Promises,
Promises, Pension Promises
By John Mauldin
You
made me promises, promises
You knew you’d never keep
Promises, promises
Why do I believe?
You knew you’d never keep
Promises, promises
Why do I believe?
–
Naked
Eyes (1983)
It’s
election year in the US, so once again we see politicians promising the moon.
That’s what happens in a democracy. Regardless of party or office, all
politicians make promises in order to get elected. This is their nature. Dogs
bark, birds sing, politicians promise.
In the
investment business, we’re taught not
to make promises because they create liability. Lawyers and compliance officers
review documents for “promissory” language. Instead of “This fund will give you
a profit,” firms say things that generally sound like “This will give you the opportunity to profit,”
thereby avoiding lawsuits and regulatory action when profit proves elusive.
With
the Republican convention just concluded and the Democratic convention just
ahead, with the presidential candidates making promises by the dozens, let’s
imagine what a presidential promise would sound like if it had to comply with
the same rules that investment advisors and brokers must adhere to. It would go
something like this:
If
you elect me as president, I will (insert promise), assuming of course that I
can get both houses of Congress to agree, which means of course that I must
persuade enough of the opposition Senators to bring my total up to 60 votes in
the Senate, assuming that none of my own party votes against me. And that also
assumes we can find the money to fulfill this promise, which is unlikely
without some real (and unlikely) compromises.
Would-be
elected officials face no such restraints, except from voters, who by the next
election tend to forget what they were promised. There are exceptions, though.
Some political promises don’t fade away. They come back years later and demand
fulfillment. Which brings us to the topic for today’s letter: the promises made
by politicians concerning public employee pensions.
Chicago
residents are learning about this the hard way. They won’t be the only ones.
Voters all over the US will pay for the promises their elected officials made
long ago – and broke.
Last
week in “The
Age of No Returns” we discussed the prospect of persistently low market
returns in the coming years. Here is the GMO
forecast again.
A
portfolio balanced between major equity and fixed-income asset classes will be
lucky to break even in the NIRP-heavy world I foresee. Poor returns will be an
especially thorny problem for anyone who is contractually obligated to use
portfolio returns to pay certain amounts on certain dates but hasn’t set aside
funds to do it.
Defined-benefit
pension plans are the primary example. Today these exist mainly for
public-sector employees. Private industry long ago shifted to 401(k) and other
defined-contribution plans.
Public
pension plans are rarely fully funded. They assume that future investment
returns will make up the difference. What if they don’t? Retirees go back to
the taxpayers whose representatives made the promises and demand they pay up.
This
is happening in Chicago right now. After years of fruitless argument and
litigation, authorities raised property taxes to meet pension obligations. Cook
County taxpayers recently received
their bills and were not amused.
Outside
the assessor’s office, city homeowners told one property tax horror story after
another.
“Our
taxes increased fivefold,” said William Phillips of Rogers Park. “I was
expecting it to go up maybe twice as much but not four to five times as much.”
“My
tax bill increased almost $1,200 dollars,” said Cornes King of Chatham.
“More
than tripled. The city’s piece more than tripled,” said Logan Square resident
Janelle Squire.
The
bills that arrived over the weekend reflect rising Cook County real estate values
and, in Chicago, the city’s $588 million levy increase. Most of it is to
restore police and firefighter pensions that Mayor Rahm Emanuel says his
predecessors underfunded.
“A
number of people across the spectrum politically, denied, deferred, and delayed
the day of judgment,” said Mayor Emanuel.
“I
don’t think that I’m getting the services what I’m paying for,” said King.
Unfortunately
for the taxpayers, that’s not actually how the system works. Paying your taxes
is not a commercial transaction. You don’t give the government money in
exchange for goods and services. You must pay taxes, but the government need
not give you anything
in return. They allow you to go on living somewhere besides a prison cell.
That’s all they have to do.
Of
course, if we’re unhappy with the way the city, county, or state is
administering our taxes, we can vote for different politicians who will spend
our money more in line with what the majority of us think. So, in general, we
do get roads, police and fire departments, parks, and other services that are
paid for by our taxes.
