Angst in America, Part 5: The Crisis We Can’t Muddle Through
“The ship of democracy, which has weathered all storms, may sink
through the mutiny of those on board.”
– Grover Cleveland, the 22nd and 24th
president of the United States
“It is your concern when your neighbor’s wall is on fire.”
– Horace
“The biggest mistake investors make is to believe that what
happened in the recent past is likely to persist. They assume that something
that was a good investment in the recent past is still a good investment.
Typically, high past returns simply imply that an asset has become more
expensive and is a poorer, not better, investment.”
– Ray Dalio, Founder, Bridgewater Associates
When you spend a couple of decades writing weekly letters to
hundreds of thousands of people you think of as friends, your readers naturally
come to associate you with a few key ideas. I have certainly become known for
at least one. My longtime regular readers think of me as the “Muddle Through”
guy. That’s not an image I have tried to cultivate, but I have it anyway.
I have to confess that it’s usually accurate. In a typical letter
I will describe some sort of potentially scary problem, explain what might
happen, then conclude that we’ll probably avoid the worst and muddle through.
That has almost always been the right call. The worst doesn’t happen, and we
all survive. “Muddle Through” can mean widely varying outcomes for individuals,
but for the world at large, things generally work out OK.
As a statistical matter, this stance makes sense. The extreme
tails of any distribution curve comprise outcomes that almost certainly won’t
occur. The most probable outcomes cluster around the fat middle.
Yet there is one problem that is very definitely coming our way
that I really don’t think we can Muddle Through and where even the
middle-of-the-road scenarios are terrible, and that’s the public pension
crisis. I really see no way it can end well. It’s going to hurt just about
everyone.
“But wait,” my Canadian and German friends will say, “that’s an
American problem. Leave us out of it.”
I wish I could. The sad fact is that the US is the big fish in the
global economic pond. One way or another, our problems affect everyone. You
catch cold when we sneeze. The “Disappearing
Pensions” crisis I described last week will hurt you, too. The only
question is which transmission mechanism will bring it to you. Further, most
developed countries have their own version of the pension crisis in the form of
government promises that can’t be kept. Same song, different verse.
Today I want to delve a little deeper and explain why pension
angst is completely reasonable and not at all overblown. If anything, it has
been understated.
Most pension fund analysis focuses on funding levels, i.e., the
assets a plan actually has versus how much it should have at a given point,
based on actuarial analysis of future liabilities and assumptions about future
contributions and investment returns.
Funding levels are important. They are a useful canary in the coal
mine – but only to the extent that the responsible parties pay attention to
them and respond correctly. No such thing is happening. Worse, the assumptions
that are being made mean that funding levels probably understate the coming
disaster.
Yes, disaster. I use that word because I don’t have a stronger one
that I can use in a family-friendly letter.
Let’s make this simple. The “defined benefits” that any DB plan
will eventually pay its beneficiaries come from two sources:
1. Cash contributions, mostly from the employers but often from
workers, too
2. Interest, dividends, and capital gains earned on the
investments into which those cash contributions are placed.
That’s it. There is no pot of gold at the end of the rainbow.
There’s not even a rainbow. Every penny that every retiree receives from every
DB plan comes from those two sources. Unlike the federal government, cities and
states can’t mint currency by fiat. No magical ponies will come pulling carts
full of cash to bail out the pension plans. (We do that only for banks.)
The problem is that, with few exceptions, neither source is
producing at the level necessary to deliver the promised benefits. In many
cases there is a vanishingly small chance they ever will produce enough. And
the longer we go without fixing the problem, the smaller the chance becomes.
In each municipality and state, a few hardy souls are jumping up
and down and screaming about the coming crisis in their locales. But when
politicians do pay attention, the required actions are so painful that they
conclude there is very little chance of anything substantive being done. And so
they do nothing. The sad fact is that even actions that would fix part of the
problem are often pushed away.
There is a perverse logic to this failure to act, and it has to do
with the Merciless Math of Loss.
We’ll start with contributions. The amount a city or state agency
must donate to its pension plan(s) is a function of the promises made to its
workers, typically in union-negotiated contracts.
The unions naturally want as much as possible. The employer wants
to contribute as little as possible. Fair negotiations should produce a number
acceptable to both sides – but that assumes negotiations are fair. Often, they
aren’t.
Here we must recognize a practical distinction between public and
private. In theory, a city council is responsible to its voters just as a
corporate board is responsible to shareholders. Yet the relationships are quite
different.
