The Public Pension Black Hole - Sucked in the vortex of an undiscovered universe

“It’s not what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so!” – Mark Twain

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The beauty of pension accounting is that slight tweaks can make a large unfunded liability seemingly disappear or at the very least shrink it to “she’ll be alright mate” levels. However if a pension fund plays the game of understating its risks for long enough then eventually it catches up, especially if performance is consistently poor. This is what we are starting to see in vivid colour among state and local (S&L) governments in America. Reality is biting. Let’s jump right in.

California Dreaming

To put this in perspective the California Public Employee Retirement System (CalPERS) lost around 2% of its funds in 2015/16. The fund assumes an aggressive 7.5% return. Dr. Joe Nation of Stanford Institute for Economic Policy Research thinks unfunded liabilities have surged to $150bn from $93bn in the last two years. Furthermore suggesting the use of a more realistic 4% rate of return. CalPERS has an unfunded liability of $412bn (or the equivalent of 3 years’ worth of state revenue).  California collects $138bn in taxes annually in a $2.3 trillion economy (around the size of Italy). With over-inflated asset markets and increasingly negative returns on highly rated paper, the growth in unfunded liabilities is even more concerning as any market correction (likely to be severe given such blatant manipulation to date). If the correction is huge it will push the unfunded portion to even more dizzying levels.

US Pension Tracker (USPT) defines its methodology to assess the true mark-to-market value of unfunded liabilities versus actuarial assumptions.

“[We] reflect market pension debt using a discount rate equal to 20-year Treasury yields rounded to the nearest one-quarter percentage point. The yield in 2014 was 3.00%. The use of this discount rate here is intended, as most financial economists agree, to more closely represent market realities and system liabilities.”

USPT assumes that public pension funds have a market based unfunded pension deficit of $4.833 trillion. The actuarial base (using a discount rate of 7.5%) of the pension deficit is approximately $1.041 trillion. This assumes an unfunded portion of $3.8 trillion. Using the 2016 20-year US Treasury bond yield of 1.71% the market based pension deficit explodes to over $8.8 trillion or a $7.5 trillion unfunded portion equating to around $74,000 per American household. For California alone this would push the pension debt per person above $135,000.

This study is a mere snapshot of the state of public pensions in the US. Once again we have a festering problem that is turning gangrenous yet not enough attention is being focused on solutions. The over reliance on authorities to get us out of this economic mess is concerning. Perhaps there is a wish that helicopter money (as B-52 might be more appropriate) will somehow kick off inflation and cut back into these unfunded liabilities. However, we should be careful what we wish for. The risk of duration on the negative yielding debt would wipe out large portions of pension assets making the journey highly challenging not to mention any hyper-inflation risks would reduce the purchasing power of any retirees who got paid their promised distributions. Quite simply there is no easy way out of this and whatever solution is found will involve pain. For all the kicking and screaming in the world, the problem has festered over the past decade and many administrators have chosen not to do anything serious about it. Brace yourselves.

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