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COMMENTARY: Fed screams softly in warning about public pension crisis

April 18, 2012

This is what it sounds like when the Federal Reserve Bank screams: "Much has been written about the various headwinds restraining economic activity over the near term. However, our economy also has other headwinds to confront over the medium- to-longer-term. ... the finances of some state and local governments are also under stress and in need of serious adjustments."  - Federal Reserve Bank of Cleveland President Sandra Pianalto

Pianalto's carefully worded column in the latest "Forefront" magazine refers to "Public Finances: Shining Light on a Dark Corner," three reports on a year of research by the Cleveland and Atlanta Feds.

Forefront editors introduce the issue: "Many state and municipal budgets are in woeful shape. What concerns should we have about public pensions and municipal bond markets? ... we explain where risks could be building and how reforms might help forestall their impact on the broader economy and financial system."

Forestall? How about prevent their impact on the broader economy and financial system?

No such luck, citizens. "Public Pensions Under Stress" reports, "It now seems inevitable that sacrifices will be required from current employees, employers, and in some cases, retirees. ...

"Without strong remedies, at what point would pension plans run out of money, leaving financially impaired state and local governments on the hook? That question is not quite settled."

Actually, asking when they will run out of money instead of if they will run out of money confirms that politicians and pension fund managers have been denying reality for years.

Even under the most optimistic - even delusional - assumptions about fund investments, the article cites a study showing virtually all plans eventually "exhausted" even when using up annual contributions.

The study admits: "Other estimates paint a bleaker picture. Joshua Rauh, Northwestern University professor, ..." who calculated exhaustion dates if pension plans use risk-free assumptions and do not cannibalize annual contributions, but said, "... a recent GAO study concludes that Rauh's projected exhaustion dates are not a realistic estimate ...."

Actually, the Government Accountability Office said just the opposite.

The federal study offers a scary warning: "At this point, it seems unlikely that any major pension fund will run out of cash in the next few years, barring a general worsening of economic and financial conditions. Indeed, increased public attention on the underfunding problem has motivated pension plan sponsors to work with state legislators to implement substantive reforms. ...

"But most of these changes have only a limited effect on plan funding. ..."

That means "... we are not out of the woods yet. Many funds will require ... painful new contributions from employers and employees. ... Meanwhile, an imminent collapse of several large funds, accompanied by a shock to the financial system, remains improbable - though not impossible."

What if economic and financial conditions generally worsen and the improbable becomes possible? This study does not say.

However, fund "Managers' ‘reach for yield,' if practiced widely, would make pension plan sustainability particularly vulnerable to another negative shock to equity prices."

Managers are increasing risk by reaching for yield in desperate efforts to meet investment goals needed to keep funds from collapsing, just setting us up for a bigger crash next time. That, in turn, will have a negative impact on the general economy.

Think not? Consider "Monitoring the Risks of State and Local Government Finance."

The second federal study asks: "Just how much should most Americans worry that some state and local governments could go into default?"

Researchers have "been looking at how shocks to the municipal bond market, continued problems with pension funding, and general fiscal stress could ripple into something much larger - either in the form of a (rather unlikely) threat to financial stability or perhaps as an aggravation of regional economic woes."

Rather unlikely? Those are the Fed's parentheses, citizens, not exactly reassuring.

The study ranks risk of state government default "extremely low" because, "After all, state governments maintain the authority to raise taxes (however politically unpopular) to cover any shortfalls." Again, parentheses are the Fed's.

They never even consider the possibility of taxpayers just saying NO!

"Even so, as the financial crisis demonstrated, improbable events can occur. So it's a useful exercise to think through what might happen if a government did fail, triggering a contagion that could spread to players ranging from banks to money market mutual funds."

What would that mean? According to the study: "Our preliminary analysis suggests that an isolated default is unlikely to trigger a systemic event, but it might cause a temporary contraction of credit as financial institutions reallocate their holdings and divest downgraded municipal debt. And we're still digging into what might happen if more than one default were to take place at the same time."

Gee, what are the odds of that happening with California and Illinois unable to pay bills and their governments paralyzed?

But states are the good news. Cities, counties and towns are the bad news, because financial "disclosures by municipalities or by other issuers, such as school and sewer districts, are provided inconsistently and with considerable lags."