Corporate board members are generally themselves shareholders, who
share in the gains or losses their choices cause the company, and there is
actually quite a bit of legal liability attached to being on a corporate board.
The more happy and productive the board can keep the workers, the more valuable
their shares will be. City council members, while residents in the communities
they represent, don’t gain or lose monetarily from the contracts they approve.
Their incentive is to garner political support that leads to re-election or
advancement to higher office.
So public worker contract negotiations are a competition between
highly organized and motivated workers on one side and diffuse and often
disinterested voters on the other. Elected officials may nominally answer to
the voters, but the unions have more immediate influence, so the elected
officials may not negotiate as zealously as they should, especially when the
city, police, fire, and school workers tend to vote en masse for the candidate
that is the most favorable to the unions. And in most municipal elections such
workers may represent a high percentage of voters: Turnout for elections is
generally less than 20%, and in many cities it is less than 10%. In the last
mayoral election in my hometown of Dallas, only 6.1% of eligible voters
actually participated.
On the other side of the equation, workers have every incentive to
demand higher retirement benefits. To them, a pension is substitute
compensation for cash the agency doesn’t have to put in their paychecks today.
They accept the promise of future retirement benefits in lieu of higher pay.
And the elected officials have every incentive to promise those benefits,
because the immediate cost of doing so is much smaller than the perceived value
they give to workers, and they get the votes and cooperation of the workers.
The problems that come down the road will be dealt with by other politicians.
The immediate cost, though smaller, is not zero. Government
agencies have to make annual pension contributions, and the amounts of those
contributions are a function both of the benefits politicians promised and
other factors, like market returns, life expectancies, etc.
The fatal flaw here is that required annual pension contributions
are an easily gamed number. A city council can shop around for a consultant who
gives them whatever number they desire, and they frequently do just that. But
the game gets harder to play as time passes and the bogus numbers get bigger
and bigger.
Repeated rounds of this process lead to funding ratios like these
in Massachusetts:
As I said, these funding ratios depend on assumptions that are
often far too optimistic. Yet most pension experts will tell you that there is
no bouncing back, no restoring the ratio to a healthy level once it has dropped
below 50%. Almost all the entities in the table above are in or near that zone.
City of Springfield retirees are in deep trouble, and the rest not far behind.
What, realistically, can retirees expect from government agencies
like these? Very little, frankly. I repeat: Benefits come from plan
contributions and investment gains. I don’t know the situation in these
specific communities, but it’s highly unlikely that elected officials can raise
taxes or cut other spending enough to make the kind of contributions required
to make up these shortfalls. It can’t happen, which means it won’t happen.
I’ve said this before, but it bears repeating: City limits are
static, but the tax base is not. People can move away. Companies can relocate.
Both will happen if local officials push too hard. That is what ultimately
forced Detroit into bankruptcy. The city was depopulating, but its expenses
didn’t fall accordingly.
The table above came to me via Marc Faber, who in turn got it from
pension expert Frederick Sheehan. The title of Sheehan’s report is good advice:
“Public Pension Recipients:
Start Saving. You Are on Your Own.”
That falls into the category of “advice no one wants to hear,” but
it is nonetheless correct. Many, perhaps most, current city and state workers
simply aren’t going to get anything like the pension benefits they have been
led to expect. Sheehan puts it this way.
“We are promised...” is the haphazard refrain often encountered
when the reduction of pension claims is mentioned. Promised or not, one
distinguishing feature of non-federal government spending commitments stands
out: only the United States has a printing press. States cannot print money.
They can earn returns on their pensions’ invested assets, they can sell city
hall, lay off the public works department, and tax, but an underfunded pension
plan can only pay claims with dollars that exist.
This list of options is actually too generous. Sell city hall?
That presumes someone will buy it. Lay off the public works department? Not
good for property values. Raise taxes? Right, on all the people in those houses
without sewage service.
Repeat Sheehan’s last line and burn it into your brain: “An
underfunded pension plan can only pay claims with dollars that exist.” No one
gets anything if the money isn’t there, and in a disturbing number of places it
isn’t.
Keep in mind, those horrifyingly low funding levels would be far
lower still if they didn’t assume investment returns that are, in fact,
unrealistically rosy. Between 7½% and 8% is typical now. Exactly how is that
going to happen?
We know that pension plans typically have only 40–50% of their
assets in equities, something like 40% in bonds, and the rest in real estate
and alternative asset classes. How do you get 8% from that mix? Keeping 40% in
bonds at 3% (if you’re lucky) means everything else has to make 15%.