The
problem is that, in all too many cases, politicians make promises to various
government employees that include future retirement benefits, but they don’t
actually spend the money to fund those promises. And those unpaid balances keep
adding up until the future becomes today, which is what is happening in
Illinois and other states around the country.
When
the current political powers that be in Illinois decided that they couldn’t
afford to pay for the promises made by past politicians, the unions and
retirees (not unjustifiably) asked the courts to force the various government
agencies involved to keep those promises.
And
the courts determined that, under state law, retirement benefits cannot be
reduced after the fact.
Thus
Illinois courts have determined that retired public employees have more rights
than taxpayers do. Retirees are entitled to what their elected officials
promised them, no matter how impossible it may be to keep those promises. So
elected officials are forced to either reduce current services such as police
and fire and parks and roads, or raise taxes. Paying already contracted
retirement benefits is at the top of the list of city expenditures.
Now,
let’s go back to that Cook County news story:
[T]he
Chicago Public Schools Board is expected to approve a $250 million property tax
hike to pay for teacher pensions. The new levy was enabled last week by the
Illinois General Assembly and Governor Bruce Rauner. The additional charges,
hundreds of dollars more for an average city house, will appear on tax bills a
year from now.
“We
might have to consider selling. I don’t know if we’ll be able to afford it,”
said Phillips of his Rogers Park home.
Mr.
Phillips is free to sell his home, but to whom? And at what price? A home’s
market value is a function of supply and demand. Prospective buyers want to
know more than the building and land costs before they buy – current and future
tax liabilities are part of the equation, too. Mr. Phillips will have to set a
selling price that reflects the known and unknown liabilities associated with
his house.
In the
US today, most people who are buying homes look not so much at the total
mortgage but at whether they can afford the monthly payments. For instance, I
have a mortgage on my apartment. But a prospective buyer of my home would be
interested not only in how much my monthly mortgage costs but also in my tax
and insurance bills as well as my homeowners association dues and payments for
utilities and other services. It turns out that my HOA dues and taxes are
significantly higher than my mortgage payments. The total of those costs
affects the price I could get for my home if I wanted to sell.
So
when Mr. Phillips says he may have to sell his home, those higher taxes are
going to reduce its value. He’s going to pay the higher taxes one way or
another. He either stays where he is and pays them, or he sells the property at
a lower price because of the taxes. Those are his choices.
This
isn’t just a Chicago problem or an Illinois problem. A significant number of
public-sector pensions everywhere are in the same fix, to varying degrees. They
all assume their portfolios will deliver returns well above the 2% to 4% or so
that they may actually be able to get in the next decade. They can try to
extract more from taxpayers, but at some point the taxpayers will simply leave.
That’s what happened in Detroit.
Every
state and local government has workers toiling away to provide public services,
and their elected leaders have promised them certain retirement benefits. Some
states and cities have been more generous than others. Some do a better job of
managing their pension obligations. But nationally there is a big problem.
Estimates
of the unfunded liabilities vary, not because of dishonesty but because the
estimates necessarily involve many assumptions: life expectancies, healthcare
costs, interest rates, stock market returns, tax rates, and more. Tweak any of
those numbers just a little bit now, and the difference over 30–50 years or
more can be dramatic.
An
April 2016 Moody’s
analysis pegged the total 75-year unfunded liability for all state and
local pension plans at $3.5 trillion. That’s the amount not covered by current
fund assets, future expected contributions, and investment returns at assumed
rates ranging from 3.7% to 4.1%. Another
calculation from the American Enterprise Institute comes up with $5.2
trillion, presuming that long-term bond yields average 2.6%.
Are
any of those return assumptions reasonable? Over a really long period like the
next 75 years, maybe so. I see almost zero chance of hitting them in the next
10 years. Failing to hit them will put many more plans on very thin ice. Baby
Boomers will keep reaching retirement out until 2030 or so. If life expectancy
keeps going up, people will survive to collect benefits longer. A big crunch is
inevitable.