That means we don't have a clue how big this catastrophe could be.

"A sudden, unanticipated municipal bond default could cause a sharp decline in investor confidence, potentially leading to a rapid selloff. If investors thought that defaults among multiple issuers were highly correlated, growing uncertainty could fuel a downward spiral of selling and investor losses."

Such "potential for systemic risk seems low ...," according to the study. Seems?

However, "While the conclusions of preliminary analysis do not suggest the risk of systemic threats, we remain vigilant in monitoring conditions that could shock the financial system or threaten the economy's footing on its path to recovery."

Fixing underfunded pensions now would be the best way to prevent - not forestall - calamity. But that is not so easy, as the third article, "Navigating the Legal Landscape for Public Pension Reform: Travel at Your Own Risk," states explicitly.

Pension "... reform-minded policymakers have to tread carefully, treating each state as a separate case. By no means is public pension reform out of the question, but legal precedent in a given state determines what reforms are realistic there."

One reality the Fed delicately tiptoes around is that public-employee union voter drives and campaign contributions coupled with general voter ignorance, apathy and low turnout can be impenetrable barriers to reform until it is too late.

Ultimately, "If you want to help public pension plans close their funding gaps by reducing benefits, the law will probably work against you." Except citizens get to change the law.

Bottom line: Rotten state and municipal finances hit by pensions "whose troubles with chronic underfunding predate the financial crisis" could threaten the economic recovery necessary to save states and municipalities from their rotten finances.

This could be a fiscal event horizon feeding on itself and sucking America into a black hole of eternal debt.

Of course, that is not what the calm, measured words of the Fed say because the Fed always screams softly.

Think not? For perspective, consider these words by Donald Kohn, then-Fed vice chairman, in a speech May 20, 2008, to the annual National Conference on Public Employee Retirement Systems, or NCPERS, the people who have been and still are assuring us they have everything under control, and there is no public pension crisis:

"Although the current financial and economic situation remains quite difficult, I believe that the most likely scenario over the next year or so is one in which economic activity firms during the second half of this year and then gathers some strength in 2009. ...

"The pace of activity should continue to improve next year, with an important part of the gains coming from the abatement of the forces currently restraining activity. That said, a number of factors suggest that the recovery could be relatively moderate."

Relatively moderate? How about a 49 percent plunge in the Dow over the next nine months and the worst recession since the Great Depression?

As for public pensions, Kohn said, "From what we have seen so far ... systems generally appear to have avoided the worst of the damage resulting from the recent tumult." They did not avoid it for long.

He pointed out that as of 2007 "Even by current measures of liability, which themselves may not be fully revealing, last year about three-fourths of public pension systems were underfunded, and about one-third were funded at less than 80 percent. ...

"The funding situation puts systems under a great deal of pressure to reach for higher returns by investing in riskier assets. ... The generally high weight on equity and real estate investments in the typical public pension fund portfolio has increased in recent years."

Since then, it's just gotten worse. What about those high return on investment assumptions politicians and pension fund managers use to assure us everything is OK?

Kohn told NCPERS, "While economists are famous for disagreeing with each other on virtually every other conceivable issue, when it comes to this one there is no professional disagreement: The only appropriate way to calculate the present value of a very-low-risk liability is to use a very-low-risk discount rate."

Doing otherwise "pushes the burden of financing today's pension benefits onto future taxpayers, who will be called upon to fund the true cost of existing pension promises."

But we do not even know how huge those costs are because "... public pension systems do not account for liabilities in a standardized way. As a result, public employees, taxpayers, municipal bond investors, credit rating agencies, and other market participants have a hard time comparing funding levels across systems and over time."

He concluded, "Public pension funds hold more than $3 trillion in assets and cover nearly 20 million workers and retirees."

Four years after that warning public pension fund assets are down about $500 billion and must cover nearly 24 million employees; current obligations increased more than $600 billion and return on investments fell more than $1.3 trillion short of what is needed to pay promised benefits. The accrued actuarial liability probably is more than $4 trillion.

This is what happens when the Fed screams softly and nobody listens.

State and local politicians must listen up this time and begin the painful work of cutting pensions before contributing to the next crash, or they not only will help cause it, they will make it worse.


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