Do you really want to bet that stock returns will average 15% over
the next decade? If you actually think that is your future reality, then all I
can say is that the ’60s were probably pretty good for you, and you may still
be living in a drug-induced hallucination. If you are a public pension
beneficiary, that may be your best shot: just pretend. Good luck with that.
Marc Faber, who is even better at scaring people than I am, points
out something that should be obvious but apparently is not: Pension plan funding
ratios have been declining even as financial markets have posted impressive
gains:
I find the deteriorating funding levels of pension funds
remarkable because post-March 2009 (S&P 500 at 666) stocks around the world
rebounded strongly and many markets (including the US stock market) made new
highs. Furthermore, government bonds were rallying strongly after 2006 as
interest rates continued to decline sharply.
In fact, if I look at the total return of both equities and bonds
(including interest for bonds and dividends for equities) over the last ten
years (ending August 31, 2016), I note that the return levels exceeded the
expected asset return of almost 8% a year.
My point is this: If, despite these truly mouth-watering returns
of financial assets over the last ten years, the unfunded liabilities have
increased, what will happen once these returns diminish or completely
disappear? After all, it is almost certain that the returns of pension funds
(as well as other financial institutions) will diminish. Consider pension funds
that have increased their allocation to bonds, and now (in the case of S&P
500 companies) exceed the equity allocation.
Now consider the following. Ten-year US Treasuries yield 1.74% and
30-year US Treasuries 2.48%. In Europe and Japan, government bond yields are
frequently negative. How will it be possible with these low yields to achieve,
in the long term, returns that even come close to the expected return of 8%?
Marc wrote that in October 2016, so those yields are a bit higher
now; but you get his point. Yields are nowhere near high enough to deliver the
kind of returns pension trustees are assuming. It just won’t happen.
Worse, even if return assumptions are fulfilled for a while, as
unlikely as that may be, those good years will not be enough if a bear market
strikes at the wrong time. Sheehan quotes a study by Steven Malanga in City Journal last year.
The State of Utah’s pension plan lost 22.3% of its assets in 2008. It gained
back 13% in 2009. A good start to recovery, right?
No, not right. Utah determined that its investment returns would
have to compound at over 10% annually for the next 20 years just to recoup that
2008 loss. Why is that? Because while the portfolio was down, workers were
continuing to earn new retirement credits. You have one set of people trying to
fill the hole while another group digs it deeper. So just making back what you
lost is not enough. You also have to make back the additional obligations you
took on while you were trying to recover.
The word serendipity
was introduced to the English lexicon in 1754 by Horace Walpole as luck that
takes the form of finding valuable or pleasant things that are not looked for.
Let me introduce you to a new word. In 1998 William Boyd coined the term zemblanity to mean basically
the opposite of serendipity. The Urban
Dictionary defines zemblanity as the inevitable discovery of what
we would rather not know. If you are or have been the parent of teenage kids,
you have had some of those zemblanity moments.
America is going to be experiencing its own zemblanity moment
during the next financial crisis when it discovers that many of its municipal
and state pensions have crossed the threshold from merely difficult situations
to almost impossible-to-fix ones. We are going to do a little math here, but I
promise you it will be rather elementary. No calculus required. Seriously, this
is so simple that even a politician could understand it. If you could get one
to sit down and really think about it, much less do anything.
My friend Steve Blumenthal wrote a little essay called “The
Merciless Math of Loss.”
He opens by quoting Ned Davis:
“It’s a little-known but startling fact: The average buy-and-hold
stock market investor spends 74% of his or her time recovering from cyclical
downturns in the market (from 1900–May 2015).” (Ned Davis Research)
That’s according to well-respected Ned Davis Research, Inc., in
Venice, Florida. It raises a big question: How is it possible that investors
spend three quarters of their time just getting back to the starting line?
The answer is explained by the unforgiving mathematics of loss:
When investments lose ground, they must make up more ground, percentage-wise,
just to get back to even.
Say you invest $10,000 and your account takes a 10% loss over six
months. You’re down to a $9,000 balance. Because of your reduced capital base,
you will have to earn 11% to recoup your losses. The steeper the losses, the
higher the hurdle becomes for breaking even. For example: Recovering a loss of
30% requires a 42.9% gain; a 50% loss requires a 100% gain. To recover from a
loss of 75%, a 300% gain is required.
Getting back to even can eat up precious time. Take that 10% loss
over six months. Earning a steady 4% annually after that, you will still need
two and three-quarter years just to get back to where you started. That time
would be much better spent accumulating new money. Remember, the idea is to
grow your money, not just regain lost capital.
