Is Every Pension Fund in America Bankrupt?

Paul Sterne June 26, 2012

Wise politicians like Mayor Bloomberg realize that the math doesn’t work. New York City’s pension funds are based on the assumption that they will earn 8% per annum forever. Mayor Bloomberg has called this “indefensible” at a time when the risk free rate is 1.63%. Prudent actuarial accounting would say that the right number is about 300 basis points above 10-year Treasuries of around 5%. Stray from a realistic investment assumption at your own financial risk. It will lead to under-funding of future obligations and unsustainable commitments to pensioners.

According to the New York Times (http://www.nytimes.com/2012/05/28/nyregion/fragile-calculus-in-plans-to-fix-pension-systems.html?pagewanted=all) lowering the investment assumption for New York City’s pension plan from the current 8% to 7% would increase annual funding requirements by close to $2 billion. New York City currently pays $7.3 billion per year into its pension funds, so a one percentage point drop would increase pension spending by 27%. If the investment assumption were to be dropped to a more prudent 300 basis points above the risk free rate of 1.63% or around 5% , New York City would have to declare bankruptcy or halve pension entitlements. Reducing the investment assumption to 5%, which is in line with recent investment returns for large pension plans, would involve a 80%+ increase in pension funding.

For fiscal 2013, New York City’s spending is estimated at about $51 billion. A proper pension investment assumption would increase that spending to $57 billion, a 10% increase in total expenses – in an era of 2% real estate tax caps. Since Wall Street, corporate or income taxes can’t be raised in NYC without a mass exodus of businesses and rich people, residential property taxes would have to be raised to cover the shortfall. If residential property taxes are increased [read doubled], New York City real estate values would fall off a cliff setting off a wealth destruction cycle similar to the one that created the Great Recession.

Extrapolating the investment assumption dilemma to all public and private pensions in America and our great country looks suddenly like Greece – sixty years of unsustainable promises to workers, salarymen, public servants and the military to support political stability.

I worked at General Motors in the late 1970’s as a pension costing analyst. We were living in a high inflation environment and considering raising the pension investment assumption to 10% per year. The actuaries in the room were very skeptical. They didn’t what to raise the investment assumption without raising the salary escalator as an offset [pretty complicated math to get at the real rate of return which should be about 300 basis points above the risk free rate, if the portfolio is properly diversified]. At a key moment in the meeting, Michael Moore’s favorite executive told us to “just do it. Investors don’t read the footnotes to financial statements and they won’t understand what we have done, plus we need some non-cash earnings to bolster quarterly results.” I think that we actually inched the assumption up a ½ percent to escape notice – and stay below the materiality threshold.

The net effect of these investment assumption increases was that General Motors was able to give generous pension increases for about a decade to paper over wage disputes and buy labor peace, but in the 1990’s the chickens came home to roost and the pension fund had to be bailed out by a donation of appreciated EDS stock and then Hughes Aircraft shares.

Looking at the pension investment assumption time bomb, it is safe to predict that the rest of America will follow the example of Wisconsin. Pension benefits will have to be cut to current and future retirees – not just future employees -- or local governments will have to cut essential services and too many jobs. Public safety will need to come before the demands of pensioners.

More and more it looks like The Great Recession is not over. The world appears to be at the end of a long debt cycle that started during the Second World War. A debt cycle has to end with debt destruction like it did in Greece with the creditors losing half their money and the population giving up half their entitlements. Only after debt and entitlements have been reduced to sustainable levels can economic growth resume. The end of a debt cycle is very difficult for politicians to navigate in a democracy because the electorate will tend to vote out the incumbents and no politician wants to give up power. If Mayor Bloomberg has the stomach in his last year in office, he should bite the bullet and reduce the pension investment assumption to 5% while simultaneously reducing pension entitlements for current and future retirees and set the stage for resumed economic growth in 2015.