Joshua Rauh, of the Kellogg School of Management at Northwestern University, and Robert Novy-Marx, of the University of Rochester, estimate that the states’ pension shortfall may be as much as $3.4 trillion and that municipalities have a hole of $574 billion. Mr Rauh calculates that seven states will have exhausted their pension assets by 2020—even if they make a return of 8%, a common assumption that looks wildly optimistic. Half will run out of money by 2027. If pension promises are to be kept, this will place immense strain on taxes. Several have promised annual payments that will absorb more than 30% of their tax revenues after their pension funds are exhausted.
The severity of states’ pension woes was disguised for years, because asset markets were so strong and because of the way states accounted for the cost of pension provision. But the 21st century has been dismal for stockmarkets, where most pension money has been put. State budgets came under huge pressure as a result of the 2008-09 recession, which caused tax revenues to plunge. Meredith Whitney, an analyst who made her name forecasting the banking crisis, believes the states could be the next source of systemic financial risk.
The pension problem is compounded by the fact that we live in a ZIRP world thanks to the Federal Reserve. Most pension plans assume a 7-8% average annual return which is impossible to achieve in today's environment. The only way you could get those kind of returns would be to massively increase risk (and jeopardize asset quality) or use leverage to enhance low returns. Despite the fact that we just witnessed a massive financial collapse in 2008-2009, pension funds are already starting to use leverage to juice returns as has been reported by the WSJ. This of course has financial ruin written all over it as most of these plans are already mismanaged and the use of leverage will only compound the problem. Not only will these plans lose all of the pension money, but they will be left owing money to creditors. I guess the goal of these underfunded pension plans is to become too big to fail so that they can qualify for a federal bailout (financed by the Fed's money printing). The argument will go something like we have to bail out these pension plans because their failure will hurt their creditors (major banks), which will in turn damage the general economy. So to save the economy we have to save the pension plans and voila you have the justification for another taxpayer funded bailout.
Black Swan Insights