You can see the required recovery levels more graphically in this
chart from my friend Ed Easterling at Crestmont Research:
A 50% loss requires a 100% return to get back to breakeven. Add
just another 10% loss for a total loss of 60%, and it takes 150% to get back to
breakeven. The mathematics get uglier the bigger the loss.
Let’s look at two charts of the S&P 500. The first
shows straightforward index levels since 1977. If you click on the link above
or the chart below, you can bring up an interactive version of the chart. Click
on “max” and then run your cursor back and forth to see where the index was on
various dates. Note that it took 13 years to recover from the peak of 2000 (not
including the very temporary peak of 2007). Since 2000, the market has risen
roughly 50%. A 50% return over 17 years is not exactly what people thought they
were going to get back in 2000 – it’s a little less than 3% a year on a compounded
basis.
But that’s not really a fair way to look at it. While the NASDAQ
and other indexes have small dividend payouts relative to the size of their
indexes, the S&P 500 actually has reasonable dividends compounding over
time. So this next chart shows the level of the S&P 500, including
dividends, since 1988. And yes, while it did take almost 13 years for the
market, including dividend returns, to fully recover from the top in 2000, since
that time it has actually more than doubled with the help of dividends. That
slightly-larger-than-2% dividend has compounded nicely over time.
That pleasant result has lulled pension plan managers and other
investors into believing that this period is somehow normal. And it has
convinced them that their pensions must be recovering lost ground. The problem
is, that’s an illusion.
I read recently that the average pension fund in the United States
expects its investment prowess to bring home returns of 7.69% in the future. A
number of funds still use 8% as their target. Seriously.
Now let’s do some math based on the rule of 72. The rule of 72 is
basically (according to Investopedia) a simplified way to determine how long an
investment will take to double, given a fixed annual rate of interest. By
dividing 72 by the annual rate of return, investors can get a rough estimate of
how many years it will take for the initial investment to duplicate itself.
Investopedia even provides this handy table:
Let me reiterate that the biggest portion of the money that will
be used to pay retirees from a pension fund comes from actual returns on
investments and not from the original contributions. That means that if there
is a portion of the pension fund that is currently unfunded, those
(nonexistent) dollars can’t grow so that they can be redeemed 30 years later by
the retirees.
Further, the amount by which a pension plan is underfunded is
determined by the assumptions on returns that the fund makes. These next few
paragraphs will drive the actuaries and math nerds among my readers crazy, but I
am going to simplify here to make a point.
If you project returns of 8%, then you expect your assets to
double every nine years. Thus in 27 years, $1 that is sitting in the fund today
will have become $8.
But what if your returns grow at only 5%? Looking at the handy
chart above, we see that it takes 14.2 years to double your assets, so that in
28 years $1 will have grown to only $4. That is only about half of the dollars
that your actuaries and consultants have assumed would be there.
If you project 5% returns for the next 30 years, then you have to
almost double the current level of contributions to have the necessary assets
in 30 years. So basically, any pension fund that is assuming 8% compound
returns and is falling significantly short of that level now, will turn out to
be massively underfunded, far more so than funds are telling their retirees or
the public.
I understand that the actuaries actually calculate the
underfunding for each year, not just 30 years out. That makes the math far more
complex, but the principle is the same. The lower you make your return
assumptions, the more you are required to fund current pension balance sheets.
And that funding comes from only two sources, taxpayers and current workers. Of
course, you could go to your current retirees and tell them they are going to
get less money, starting right away, but how popular will you be then? (And how
illegal would that be?)
What happens if Jeremy Grantham is right (and he has been right
97% of the time with his seven-year projections), and total market returns are
less than 1% over the next seven years?
Then not only will pension funds have to grow returns much faster
in subsequent years to catch up, they will also have to go to their respective
states, cities, or schools and say, “You need to give us more money, because
we’re becoming more underfunded each year.”
Let’s just make this pension data analysis even more fun. During
the Great Recession, the market fell 58%. A 50% drop in the stock market during
a recession is not unusual. What is the probability that we will not have a
recession in the next four years? Pensions are making a huge wager on that
proposition, so it is not a trivial question.
The more I look at the situation with pensions, the more clearly I
see that there is no practical way out. We know three things with near
certainty:
1. Public pension plans are nowhere near able to meet their obligations.
2. Most cities and states can’t possibly contribute enough to
cover the gaps without serious budget upheaval or increased taxes.
