“Pension-change advocates failed to find funding for a measure during the depths of the 2008 recession and the havoc it wreaked on government budgets, so they won’t pass (a measure) when the economy is doing well.”
– Steve Maviglio, political consultant and union coalition spokesperson, Sacramento Bee, January 18, 2016
It’s hard to argue with Mr. Maviglio’s logic. If the economy is healthy and the stock market is roaring, fixing the long-term financial challenges facing California’s state/local government employee pensions systems will not be a top political priority. But that doesn’t mean those challenges have gone away.
One of the biggest problems pension reformers face is communicating just how serious the problem is getting, and one of the biggest reasons for that is the lack of good financial information about California’s government worker pension systems.
The California State Controller used to release a “Public Retirement Systems Annual Report,” that consolidated all of California’s 80 independent state and local public employee pension systems into one set of financials, but they discontinued the practice in 2013. The most recent one issued, released in May, 2013, was itself almost two years behind with financial data – using FYE 6-30-2011 financial statements, and it was almost three years behind with actuarial data – used to report funding ratios – using FYE 6-30-2010 actuarial analysis. Now the state controller has created a “By the Numbers” website, but it’s hard to use and does not provide summaries.
No wonder it’s so easy to assert that nothing is wrong with California’s pension systems!
The best source of raw data on California’s pensions comes from the U.S. Census Bureau. Since that data is better than nothing, here are some critical areas where roughly accurate numbers can be reported.
(1) The Cash Flow, Money In vs. Money Out
What is the net cash flow of these pensions funds? How much are they collecting in contributions and how much are they distributing in pension benefits? This information, especially if it can be compiled over a period of years, determines whether or not pension funds are net buyers or sellers in the markets. The reason this matters is because if America’s pension funds, with over $4.0 trillion in assets, are net sellers, they put downward pressure on stock prices. They’re that big.
California State/Local Pension Funds Consolidated
2014 – Cash Flow
This cash flow (above) shows that during 2014, California’s state/local pension funds, combined, collected 30.1 billion from state and local agencies, and paid out $46.1 billion to pensioners. They are paying out 50% more than they’re taking in, and this is a relatively recent phenomenon. Historically, pension funds have been net buyers in the market. Now, pension funds across the U.S., along with retiring baby boomers, are sellers in the market. This is one reason it is difficult to be optimistic about securing a 7.5% average annual return in the future, despite historical results. And as for that healthy 15.4% return on investments in 2014? That was offset in 2015, when the markets were flat. It is also noteworthy that employee contributions of $8.9 billion are greatly exceeded by the $21.2 billion in employer (taxpayer) contributions. How many 401K recipients get a 2.5 to 1.0 matching from their employer?
(2) The Asset Distribution and Portfolio Risk
What is the asset distribution of these pension funds? How much have they invested in relatively risk free, fixed income bonds, vs. their investments in stocks and other variable return assets?
California State/Local Pension Funds Consolidated
2014 – Asset Distribution
This asset distribution table (above) indicates that the ratio of riskier, variable return investments to fixed return investments is nearly four-to-one. What if stocks fail to appreciate for a few years? What if real estate values don’t continue to soar? What if there simply aren’t enough high-yield investments out there to allow these assets, valued at a staggering $751 billion in 2014, to throw off a 7.5% annual return? This is a precarious situation. If these projected 7.5% returns were truly “risk free,” the ratios on this table would be reversed, with most of the money in fixed return investments.
(3) The Unfunded Liability and the “Catch-up” Payments
What is the amount of the unfunded liability for these pension funds? And of the total amount collected and invested each year in these funds, how much is the “unfunded contribution” – the amount allocated to pay down the unfunded liability and eventually restore the systems to 100% funding – and how much is the “normal contribution” – the amount required to fund future pension benefits just earned in that particular year by active workers?
