected, as well: there's a 25 percent chance of the fund
running out prior to 2019 and a 10 percent chance of insolvency by
2017.

 

New Jersey's lawmakers, led by Governor Chris Christie, are
considering reforms to public pension funding and benefit rules. But
they will need to go beyond the current proposals, the effects of which
are limited. And time is running short.

 

And that's not just the
case for New Jersey, but for states around the nation. Rauh projects
that, in addition to the New Jersey, Illinois, Connecticut, and Indiana
pensions that could run short before 2020, another 16 states could run
out of funds by 2025.

I'm not feeling optimistic that states
will get on top of this problem, so the key may be for investors and
members of the public to think about which states they would live in,
pay taxes to, or hold bonds belonging to, if they take seriously the
need for state-level bailouts or defaults.

Mr.
Biggs is well informed on the mounting problems state pension funds
face. From 2008 to 2009 he served as principal deputy commissioner of
the Social Security Administration and as secretary of the Social
Security Board of Trustees. Biggs most recently
questioned whether we should “Tax to
the Max?
” on Social Security and said, “Should
We Raise Taxes on the Middle Class? We Already Are
,” and “Are
Government Workers Underpaid? No
.” His other work includes a look
at “The Market Value of
Public-Sector Pension Deficits
” and a forecast for the “Entitlement Apocalypse.”

Of course, Biggs is a resident scholar at the American
Enterprise Institute, so we shouldn't be surprised with his
"apocalyptic" scenarios. But he makes a valid point that using
unrealistic and rosy investment projections forces funds to take
increasingly higher risks to achieve their objectives and exposes them
to serious downside risk.

I don't know
when the day of reckoning will come, but we are on a major collision
course and as long as the stock market keeps heading higher, nobody
seems to be noticing. But this is long-term structural issue that won't go
away, and will require some difficult political choices ahead (look at
the UK & Greece). To think otherwise is highly irresponsible and
just plain old wishful thinking.

 

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Sun, 07/11/2010 - 16:10 | 463368 Vendetta
Vendetta's picture

what's a pension?

Sun, 07/11/2010 - 09:57 | 462996 mrdenis
mrdenis's picture

The one thing not mentioned is draw down ..I'm familiar with NJ and it's annual draw down in 09' was 7 billion ,which would increase to 10 B in 2 years ..with new deposits by employees of about 1.2 any drawdown funds must be kept in short maturities ....so how much can you be kept in "8 1/4" ..investments ? Another wild card is Gov Christie has everybody scared shitless a lot of people are opting for a early retirement (to Fla no income tax )....my bet is sooner than 2017 ... 

Sun, 07/11/2010 - 00:42 | 462772 John_Coltrane
John_Coltrane's picture

The solution to the pension problem is so simple.  Just decrease the average life expectancy by increasing obesity, poor diet and lack of movement and exercise by large fraction of the population.   All three are reaching epidemic proportions, so pensioners will die before collecting significant benefits.     This also solves the SS problem.  So, it should be obvious what "health care reform" is really all about-making sure no breakthroughs occur which could mitigate the natural course of human laziness.  The "funding" problem will take care of itself.  And this outcome ignores the likely possibility of a major medical viral pandemic enabled by population concentration in cities and worldwide travel.

 

Sun, 07/11/2010 - 02:41 | 462828 Akrunner907
Akrunner907's picture

That is where Health rationing comes in................

Sat, 07/10/2010 - 22:47 | 462648 RedwoodTree
RedwoodTree's picture

Agree, the entire premise of even this (pessimistic) article is ridiculuous: 8+% returns/annum.

So...let's discuss reality now please, or it diminishes your (the author's) credibility...

So in effect: you lost me at "8%" assumption, everything else is fictdion after that, too bad, could have been a realistic/good/helpful article.

 

I am not Chumba Bumba Numba Rotumba or anyone else...

 

Sat, 07/10/2010 - 20:50 | 462543 ZackAttack
ZackAttack's picture

Gotta make sure no federal money is used to cover state pension shortfalls.

 

Sat, 07/10/2010 - 20:39 | 462541 Kreditanstalt
Kreditanstalt's picture

But I think the bigger question is: Will local, municipal and state governments actually force their tax herds to pay for these pension underfundings and actuarial errors or not?  As it stands, taxpayer herds ARE legally responsible...

The alternative, as Mish points out constantly, is bankruptcy, which might be the responsible route to take.  Stiff the "creditors"!