3. Plan investments won’t achieve projected returns, let alone
earn enough to cover the contribution gaps.
I suppose in a different flavor of quantum universe where math
works differently, it might be possible to make these pension plans work. Here
in our universe, not so much. Not going to happen.
What does that mean?
It means several million more people are not going to have the
kind of retirement they envisioned. If you’re one of them, you need to
aggressively start saving every penny you can, right now.
Further complicating the situation is that in many places, state
and local workers don’t participate in the Social Security system. They won’t
even have that minimal amount to cushion the blow.
All these unexpectedly uncomfortable retirees will affect the
economy. Their added savings will serve to keep interest rates low for
everyone. Their consumer spending will be lower, reducing demand for many goods
and services. They may have to sell their homes and move to more economical
locations, thereby depressing property values.
None of this is built into anyone’s economic projections, which
are often not so good in the first place. I’d like to point out a silver
lining, but I just don’t see one. All I see are clouds: dark, ugly clouds
threatening to rain on us all.
Will we Muddle Through? Most of us will. But I am 100% confident
that this pension debacle is going to end very badly for many millions of state
and local public workers. And we haven’t even talked about the social impacts.
You think the 2016 presidential campaign was ugly and divisive?
Wait until your local elections turn on whether or not to cut your neighbor’s pension
in half. The arguments are going to be up close and personal. What kind of
person will run for local office in those conditions? Probably people who
shouldn’t. Which will only make it all worse.
Like state and local pension obligations, US federal government
pension obligations are also basically unfunded. They are expected to come from
future tax revenues. Those obligations are the bulk of the over $100 trillion
in unfunded liabilities that show up in the estimates of how much the United
States is really in debt. That money is going to have to come from somewhere.
But just as the United States will never default on its actual debt, I truly
don’t believe we will default on US government pension obligations.
Future politicians are going to be faced with some very
uncomfortable choices, one of which will be how much money to ask the Federal
Reserve print in order to honor those obligations. Or should they cut future
pension payouts, or maybe even current ones?
When Illinois or any other state finds itself unable to pay its
pensioners, I think it is unlikely that the federal government will ride to the
rescue. And the other states will look at each other and say, “Not my monkey,
not my circus.”
But what happens when a majority of the states and citizens in
those states begin to demand that something be done to help the poor public
service workers whose lives are being seriously impaired? We can say that in
today’s political environment it is unlikely that the federal government would
rescue states and cities. But in a future political environment? Hard to say.
The pressure to “do something” is going to be huge. And it’s going to be coming
from seemingly everywhere.
If you aren’t already angst-ridden, consider this letter your
ticket to the club. It’s going to hurt to belong; but we’re all in this
together, one way and another.
Last week we had a bit of an “oops” moment. I mentally knew that I
had committed myself to an investment speaking engagement in Sonoma sometime in
April or May, but for whatever reason that event did not make it onto my
calendar. I have actually had conversations about the event with the host
organizers, Brian Lockhart and Geoff Eliason of Peak Capital Management, but
somehow the event never got firmed up here on my end, which of course meant
that no one had actually booked airline tickets. I got an email on Wednesday
asking me to confirm a time for a conference call about next week’s event. I
immediately got on the phone to confirm the details and then asked my new
executive assistant, Tammi Cole, to look into last-minute airline reservations
and so on. Turns out there were seats available, and Shane and I will be in
Sonoma on time Monday afternoon. Then, if I haven’t missed putting anything
else on my calendar, my next trip wi ll be to the Strategic Investment
Conference May 22–25 in Orlando. On the 26th Shane and I fly up to
Washington DC to be with Neil Howe and bride Gisela at their wedding. I’m
particularly honored that he would be willing to speak at SIC on Thursday
morning and then fly back to get married! But then, what are friends for?
This past week has was filled with an endless array of meetings,
conference calls, and research and writing, with my number one goal of working
on next week’s letter somehow slipping until today, so I now find myself
writing Sunday afternoon in an effort to get ahead of next week so that I can
actually spend some time with my friends in Sonoma, rather than stay in my room
writing. I don’t want to say that I’m running fast, but my shadow has started
to complain about having to keep up.
Who knows, in Northern California I might even have to borrow some
golf clubs and play a few holes to see if my back is up to it. I have been feeling
a bit looser lately. I think the best idea might be to buy six balls and play
until I lose them. Surely I can last a few holes.
You have a great week.
Your hearing the gym call my name because it misses me analyst,
John Mauldin
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