This question, for which neither the State Controller, nor the U.S. Census Bureau, can provide timely and accurate answers, is the most complex and also the most important. While consolidated data is not readily obtainable for these variables, by assuming these pension systems, in aggregate, are officially recognized as 75% funded, we can compile useful data:
California State/Local Pension Funds Consolidated
2014 – Est. Required Unfunded Contribution
The above table estimates that at a 75% funded ratio, at the end of 2014 the total pension fund liabilities for all of California’s state and local government pension funds was just over $1.0 trillion, with unfunded liabilities at $250 billion. The middle portion of the table shows, using conventional formulas adopted by Moody’s investor services for analyzing public pensions, that if the annual rate-of-return projection is lowered to a slightly more realistic 6.5% (already being phased in by CalPERS), the unfunded liability jumps to $380.1 billion, and the funded ratio drops to 66%. For a detailed discussion of these formulas, refer to the California Policy Center study “A Method to Estimate the Pension Contribution and Pension Liability for Your City or County.”
The lower portion of the table spells out just how deep a hole California’s state and local public employee pension systems have dug for themselves. Using standard amortization formulas, and a quite lengthy 30 year payback term, at a 6.5% rate-of-return assumption, it would take a payment of $29.1 billion per year to return California’s pension funds to 100% funded status by 2046. Since the total payments into California’s pension funds – refer back to table 1 – were only 30.1 billion in 2014, it is pertinent to wonder just how much the normal contribution was, in aggregate, in 2014, vs. the unfunded contribution.
One promising pension transparency project is being directed by professors Joshua Rauh and Joe Nation via Stanford University’s Institute for Economic Policy Research. Their “Pension Tracker” website has already compiled an impressive body of data, especially useful at the local level. Hopefully they, or someone, will get eventually compile and present accurate data, both locally and statewide, not only showing cash flows, but differentiating between the normal contributions and the unfunded contributions.
In the absence of data, here’s a rough guess: Approximately 1.5 million active state and local government workers in California probably earned pension eligible income of at least $100 billion in 2014. If the “normal contribution” is 16% of payroll, that equates to $16 billion per year. This is a very conservative estimate.
Mr. Maviglio, and all of his colleagues who wish, like many of us, to save the defined benefit pension, are invited to explain how California’s pension systems will ever become healthy, if, best case, their required unfunded contribution is $29.1 billion per year, their required normal contribution is $16 billion per year, and the total payments actually being made per year are only $30.1 billion. That’s a shortfall of $15 billion per year.
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“Alright, but apart from the sanitation, the medicine, education, wine, public order, irrigation, roads, the fresh water system and public health, what have the Romans ever done for us?”
– John Cleese, Monty Python’s Life of Brian, 1979
Any discussion of California’s neglected infrastructure has to recognize the three factors most responsible, libertarians, environmentalists, and government unions. Picking libertarians as the first example is not by accident, because libertarians are perhaps the most unwitting participants in the squelching of public infrastructure investment. By resisting government involvement in any massive public works project, libertarians provide cover to public sector unions who know that public works funding competes for tax revenues with their own pay and benefits.
When it comes to squelching public infrastructure investment, however, nobody can compete with California’s environmentalist lobby. Their lawsuits have stalled infrastructure development for decades. And the identity of interests between government unions and environmentalists is multi-faceted. The most obvious is that when there is no money for infrastructure there is more money for government worker pay and benefits. And of course, the more environmentalist regulations are passed, the more need to hire more unionized government workers.
Then there are the unintended and largely unnoticed financial consequences of environmentalism abetting the government union agenda. As California’s carbon emission auction collections slowly grow into billions per year, government jobs are redefined to incorporate “climate change mitigation.” Code inspectors and planning dept. personnel become climate change enforcers ala revised building codes and zoning laws. Bus drivers become mass transit workers mitigating climate change. Firefighters combat lengthier fire seasons, and even police are called into action because hotter weather is correlated to higher crime rates. And as they work to mitigate the impact of climate change, all of them quietly qualify for a share of the carbon emission auction proceeds.
