Time To Worry About Underfunded Pensions?

Time To Worry About Underfunded Pensions?

I recently attended a seminar about public pension reform led by Chuck Reed, formerly mayor of San Jose and currently board member of the Retirement Security Initiative. As you probably recall, Reed led the effort to pass a pension reform measure for San Jose in 2012.  Here are some of the implications of the underfunded pension situation across the U.S. today, not just for those on public pensions but for all retirees.

It has been variously estimated that the public pension obligations of states and municipalities across the U.S. exceed their ability to pay by anywhere from 20% to over 100%. If you’re wondering who’s responsible for this state of affairs, the cast of characters include politicians, union leaders, and (to a lesser extent) bond rating agencies.

There has been a lot of public backlash over what many in the private sector consider overly-generous public pensions, such as the ability for police and firefighters in numerous cities to retire after 30 years of service and collect 100% of their salary for the rest of their lives. But it is not appropriate to blame the employees.  After all, it was the city leaders who offered such benefits to them without allocating sufficient funding to pay for them.  Certainly pensions such as these are significantly more expensive than those providing retirees with a more reasonable 50% of their pay.  But there would have been no problem with municipalities providing either benefit as long as the politicians had funded them appropriately rather than having left it to some future politicians to deal with the cost. Would you call that irresponsible?  Unconscionable?  You pick the appropriate adjectives.

Next we have the public employee union leaders, who (with only a few exceptions) take the position that the money is always there and all the municipality has to do to cover the costs is to shift funding away from other priorities or raise the money through taxes or bonds. This unwillingness to participate in broader discussions about pension reform solutions is both unrealistic as well as irresponsible.  That’s because there are really only four ways to deal with the problem.  In addition to cutting services or raising taxes, the only other choices a city has is to cut benefits to retirees and/or cut payments to muni bond investors.  Since pensions have been underfunded for so long, in many jurisdictions no single approach is sufficient at this point.  The simplistic “cut a few services” just won’t suffice.  Look at what Detroit is being forced to do.

Where do the bond rating agencies fit in? By having demonstrated that they have learned nothing since 2008, when they rated bonds from Lehman Brothers as investment grade a week before the company went bankrupt.  In 2013 Puerto Rican bonds were rated investment grade, despite the fact that they were being used to cover the government’s pension obligations (an unsustainable financial strategy).  And today Puerto Rico has reached the point of crisis, necessitating bondholders to have to give up some amount of principal (known in financial parlance as a haircut).  How could the rating agencies not have seen that coming?  If the federal government ever decides to prosecute some of the financial leaders who brought about the financial collapse of 2008 through their reckless risk taking, in my opinion bond rating agency leaders deserve at least dishonorable mention.

You might think that underfunded public pension liabilities are a problem only for public employees. However, as Reed points out, we are all going to share in the fallout.  Let’s start with where you plan to retire.  Whether or not you’re a public pensioner, if you end up in a city that is forced to cut services or raise taxes to fix its public pension problem, the quality of your life is going to be impacted even if your pension does not take a direct hit.  And as a private-sector retiree you probably will be depending to a large extent on your investment portfolio to support you.  How safe can you make it while still getting a decent return?  Muni bonds once filled this role to a large extent, but today you need to carefully vet them (without expecting much help from the rating agencies) before investing.  Are you, your financial advisor, or the mutual fund company able to provide the appropriate level of due diligence?

What you can do to improve the situation? In preparation for evaluating the financial health of any retirement locale you are considering, you could start by determining the extent to which pensions are underfunded in your own local city or town.  The ease with which you uncover the data will indicate how transparently that municipality and its leadership are managing the problem.  And during elections, be sure to interrogate candidates on their understanding of and their position on this topic.  Even though they didn’t cause the problem, they should still be held accountable to solve it, not kick it down the road like their predecessors.

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