There
is a fact about pensions that very few people actually understand. The largest
part of the money that a pension manager assumes they will pay out in 20 years
comes from the investment returns on current assets. Depending on the rate of
return your pension plan assumes, as much as 70% (or possibly more) of your
future payments depends on the returns your fund manager will make on
investments. If you are a government employee who is 30 years old and expecting
to get a pension in 35 years, the money you are putting into your pension fund
will cover less than 20% of your expected future payout. Everything, and I mean everything, about
your future pension payments depends on the rate of return your pension plan
gets on its investments – and on the willingness and ability of future
taxpayers to continue funding your underfunded pension plan.
My
friend Rob Arnott, founder of Fundamental Research, is one of the most
respected financial analysts in the country. He and his very talented staff
spend a great deal of their time thinking about future returns for pension and
retirement funds. We were together in Las Vegas last week, and one of the
topics we discussed was the problem of underfunded pensions. The average
retirement plan assumes it will get annual returns north of 7%, and many assume
7.5% or as much as 8%. Rob copied me on an email he sent this week to a
high-ranking politician, asking about that very issue. Let me show you his
calculations on potential future returns. Remember, he is talking about the
long term here, not just the next 10 years. In our conversation in Vegas, we
agreed that the next 10 years will be challenging in regards to investment
returns. Quoting from his letter (in which he assumes the typical 60%
equities/40% bonds ratio that most pension funds use), here’s the math:
40%
Bonds. Yield is 2% for the US aggregate bond market.
60% Stocks. Our base case is 5.4% for US stocks, but we think valuations are too high, so we trim this to 3.3% for the coming decade. Here’s our logic:
60% Stocks. Our base case is 5.4% for US stocks, but we think valuations are too high, so we trim this to 3.3% for the coming decade. Here’s our logic:
The
yield is 2%.
Earnings growth over the past century has been 4.5%, of which 3.1% was inflation (real growth of 1.4% … far less than most people realize).
Inflation expectations are about 2%, so perhaps we should trim this forecast by 1.1%.
This gives us a base-case of 5.4%.
Valuation multiples are stretched, with the stock market priced at 25 times the 10-year average earnings, against a historical norm of 16.8x. If we’re back to historical norms in 10 years, that costs us another 4.2%. Since valuation multiples could (a) return to historical norms, or (b) remain at today’s lofty multiples, let’s split the difference, and trim our return expectations another 2.1%.
This gives us a likely outcome of 3.3% from stocks.
Earnings growth over the past century has been 4.5%, of which 3.1% was inflation (real growth of 1.4% … far less than most people realize).
Inflation expectations are about 2%, so perhaps we should trim this forecast by 1.1%.
This gives us a base-case of 5.4%.
Valuation multiples are stretched, with the stock market priced at 25 times the 10-year average earnings, against a historical norm of 16.8x. If we’re back to historical norms in 10 years, that costs us another 4.2%. Since valuation multiples could (a) return to historical norms, or (b) remain at today’s lofty multiples, let’s split the difference, and trim our return expectations another 2.1%.
This gives us a likely outcome of 3.3% from stocks.
If
our logic is sound, we earn 0.8% from our bonds (40% allocation x 2% return)
and 2% to 3.2% from our stocks (60% x 3.3%, or 60% x 5.4%). Add up the return
from stocks and the return from bonds, and we get 2.8% to 4% from our balanced
portfolio.
Bottom
line … US public service pensions are toast. One of three constituencies
gets nailed: the taxpayer (keeping in mind that the affluent are
mobile!), the current and/or future pensioners (keep in mind that
private-sector pensions are now far less generous than public pensions …
there’s an inequity here!), or the public services that are on offer to our
citizenry, net of sunk costs from servicing past generations. Most likely, it’ll
be a blend of the three.
Our
judicial system has a time-tested option for those who can’t pay their debts:
bankruptcy. Individuals and businesses use it all the time. The debtor submits
itself to a court, which tries to reach the fairest possible settlement with
creditors. It’s messy, but it usually works for the best.
