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Why Pensions Are A (Big) Black Swan

When talk turns to what might derail today’s debt-driven “recovery,” the big names and easy stories get most of the attention: China with its soaring debt, volatile equities and heavy-handed intervention; Japan with its stratospheric debt and science fictiony demographics; Greece, which needs no explanation; the developing countries with their weak currencies and mountain of dollar-denominated debt. And of course America’s triple bubble of stocks, bonds and derivatives.

Underfunded pension plans, to the extent they come up at all, tend to be mentioned in passing largely because most of them are 1) too small to matter on their own and 2) too hard to understand for most people to form a strong opinion.

But they deserve a closer look. In the US there are dozens of state and local pension plans that in the aggregate are underfunded by several trillion dollars (meaning they’ve promised this much to beneficiaries but don’t have it). When one plan blows up it will impact lots of others, so the aggregate number is a pretty good indicator of the real risk.

The generally-accepted poster child for pension mismanagement is Chicago. As the Wharton business school recently noted:

Chicago’s unfunded liabilities are 10 times its revenues. Just assume that they’re going to have to pay 5% of that [number annually]. That means you’re looking at 50% of their cash that will have go to pensions.

For a more detailed account of the mess that is Chicago see Emanuel fiddles while Chicago burns by enraged Illinois resident Mike Shedlock.

But, you might reasonably say, pension funds have big investment portfolios so they must be making fortunes in today’s bull markets. You’d be right in some cases. But apparently it’s still not enough to offset rising liabilities as baby boomer teachers, cops and fire fighters retire. And now, as financial markets peak and start to roll over, it’s getting harder to make any money at all. Consider the plight of huge California pension plan CalPERS:

CalPERS misses its target return by a wide margin

The California Public Employees’ Retirement System said it missed its return target by a wide margin, hurt by a sluggish global economy and an under-performing private equity portfolio.

The nation’s largest public pension fund said its investments returned just 2.4% for its fiscal year, ended June 30, far below its 7.5% investment target.

In a conference call with reporters Monday, CalPERS’ chief investment officer, Ted Eliopoulos, said the main culprit was a sluggish world economy that held down returns on its giant stock portfolio, which makes up 54% of the $301-billion fund.

The stock portfolio’s return was only 1%, underperforming the 1.3% returns at its benchmark portfolio. Eliopoulos noted that the fund has done better than the 7.5% target over the previous three- and five-year periods.

And this is during a year when stocks and bonds did okay. What happens when — after one of the longest bull markets ever — the inevitable bear market occurs? A diversified stock portfolio will fall by 20% (the definition of a bear market), real estate will tank as it always does in hard financial times, and bonds, which would normally outperform in such an environment, might only be stable since they’re already yielding next to nothing. The net result: A loss of 10% – 15% at a time when the fund needs at least +8% just to keep up with soaring obligations. The funding gap becomes a chasm, leading to calls for benefit cuts (which lower the incomes of current and prospective retirees and send them en masse to the polls to vote out the ruling party), big tax increases to rebuild pension portfolios (sending taxpayers not covered by these plans to the polls to vote out the incumbents), or massive spending cuts to free up money to rebuild pensions (which dumps the local economy into a deep recession, sending newly-poor residents to the polls…you get the picture).

If this sounds a little Greece-like, that’s because states and localities are in a very similar bind: they’re small economic units that have accumulated unpayable debts. Lacking the ability to print and/or devalue their own currency, they have no choice but to (at some point) live within their means. But this inflicts extraordinary pain on a populace that isn’t used to suffering and sees no point in starting.

The ensuing crisis will be “solved” in one of two ways:

1) A default by, let’s say Chicago, which sends its municipal bonds down to pennies on the dollar and, much more important, panics everyone who owns munis, tanking the whole sector. States and localities around the country find themselves unable to borrow, and they start defaulting on their outstanding bonds and/or laying off tens of thousands of workers, turning a narrow little muni crisis into a full-blown recession. This in turn lowers the returns generated by stocks and real estate, further widening the pension gap.

2) Washington (DC) steps in and bails Chicago out before it can default. But — same as if the eurozone forgave Greece’s debt — all the other badly run pension plans decide they’re Italy and demand the same sweet deal. The cost spirals into the trillions, the financial markets realize that government debt and money creation are now on a one-way train to infinity, and everyone freaks out.

Pretty impressive black swan, no?

17 thoughts on "Why Pensions Are A (Big) Black Swan"

  1. The Glass–Steagall Act was passed in 1933 it kept commercial banks form gambling with depositors funds. It worked very well until under the democrats in the late 1990’s (Dodd Frank) repealed the law now allowing Investment banks like Goldman Sacks and similar gambling houses to be covered by the FDIC and be called commercial banks. That was the start of the end. The government and FED will give all the BS why this is not the case but like all government frauds the MSM covers their tails. Do your own research. Shine the light of day on these fraudulent crooks.

