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SKARBECK: Expect more battles over public pensions

September 18, 2010

Ken Skarbeck InvestingBloomberg, the financial news company, recently held a conference titled, “Cities and Debt Briefing: Defusing the Municipal Pension Bomb.” The topic is also the focus of several recent studies that have cast the spotlight on this urgent problem.

The Great Recession has brought to the forefront what once were pension liabilities that “would eventually have to be dealt with much later-on-down-the-road.” Now a litany of problems—including strained state budgets, a failure of states to make necessary pension contributions, recent large investment losses, limp investment performance over the past decade, and historically low interest rates—have all conspired to bring the ticking pension bomb to a reality today.

In at least 14 state pension funds, benefit payments in the most recent fiscal year have equaled more than 10 percent of assets. If the combination of taxpayer plus employee contributions and investment performance falls short of that 10 percent, the plan is essentially liquidating assets to meet obligations. Also, in these stressed pension plans, managers are forced to keep significant monies in short-term investments that are paying negligible returns just to meet the high current payouts. One investment manager has described the situation as a “death spiral.”

Illinois’ pension system is in the worst condition, with fund assets covering only 50.6 percent of promised benefits. In the year ending June 30, 2009, the Illinois Teachers’ Retirement System paid out $3.7 billion in benefits, or 13 percent of the assets of the fund. Earlier this year, the fund borrowed $3.5 billion to meet its obligations, but lawmakers are unwilling to approve another bond sale for fiscal 2011. Therefore, the fund may sell $3 billion in assets to cover benefits.

There are signs that lawmakers are beginning to consider the politically unpopular move of reducing previously granted pension benefits. This year, 15 states have enacted legislation to reduce future public pension obligations, however most of the changes typically affect only new employees. Few have dared to address the pension shortfalls on benefits that have accumulated for existing employees—which will be the next battle for lawmakers in states with severely underfunded pension plans.

A complicating factor is that most pension plans have an “assumed rate of return” around 8 percent. Many think that achieving an 8-percent return is unrealistic in the current environment of historically low interest rates. Considering that over the past 10 years, annual returns on state pension plans have not come close to this rate, experts have argued that assumed rates need to be lowered to around 6 percent. Unfortunately, doing this would substantially increase the contributions necessary to meet the same amount of future benefits.

To meet California’s pension obligations, and after losing $70 billion during the credit crisis, the new chief investment officer of Calpers is said to embrace riskier investments in emerging nations, hedge funds and private equity to reach the fund’s 7.75-percent assumed rate of return. A former Texas pension board member considers that a mistake, saying, “It’s folly to think a $200 billion pension fund is going to do better than the economy. To move out on the risk spectrum to beat the market is imprudent; it’s like running your retirement from Las Vegas.”

For the record, according to the Bloomberg study, Indiana was the 14th-worst-funded state with pension assets covering 68.7 percent of promised benefits at fiscal year-end 2009.•

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.

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