Sat, 07/10/2010 - 20:54 | 462554 ZackAttack
ZackAttack's picture

I had imagined diaspora from states where the tax increases required to cover underfunded pensions would be particularly onerous.

I don't believe there's a mechanism for a state to declare BK, though, is there? There's a specific chapter for individual municipalities. Then pensioners would get in line with other creditors. I have no idea what the precedence of claims would be in this case.

Leo, can you help with this question: What precedence do pension claims have among the various creditors in the event of a municipal bankruptcy?

Sat, 07/10/2010 - 22:23 | 462618 Kreditanstalt
Kreditanstalt's picture

I think a state could declare bankruptcy legally or otherwise if the legislators got up on the hind legs and showed their teeth...

Sat, 07/10/2010 - 19:52 | 462501 Kreditanstalt
Kreditanstalt's picture

Even with the stock market heading higher, there WILL be problems.

"We can guarantee cash benefits as far out and at whatever size you like, but we cannot guarantee their purchasing power." ~ A Greenspan, February 15, 2005.

And even IF the projected rate of returns is somehow met, what will that buy when the payouts get into the hands of the recipients?

ROI is likely to be somewhere in the range of +/-2% for years to come.  We all know that.  Dickering about whether the fund will earn 8.00% or 8.25% is a sheer waste of time.  Benefits cuts have to be made NOW, to existing and future recipients, and contribution rates have to be greatly stepped up.

Given that the employer is the taxpayer, it might also be wise to cease making employer "contributions" altogether.

Sat, 07/10/2010 - 18:49 | 462445 geno-econ
geno-econ's picture

Many State and labor pension funds are utilizing a host of hedge funds with diversified strategies to increase earnings .Problem is leveraged hedge funds also increase risk in a casino economy no matter how well they utilize derivatives ,swaps etc. that are offerred by the too big to fail banks. So who is left holding the pension liabilities? So how can you project future earnings in this scenario ?

Sat, 07/10/2010 - 17:16 | 462360 Akrunner907
Akrunner907's picture

This is being repeated all over the country and various state and municipal plans will begin to crater as payouts start increasing as their workforces retire.  Just as Social Security payout is escalating as baby boomers retire, so will the same draw down occur on public pensions of states.   In a number of states, up to forty percent of the states' workforce are elible to retire over the next 5 years.  Some of the employees will be able to retire prior to 59 1/2, becuase they have thirty years of service.  So we will have an extended payout period where a number of retired employees will be collecting up to 80 percent of their salary, plus health care coverage. 

The entire system is broke and will only become WORSE, not better. 

Sat, 07/10/2010 - 17:23 | 462373 Muir
Muir's picture

"This is being repeated all over the country and various state and municipal plans will begin to crater..."

 

+1 Yeap

Sat, 07/10/2010 - 17:19 | 462357 poorold
poorold's picture

 

Such unimaginative overanalysis that entirely misses the point.

 

8% returns over the next 10 years?  Absolutely hilarious.

What elements of the private sector are going to provide such huge upside returns that the average is going to be anywhere near 8%.

Alternative investments?  Leverage up at the craps table?  Even more hilarious.

Step away from the financial models and actually figure out what it is you are actually predicting...a doubling of the world economy including massive increases in productivity over the next 10 years...in CURRENT DOLLARS.  Too funny!

Any fundamental analysis that examined the following 3 items would clearly show the idiocy of the above projections:

1. Overall private sector profitability required to come close to an average 8% annual growth rate in EVERYONE's investment protfolio;

2. The investment drawdowns that will be increasing over time weighed against the available "wealth" that not only "purchases" all these drawdowns, but provides enough excess demand to provide "growth" in investment values;

3. Tax rate increases that will be enacted to fight deficit spending by overweight government sectors that will further drag on private sector profitability.

The game's actually over and it won't take till 2019 for people to figure it out.  2019 is when New Jersey has ZERO left in the account to pay ANYONE.

 

LOL.

and then throw in cap and trade.

the implosion is occurring right now.

Sat, 07/10/2010 - 20:01 | 462512 traderjoe
traderjoe's picture

Poorold, I agree with you on your comments. It's not mentioned specifically, but probably just implied by being on this site, is the incestuous nature of this entire problem. Wall Street convinces the pension managers that they can ALL get market beating returns through high fee generating PE, stocks, etc. High expected returns allow politicians and unions to argue for higher benefits. Yes, the entire system is rigged - by the parties in charge, whether consciously or subconsciously (or both). 