Federal
bankruptcy code permits cities, school districts, and other local governments
to file bankruptcy. Some have done so, and I expect many others will in the
coming years. Cities like Detroit and others in California have used bankruptcy
to renegotiate their pension plans and other debts.
States
are a different matter. Current law doesn’t let them go bankrupt.
In
theory, Congress could change the law and let
states go bankrupt. For instance, there are those who agree with President
Obama, as well as with Newt
Gingrich and Jeb Bush, that Puerto Rico should be allowed to go
bankrupt. If the law should change and a state actually tried to file for
bankruptcy, creditors would immediately file constitutional objections under
the contracts clause and the 10th Amendment. Some legal scholars
think those barriers can be overcome, but at minimum the argument would go to
the Supreme Court and probably take years to be resolved.
But
getting Congress to pass such a controversial law could be quite difficult.
There are good reasons to prevent state bankruptcies. The fact that they aren’t
eligible for bankruptcy allows states to borrow money at lower interest rates.
Lenders assume states will always figure out some way to repay their debts. But
will they? Recent history says yes. Go back some 80-odd years and the answer
isn’t so clear.
In
1933, debt-plagued
Arkansas unilaterally restructured and extended maturities on a series of
highway and other bonds. Nowadays we call that a default. Bondholders sued, of
course. The next year the state and its creditors reached a compromise
refunding. Creditors exchanged their old bonds for new ones funded by a 6.5
cent per gallon gasoline tax.
In
today’s dollars that would be about $1.16 per gallon, so this was a hefty tax
on Arkansas drivers. I am sure they complained. That deal fell apart, and after
many more twists and turns, the federal Reconstruction Finance Corporation
(predecessor to the FDIC) bought the new bonds.
Back
to the present: the Moody’s report cited above sees almost zero chance that the
federal government will bail out an indebted state government. I agree; the
other state delegations in Congress would quash any such idea. You can debate
whether the Arkansas episode was a “bailout” or just a refinancing, but it is
one of the few precedents we have for a state default.
That
leaves us in a very murky situation with regard to state and local pensions. We
know many will have a hard time meeting their obligations. Those at the state
level can’t go bankrupt, nor can they expect federal help. Something will have
to give in those states. Whatever the outcome is, it won’t be pretty.
And
not every government below the state level can declare bankruptcy to discharge
its pension obligations. Illinois and other states, including my own state of
Texas, have passed laws that require cities to honor their commitments. They
can change pension agreements going forward, but they are legally required to
honor past agreements.
This
leaves an important question: which states and local governments will hit the
wall first? Finding the answer is not as easy as you might think.
As
noted above, evaluating a pension plan’s future prospects requires all kinds of
long-term assumptions. Near-term prospects are hard to judge for a different
reason. States and localities all operate under different state constitutions,
contract laws, labor laws, and other constraints. Two states might look the
same, financially speaking, but have far different pension-system prospects for
legal reasons.
Illinois,
for instance, is in a jam because its state constitution doesn’t permit it to
reduce pension payments. Other states have more flexibility. States also give
their pension managers different degrees of authority and liability. It’s a
mess. What states are most likely to raise taxes and/or cut government
services?
I
found one analysis that helps pinpoint the top risks, considering not just
pension shortfalls but other financial obligations as well. The Governing
Institute, a group for state and local leaders, reviewed
three separate studies from J.P. Morgan, PricewaterhouseCoopers, and the
Mercatus Center of George Mason University. JPM and PWC both point to the same
four states: Connecticut,
Illinois, Kentucky, and New Jersey. The Mercatus
Center concurred on those four and added Massachusetts
to the list.
This
doesn’t mean everyone else is safe. You might live in a very sick city in an
otherwise healthy state. There are cities in Texas, arguably one of the
healthiest states, with significantly underfunded pension plans. In our teacher
retirement programs, many school districts are underfunded. You could also be
in a sick city that is in a sick state, giving you double trouble if you own
property there.
Oddly,
you may be at risk if you stay, while your city and state are at risk if you
leave. Property tax revenue depends on property values, and property values
fall if too many people want to sell. If governments raise tax rates to
compensate, then even more people will leave. At some point a death spiral sets
in. Detroit went through this and is only now beginning to recover. People left
the City of Detroit and moved to the suburbs.
