New Actuarial Rules Will Force States to Admit Pension Problems

Editor’s Note:  This post by UnionWatch contributor Mike Shedlock covers familiar territory. Our parent organization, the California Public Policy Center, has published detailed analyses of the new GASB and Moody’s rules, including: “Moody’s Final Adopted Adjustments of Government Pension Data,” “How New Rules from Moody’s and GASB Affect the Financial Reporting of Pensions in Seven California Counties,” “How Lower Earnings Impact California’s Total Unfunded Pension Liability,” and “The Impact of Moody’s Proposed Changes on Government Pension Pension Data.” But in this post, Shedlock mentions one of the key reasons why pension fund return projections are overly optimistic. He writes, “Pension plans typically assume 7.5% returns. That’s  not going to happen on a sustained basis with 10-year treasuries yielding close to 2%. Yet, any significant rise in bond yields will crush existing bondholders as well as wreak havoc in equities.” This underscores a key consequence of the Fed’s policy to lower interest rates – a run that over the past 30 years has seen the 30 year T-bill go from 16.0% down to under 3.0%.  Every time the Fed lowered their rates, new bond issues and other fixed income securities lowered their coupon rates as well. This meant that all previously issued bonds, which had all been issued at higher rates of interest, became worth more. Basically, as long as interest rates kept dropping, the prices for bonds and all fixed income securities appreciated. To the extent these investments are a significant part of pension fund portfolios – and they are – they have delivered consistently high returns, especially over the past ten years. But interest rates can’t get any lower. There is nowhere left to go. Many pundits, including economists who ought to know better, claim that the dangers of debt accumulation are overstated. The inevitable end of the bull market in bonds, and how it will add yet another challenge to pension funds striving for that mythical 7.5% return per year, is a tangible refutation to anyone spewing sanguinity in the face of peak debt.

Many states, especially California and Illinois, have had severe pension underfunding problems for many years.

However, new actuarial pension rules will finally force states to admit the problem. Thus, it should not be surprising that talk of “technical bankruptcy” and “service insolvency” is growing.

Here are some pertinent ideas from California on the Brink: Pension Crisis About to Get Worse

• Moody’s new credit standards for public pensions would nearly double the unfunded liabilities for state and local pension plans in California to $328.6 billion from $128.3 billion.
• California has the second lowest credit rating at Standard & Poor’s of all 50 states; Illinois now has the worst. Moody’s new standards would drop the funded status of these plans to 64%, versus a previous estimate of 82%, the Center said.
• “By standard accounting methods, some state pension funds will run out of assets within as little as five years”
• New rules will lower expected rates of returns on their pension assets, instead of the often overstated returns they now use to paper over holes in their plans blown out by bad investments.
• Meredith Whitney says California is papering over budget holes with gimmicks, like raising taxes retroactively, pushing state expenses onto local towns and cities that can’t afford them, and underfunding their pension funds. “It’s so much worse than the rosy picture that the headlines suggest,” the CEO of Meredith Whitney Advisory group says.
• The Senate Joint Economic Committee reiterates what Whitney says. “Many states and localities have regularly skipped or underfunded contributions to pension plans,” the report said. “Over the past five years, state and local governments have underpaid actuarially required pension contributions by more than $50 billion. The worst culprit of all, Illinois, has underpaid its pension contributions to the tune of $28 billion over the past 15 years.”
• Illinois’ plan is just 44% funded, or 30% using “conventional accounting standards,” the Senate committee says. Los Angeles’ combined plans would fall from 77% funded to 50% funded.
• San Jose’s combined plans would fall from 75% to 60% funded.
• San Francisco’s combined plans would fall from 88% funded to 69% funded.

Trouble Will Escalate

Many California cities are in serious trouble, and that trouble will grow by leaps and bounds as soon as there is a significant stock market correction.

Pension plans typically assume 7.5% returns. That’s  not going to happen on a sustained basis with 10-year treasuries yielding close to 2%. Yet, any significant rise in bond yields will crush existing bondholders as well as wreak havoc in equities.

Moody’s wants states to assume 5.5% returns, but even that is far too high. The stock and bond markets are now so bloated thanks to Fed bubble-blowing policies that 0-2% returns for a full decade is a distinct possibility. And not a single pension plan in the US is remotely prepared for such an event.

About the Author:  Mike Shedlock is the editor of the top-rated global economics blog Mish’s Global Economic Trend Analysis, offering insightful commentary every day of the week. He is also a contributing “professor” on Minyanville, a community site focused on economic and financial education. Every Thursday he does a podcast on HoweStreet and on an ad hoc basis he contributes to many other websites, including UnionWatch.