Sat, 07/10/2010 - 17:00 | 462345 Careless Whisper
Careless Whisper's picture

the entire debate about the new jersey pension is flawed because of chris christie. he is going to reform the pension plan (benefits), and so far he has been effective in keeping his reform promises. as for other states, who knows...

chris christie on cutting spending 9%, balancing the budget, reduced pay and benifits for the public sector, pension reform:

http://www.youtube.com/watch?v=BSk8s_-dxYM

 

Sun, 07/11/2010 - 17:37 | 463439 DosZap
DosZap's picture

Careless,

The NEXT Ronnie Raygun, and Volker?.

Volker said he was angry with himself for NOT SPEAKING OUT SOONER..........and more boldly.

So are we Paul Baby.

Sat, 07/10/2010 - 21:57 | 462587 litoralkey
litoralkey's picture

Gov Christie is only able to change a limited amount of the contractual obligations the state of New Jersey (the taxpayers) are on the line for in the massive pension contracts.

There are not governance and legal frameworks in place to deal with the pending disaster.  Between the New Jersey SUpreme Court which actively legislated from the bench and purposefully bankrupted the state in the name of social justice, to the Federal Third District Court in New Jersey with a host of fools on the bench, http://en.wikipedia.org/wiki/United_States_District_Court_for_the_Distri...

There will be paralysis in the current paradigm until the crisis boils over and reactionary forces working outside the civil and legal boundaries impose a new solution, UNLESS the Federal government funds the entirety of the pension shortfall through printing presses.

THe ugly part... after the collapse of the pension system in NJ a few decades from now, the majority of the destitute pensioners will be native born Caucasian American and African Americans, while the "new immigrant" majority will be the majority of the voting public.

And every single current politician in Trenton and Washington DC will retire/resign before the day of reckoning.

 

 

Sat, 07/10/2010 - 16:17 | 462316 Bruce Krasting
Bruce Krasting's picture

Leo says, " as long as the stock market keeps heading higher"

What are you talking about? Please pull up a chart of the s&p for ten years. No place. Nasdaq is down 60%. A nice stock (one that I am sure you are fond of) Microsoft, is down 70%. You like a three year 75% loss in GE? Maybe you thought C was a smart buy in 06. A nice way to lose all your money.

The stock market is for gamblers or suckers. I like to gamble. It helps my odds when I sit at a table with dumb money players.

 


Sat, 07/10/2010 - 16:27 | 462320 Leo Kolivakis
Leo Kolivakis's picture

So Bruce,

If you were running a pension fund, would your strategic asset allocation be 80% government bonds/ 20% stocks? C'mon, let's get serious when discussing pension fund allocations. Maybe they are too exposed to stocks, but there isn't much of a choice given the low interest rate environment.

Sat, 07/10/2010 - 16:42 | 462331 Muir
Muir's picture

Actually Leo, there you are wrong.

I am not retired but I already explained to family members that have retired to expect in the coming years a readjustment of their benefits.

Then, I explained that even if their benefits are reduced, if there is deflation, it is a wash.

They get it.

Do you?

Sat, 07/10/2010 - 19:21 | 462472 traderjoe
traderjoe's picture

Don't be so naive as to view inflation/deflation in the aggregate (nor to focus on the bogus government statistics - with geometric weightings, rent equivalent indexes, etc. - see shadowstats.com for a discussion on how CPI calculations have changed over time). 

Inflation (past, present, future):

Oil, food, water, utilities, tuition, health care

Deflation (2006 on...):

Home prices, wages, retirement benefits

Leo, another good article. Thanks. I saw some of his other papers through the links. 

Sat, 07/10/2010 - 17:01 | 462346 Leo Kolivakis
Leo Kolivakis's picture

If you are so sure deflation is the ONLY end game, stick to government bonds, the only asset class that will protect you. If you're not sure about the future, take a more diversified approach and allocate some money to high quality stocks.

Sat, 07/10/2010 - 18:55 | 462451 Bruce Krasting
Bruce Krasting's picture

Can't argue with you L. Some stocks might be right. But you are push 80%. That is nuts. You are off the charts on the risk scale. There is no imperical evidence to justify this conclusion. That is not investing. It is gambling and you know it.

You are not going to solve this with dow 32,000. Thinking that is the outcome will just bring you ruin.

Go back to ABCs. What is the right percentage for a person to commit to equities. Answer: 100 minus their age. By this formula you would have to be 20 to invest 80%. But that is not what the demographics say. The average investor is closer to 50. Yet they have 80% of their assets tied up stocks. What are they going to do? Sell. They need the money. Look at where we are today. The bulk of savers are going to retire in the next 15 years. Everyone of them will have to sell equities. So I don't get what you are selling.