I
think we’ll see many more Detroits. Make sure you don’t live in one.
For
instance, more and more affluent people are leaving California because of the
taxes and other high costs. Dennis Gartman wrote this note:
According
to the always interesting and strong proponent of free markets and small
government, the Mercatus Center at the George Mason University, California now
owes a stunning $118.2 billion. However, when we add to this sum the pension
fund shortfalls and other major concerns, California actually owes $757
billion. On a population of 38.8 million, that's a stunning $19.5 thousand per
citizen... Children included!
California's
problem is that the state is adding nearly $15 billion annually to its
deficits, and as those deficits rise the state’s ability to add to its roads,
its universities, its hospitals, its bridges, its all-important water supplies
et al are falling rapidly.
California,
according to the Investor's
Business Daily, is a “massive welfare state.” According to the IBD,
one/third of all US welfare recipients live in California, which, with its
generous welfare benefits, has become a magnet for impoverished immigrants from
around the world. A quarter of the population lives near the poverty line.
And
the news from California just gets worse. This from Reason magazine:
Another
year, another mess with California’s public employee pensions. The California
Public Employees’ Retirement System (CalPERS) announced this week that the rate
of return for its investments for the fiscal year ending on June 30 was less
than one percent. It was .61 percent. As the Los
Angeles Times notes, this is the worst
returns it has logged since 2009, when the housing bubble burst and hit
California particularly hard.
That’s
a far cry from the 7½% CalPERS assumes it will get. And the newly passed $15
minimum wage in California will add almost $4 billion of annual cost for
government employees as well as increase the state’s required pension
payments.
I
wrote about the retirement problem in depth a few months ago in “ZIRP
& NIRP: Killing Retirement As We Know It.” I won’t repeat that analysis
here, but I’ll say this: Whatever amount you are saving for retirement is
probably not enough. The pension crisis is one element of a much bigger one.
If
you’re a retired teacher, firefighter, etc., you naturally want what you were
promised. You probably won’t get it. That’s just simple reality. The taxpayers
don’t have the money. Now is an excellent time to accept that fact and make
alternate plans.
In
fact, that’s good advice for pretty much everyone. Your future plans, whatever
they may be, probably won’t protect you from the storm I think is coming.
I may
be wrong on this. I hope
I’m wrong. There’s still a chance the central banks and politicians will get
their acts together and change course. There are things they can do to restore sustainable economic growth
and pull us out of the mud. We’ll be dirty but not drowned.
I’ve
been having this conversation with my friend Ed Easterling. He pointed out that
the crunch I am expecting could come in a very different way. Let me quote a
paragraph from a recent email he sent me:
Lots
of folks [he left the “like you” unstated] have been worrying about a looming
financial catastrophe following policies that have included Fed QE, ZIRP, etc.,
and near-trillion-dollar stimulus programs. Maybe, just maybe, we’ll look back
in five or ten years, after no catastrophe, and applaud that such “good”
actions saved the economy without negative consequences. When, in reality, the
“catastrophe” will have been the loss of 20%, 30%, or more in our standards of
living and wage growth. The anecdote of the Frog-In-Boiling-Water may again
prove to be a truism of life….
For
planning purposes, however, the prudent course is to assume the worst. How will
you retire in a 0% world? In most cases, you won’t. Kicking back at 65 or 70
won’t be an option if your portfolio can’t generate income sufficient to pay
your bills.
If you
intend to retire in the next few years, you need to do the math that so many
pension sponsors avoid. You owe yourself an honest accounting. Will your
savings be enough to cover your expenses in a zero-return world? Find a good
financial planner to help you run the numbers in different scenarios. If he or
she starts telling you that you’ll get 9% long-term (or 7% real,
inflation-adjusted) returns on your stock market portfolio, politely glance at
your watch and remember an important meeting that you have to go to. Then find
another financial planner.
I
think it’s important that everyone have a good financial plan and financial
planner, someone who will give you a realistic estimate of your financial
condition and what your retirement might look like.
