Edward Harrison is the founder of the blog Credit Writedowns and is a finance specialist at Global Macro Advisors. Previously, Edward was a strategy and finance executive at Deutsche Bank, Bain, and Yahoo. He started his career as a diplomat and speaks German, Dutch, Swedish, Spanish and French. Edward holds an MBA from Columbia University and a BA in Economics from Dartmouth College.
About a week ago I wrote that the potential for a state and municipal fiscal and public sector pension crisis is a defining issue for the next downturn here in the US. Global strategy and research company 13D joins me in worrying about it.
Here’s what they write:
Fully-funded pensions are by their very design a mathematical impossibility —a topic we have discussed at length in these pages. In an effort to outrun their inevitable day of reckoning, these funds have assumed more risk, magnifying the likelihood of a massive unraveling. Most state pension funds now invest at least 40% to 50% of their assets in stocks. If you include private equity allocations, the overall exposure to equity investments is 70% to 80%. America’s largest public-pension fund, the California Public Employees’ Retirement Systems (CalPERs) allocates 50% of its AUM to the stock market. The state of Kentucky is now at 60%. (Historically, pension stock allocations have typically ranged from 25% to 35%.) That stance paid off during 2017’s market rally and public pensions enjoyed one of their best years of the past decade, earning an average return of 12.4%.
But what happens in the next tough, bear market in equities? We had a taste of what is possible last month, when CalPERs lost $18.5 billion in value, or 5% of total assets over a 10-day trading period. The fund has since gained much of that back, but the potential liability remains. Demographic realities mean this liability is deep and intractable. If state pension funds were unable to meet their benefit obligations after a 9-year bull market, how can they if there is a sustained downturn?
That’s exactly where I am on this on the finances.
My friend Scott told me to look at the union case Janus v. American Federation of State, County and Municipal Employees now in front of the US Supreme Court. That’s where the political side of this is going. The US Supreme Court case could deal a major blow to unions.
The plaintiff is Mark Janus. He is a state of Illinois employee who has sued his union to prevent it from collecting an “agency fee”. He doesn’t want to be in the union because he doesn’t like them.
Back in 1977, in Abood v. Detroit Board of Education, the Supreme Court said workers like Janus don’t have to pay union dues. Ostensibly, all public workers benefit from the unions irrespective of whether they are members or not. So, workers can become an “agency fee payer.” That means people like Janus pay one-third less than regular dues. But he is still paying. And since he doesn’t like unions and doesn’t want to pay, he has sued his union to not pay.
Given the Supreme Court’s composition, many believe it will decide in favor of Janus.
Now, agency fees cover all manner of things like collective bargaining. This makes unions a political force to reckon with. Getting rid of agency fees could lose public sector unions 20 to 30% of their funding. Losing funding would shift the political balance of power just in time for this underfunded pension issue to hit.
Moreover, in 2015, the Supreme Court ruled on another case that will have major implications for public sector unions and pensions. In M&G Polymers vs. Tackett, the court ruled that surviving spouses did not necessarily get all of the health and pension benefits of their deceased spouses. A collective-bargaining agreement had guaranteed retirees, surviving spouses and surviving dependents with full employer contribution toward the cost of health-care benefits “for the duration of [the] Agreement.” The court said there must be explicit proof that a collective-bargaining agreement bound a local government beyond the incumbency of the signatory public officials.
In a world of underfunded pension programs which cause a pension crisis, these two cases are significant. State and local governments will want to slough off the responsibilities of these pensions. These cases give them the political clout and more means to do so. Not only is the duration of binding contracts from collective bargaining limited, but union political clout will be as well.
My friend Scott says he had thought the solution would involve the states issuing bonds to fund the plans. Illinois has proposed issuing $100 billion to fund its plans. But, in a public sector funding crisis, that’s not viable – certainly not for Illinois.
Maybe the Fed will have to take this on. Back in 2010, I wrote that the ECB’s credit easing for Greece and Spain was analogous to the Fed’s buying California and Illinois muni bonds.
Later in 2010, Dartmouth Economist David Blanchflower suggested the Fed do exactly that – buy munis. That’s because the Fed can legally buy as many municipal bonds as it wants without congressional approval. Of course, the government can only buy short-term municipal bonds. But this would certainly help liquidity.
Look, many US public sector pension funds are underfunded. And the return expectations for these funds are too optimistic. This means we will see public sector pension funds become a huge drag on some local governments’ solvency when the next downturn hits.
I believe this will be a contentious political issue. And public sector employees will end up losers in the fallout as governments cut future benefits. More than that though, a public sector pension crisis could threaten the safety and security of the municipal bond market. And that would have grave financial stability implications, just as the mortgage market meltdown did.
P.S. – Also see Robert Pozens recent piece from Brookings. He says the new tax law means fighting over unfunded state pension plans is about to get worse.
P.P.S – I just saw this NY Times opinion 2012 piece arguing the Fed should buy munis, not mortgages. It’s worth reading now in the context of a municipal funding crisis.