Sun, 07/11/2010 - 17:35 | 463435 DosZap
DosZap's picture

Bruce,

What percentage of one's holdings should be IN HAND PM'"s?.

For Retired people,who cannot afford to lose it ALL.

10%(Uh, I do not thin in this day & time)......................20,30???

Serious question..............for the longer in tooth crowd.

Pls sir.

Sat, 07/10/2010 - 20:00 | 462500 Leo Kolivakis
Leo Kolivakis's picture

Bruce,

I was not advocating 80% in stocks, but just saying that stocks are an important part of your asset allocation. For most people, I advise a 60/40 stock/bond split because going back over 100 years, this is yielded a decent 6% return. Having said this, we all know that there are long periods where stocks underperform.

I do agree with you that having too much in stocks when you're 50 or over (and need the cash) is just crazy. At least stick to high quality, high dividend stocks. These markets are treacherous, even for top notch hedge fund managers. It's silly to think you'll be able to compete with the algos.

Finally, you're right, even if stocks rise but bond yields remain at historic lows, pension deficits will get worse. You will not magically solve the pension crisis with higher stock values, but the Fed is trying to reflate all risk assets, thinking it will put pressure on inflation expectations and long-term bond yields.

Bottom line: To deal with the pension crisis, you need pension reform, rising asset values and rising bond yields.

Sat, 07/10/2010 - 20:45 | 462546 ZackAttack
ZackAttack's picture

Yep, into the third decade of equity underperformance plus low bond yields in Japan.

They tried to reflate, too, and ran 10 stimpacks of 7% of GDP between 2000 and 2010, to no avail. I think Japan is a wildly optimistic outcome for the US.

Perhaps real estate *is* the bubble of last resort.

Sat, 07/10/2010 - 22:08 | 462598 Leo Kolivakis
Leo Kolivakis's picture

"Perhaps real estate *is* the bubble of last resort."

Nah, you ain't seen nothing yet...alternative energy bubble will last years and make RE bubble look like a spec of dust. (Ok, I am banking my retirement on it!)

Sat, 07/10/2010 - 22:52 | 462658 jdrose1985
jdrose1985's picture

I just don't see where the new credit is going to come from to fuel this bah-bul in Alternative Energy.

You look at net dollar borrowing by segment chart and look at the only thing growing...its government debt...really just an echo bubble of the last hurrah of the 60 year dollar system expansion.

You ask me, which my opinion doesn't amount to much, I look to see alternative energy investment be something that doesn't really start making returns until we've exhausted the oil system and have absolutely no other choice. What little capital remains in the world by that point will probably be in flight to Alternative energy. Til then your just at the mercy of dollar credit and that's a bad bad thing.

Sun, 07/11/2010 - 08:56 | 462939 Leo Kolivakis
Leo Kolivakis's picture

"I just don't see where the new credit is going to come from to fuel this bah-bul in Alternative Energy."

Perhaps you did not see this story on the China Development Corporation:

http://www.thestreet.com/story/10802697/1/solar-pops-on-mega-china-loans-adrs.html?cm_ven=GOOGLEN

Biggest myth out there is that solar companies will face a massive credit crunch. Bullocks!

Sun, 07/11/2010 - 04:52 | 462862 Escapeclaws
Escapeclaws's picture

In any event, the oil companies won't let us go to alternative energy until the last drop of oil is sold. At that point it is they that will sell the alternative energy.

Sat, 07/10/2010 - 17:21 | 462371 Muir
Muir's picture

There I agree!!

And, I wish you were in charge of my relatives' pensions, but only if you too acknowledged that you yourself do not know the final outcome, and therefore, hedge accordingly.

(Anyways, I loved the post and gave it a 5)

Sat, 07/10/2010 - 15:46 | 462299 pitz
pitz's picture

The government can't "print" their way out of this mess, because printing money will eventually destroy the bond investments in the portfolios (and ruin most of the stocks!).

Sat, 07/10/2010 - 15:42 | 462290 Muir
Muir's picture

Hey Leo!

Don't worry, what goes up goes down, but hey, it goes up again!

Sat, 07/10/2010 - 19:01 | 462453 Kimo
Kimo's picture

I'm sorry, did you say something?

Sat, 07/10/2010 - 20:50 | 462551 BobWatNorCal
BobWatNorCal's picture

They should be buying solars, preferably Chinese solars.

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