If, as
is likely, the numbers are discouraging, now is the time to adjust your
expectations. If you’re still working, you can try to increase your savings.
The statistics say that’s hard for most people. The better idea may be to
follow the Mauldin Plan and don’t retire.
I’m
almost 67 and not ready to retire. I could probably retire if I downsized my
home and lived a much simpler life. I don’t want to do those things, so I’m
still “working.” I put working
in quotes because if I retired I would want to be doing the same thing I am
doing now. I have the advantage of enjoying my work and being in good health.
Not everyone is so fortunate.
This
brings us to an important point. Adjusting your portfolio is only one of the
preparatory steps you should be taking. It’s necessary but not sufficient.
There’s much more to do.
Your
most important asset is your
own earning power. By this I mean the mental and physical
ability to generate income. If your portfolio returns drop to zero (or even if
they go down), but you still have earning power, you have a chance to recover.
So it makes sense to protect and expand your earning power.
Ideally,
you want to be in an occupation that won’t cut off your earning power at some
arbitrary age. Better to have some kind of work you can do for as long as you
wish. It should also be work you actually enjoy. No one wants to “retire” into
slavery.
The
other thing you should do is protect your health. Doing so gives you a double
advantage. First, good health will enable you to work longer and more
energetically. Second, people in good health have lower medical expenses.
My
friend Patrick Cox talks about “health span” instead of life span. The goal is
not simply to live longer but to stay active and independent at an older age.
That’s what I hope to do. We are on the cusp of some major breakthroughs in
life-extension technologies. I truly believe that 85 will be the new 65 long
before I reach 85. Thus I may actually get to age backwards, at least for a few
years. It’s what I optimistically tell myself, anyway.
Even
without new developments, you can do a lot to increase your health span. Get
exercise, lose weight, stop smoking, watch your diet – you know the drill. The
hard part is actually doing it. Most people don’t, until it’s too late.
In a
low-return world, your health and your earning power may be the best option you
have. Preserve them at all costs.
I know
the original plan was to mostly stay home this summer, but sometimes you have
to call an audible at the line. Maine for the annual fishing trip was always in
the plan, and you have to go back through New York anyway, so staying around
for a day or two to do media and meetings makes sense. Then, how many chances
would I get to do serious research on the future of space exploration for my
book – but to seize the opportunity I have to go to Montana for a few days;
that makes sense, too. Then the chance popped up to go to Iceland and get a new
perspective on the future of energy development. It takes a day to get to
Iceland, and then meetings and a little looking around for a day and a half,
and I’m back in Dallas. And no plans to go anywhere for another month.
A
couple weeks ago, I did an interview with my good friend Grant Williams of Real
Vision TV. I do a lot of interviews, but Real Vision is different. They feature
video-on-demand sessions with global leaders in the fields of finance and
investing – people like Jim Rogers, Jeff Gundlach, Neil Howe, William White,
Hugh Hendry, and Albert Edwards – with new content appearing every day. For me,
a big part of the value of Real Vision is that the interviews are conducted by
Grant and his partner Raoul Pal, two guys whose views I immensely respect. Now,
they’re offering my readers a 7-day free trial and a 10% discount to anyone who
signs up. You can check it out right
here.
I have
been hobbling around for the last month. I seriously pulled my right quad
muscle. There’s not much I can do other than wrap it and ice it. That and allow
about three months for it to recover and then another 2–3 months of therapy to
restore the strength I am losing by not working out below my waist. I guess the
good news is, my upper body is getting stronger. And the pain is considerably
less than it was a month ago, so I am recovering. And no, I didn’t strain it
working out. I just moved wrong getting out of bed and stretched the leg in a
direction that it evidently didn’t want to go. Consulting with the doctors and
trainers confirms that there are no miracle cures for pulled muscles other than
time. Which seems to be passing faster than ever these days, so before long I
should be normal.
It’s
time to hit the send button, so I’ll wish you a great week and move on to the
next project.
Your
not planning on retiring analyst,
John Mauldin
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