  2. There are two things wrong with your essay. 1) The “black swan” metaphor refers to a rare and very unexpected thing happening. If all of the swans are black, and the white swan is the rare bird, then the “black swan” metaphor does not work. Almost all public pensions are black swans now. They are not rare, and everyone can see that they are black. 2) The pension obligations are not “promises”. They are contracts, in the same category as mortgage contracts, purchase contracts, etc. They are binding legal contracts, not like idle promises that you can have a pony when you are 12. “Oh, sorry, we can’t afford that pony.”

  3. Are bonds assets or liabilities? At present they are treated as assets and the more they are printed, the richer the world will be?

  4. So explain why Germany thrives with a middle class with unions and didn’t follow in the foot steps of Thatcher and Reagan’s trickle down foolery and basically is the economic leader in EU while we fall further behind buying goods from them and China, and they buy up our assets? Unions didn’t create that economic policy, but was the excuse, The ideology came right straight from the Chicago School of Economics, Milton Friedman and Robert Mundell, who created the Voodoo that we all are experiencing the last 30 years. When are we going to debunk it, as in Steve Keen’s book, Debunking Economics, and return to socially responsible economics that put Americans back to work and makes corporations into what they were intended to be, responsible citizens working in the public’s interest?

  5. that which can’t be paid, won’t be paid….but that’s not to say it can’t be put in limbo forever, restructured, extended……to infinity. We live in a default-phobic world because of the fragility of the interlocked derivative forest, weak rooted trees, tied together and leaning on each other for support, if one begins to fall, the whole woods could domino down.

    much better to transform that 20 yr bond to a new 50 year bond, at a lower interest rate, with a temporary loan so you can afford the interest payments, etc etc ….any thing anything but the dreaded DEFAULT,

    If only Chicago could issue new bonds at a negative rate of interest, the problem would be solved, their debt would generate income to support them, which combined with inflation would allow them to repay the principal in Zimbabwei dollars 50 years from now. problem solved and no default, it all getting very absurd world of pretend economy, pretend solvency, pretend markets manipulated by govt pretend statistics and govt intervention preventing market downward moves. We all collectively know the crash that is building potential energy…but…shhhh…just keep going, keep pretending.

  6. The missing factor here is that a municipality in “default” is a subjective thing – subject to whatever is the most amenable “solution”. Therefore, whatever happens will be extended for years, which is also why nobody cares about the situation. We’ll all be old or dead by the time any municipality causes contagion. Until then it will be just be talk and speculation.

  7. Never fear, the money will be found! Government will just raid private pensions, or increase property taxes to such a level that real estate is incapable of being sold, thus rendering the holder ‘captive’ forever. More nuisance fees for all!

  8. Funny, Reagan was the one in 1987 that changed pensions from a liability to an asset so that people like Mitt Romney could steal them to use to buy out, at times perfectly good companies, and make a nice little profit. Stealing from the working class to make themselves wealthy was the end of the virtuous cycle and the beginning of pirate capitalism and the growth of too big to fail, fueling the one percent’s bank accounts. It still hasn’t stopped corporate debt from growing to an all time high so what have we gained from Reaganomics? The private sector’s debt took down the economy the last time and blaming the public sector for all our woes is just plane stupid, or not willing to look at the real issues in our economy because we might not like what we see. That’s why Bernie’s numbers are growing day by day.

    1. stealing from the ‘working class’ is what happens when unions get in bed with pols to pass pension bennies that are unfunded, and realistically never attainable without massive tax increase. when public service workers can retire after 25 years while the private sector workers cannot, you are building a public ‘Greek’ system, ‘borrowing’ from a shrinking middle class that themselves will never attain retirement while 45-50 yr old public workers remain retired for 30+ years — longer than they worked!

    2. Dan: Not true. I work in the defined benefit pension field (since ’79), and everything you stated is false

    3. I also worked in the defined benefit pension field from 1988 to 1990. It is true that firms were allowed to “close out” over-funded pension plans, but the pensions were still guaranteed by the “buyer” of the liabilities, usually life insurance companies.

  9. “1” is the only real option. If Chicago (like Greece) gets rescued, most of California, Detroit, Boston & the other usual suspects will be right there with their hands out. Crappy, socialist, welfare hell-holes like Chicago *need* to collapse. Default is the only thing that can save them now.

    1. “Default is the only thing that can save them now.”

      Chicago is toast already. Default is the only thing that can save the rest of us.

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