The unintended economic consequences of environmentalism abetting the government union agenda are among the hardest to explain. Of course environmentalism can slow down economic growth. At some reasonable level – which we’re well beyond – that’s even desirable. But the environmentalist squelching of public infrastructure development, along with competitive private sector development of land, energy and water resources, has created artificial scarcity. In turn, this drives up asset values which helps government pension funds two ways (1) directly through appreciation of their invested assets, and (2) indirectly, by creating new real estate collateral for consumer borrowing which stimulates consumer spending which creates corporate profits and stock appreciation. In short, the economic consequences of artificial scarcity are asset bubbles that, for a time, keep unionized government worker pension funds solvent. When you can’t afford to own a modest home, or run an energy intensive business, remember this.
What libertarians and environmentalists both need to understand is that massive public works are one of the prerequisites for broadly distributed prosperity. And the environmentalist bias against massive civil engineering projects is two-faced. For example, managing delta salinity, the flow of the San Joaquin River, and the very existence of one of the largest refuges for waterfowl in the American southwest, the Salton Sea, are all dependent on dams, aqueducts and irrigation. But no more?
If you search for interest groups that favor massive civil engineering projects, you’ll look far and wide and find nothing of significance. Private sector unions ought to be leading the charge, but in recognition of the power of environmentalists and government unions, they settle for politically correct projects of marginal productive value – high speed rail, delta tunnels, and the occasional stadium. The Silicon Valley lobby is even worse – rather than support abundance through innovation, they embrace conservation through surveillance. If Californians recovered an additional 10 million acre feet per year of fresh water through civil engineering projects such as desalination, dam storage, and sewage reuse, there would be no need to embed internet devices into “smart” (and mandatory) side loading washers, low flow toilets, water meters, dish washers, and irrigation systems.
The biggest challenge ideologically however confronts libertarians. Because in the real world, we need to build civil infrastructure within a financial and legal framework that relies to some significant degree on government. If libertarians can reconcile their ideals with the needs of Californians, they might rally private sector union leadership, practical environmentalists, and altruistic members of the public sector. Massive infrastructure development in California on all fronts is long overdue. The revenue producing elements of this infrastructure could be financed through the pension funds – only consuming a fraction of their assets – and give truth to their currently preposterous assertion that they’re helping our economy.
Imagine if California’s government, with help from private and federal sources, was truly committed to creating abundance again through massive civil engineering projects across all areas of critical infrastructure. Can libertarians find a formula that would enable them to urgently support this without violating their core ideals? Can they support development while also being the watchdog against corruption? It could make all the difference in the world.
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Ed Ring is the executive director of the California Policy Center.
Weakening pensions is a choice, not an imperative. The crisis is political, not actuarial.
– Susan Greenbaum, guest editorial, Al Jazeera America, October 20, 2014
With this thesis highlighted, Greenbaum, a retired professor of anthropology at the University of South Florida, has just published a guest editorial that provides in one place a useful example of the distortions, demonizing and inversions of logic used by those who fight against pension reform. To understand why public employees, and their union leadership, remain sincere in their delusions regarding pensions, Greenbaum’s missive may serve as Exhibit A. Because she has joined a chorus that is funded not only by the billions that are spent by public employee unions on political and educational propaganda each year, but also funded by elements of those same Wall Street financial interests they routinely deride.
Let’s examine some of these misleading arguments and tactics, in no particular order:
(1) Identify key reformers, demonize them, then accuse anyone who advocates reform of being their puppets. Greenbaum identifies a lot of “demons,” i.e., opponents, who have been the victims of character assassination for years: John Arnold, a “hedge fund billionaire,” Charles and David Koch, the “conservative billionaire brothers,” and, of course “Wall Street [whose] shenanigans, not sound financial knowledge, posed the real threat to the solvency of these funds.” The fallacy here, notwithstanding the vicious and unfounded attacks that have tainted these individuals, is that whether or not pensions are financially sustainable or equitable to taxpayers has nothing to do with who some of the reformers are. And what about liberal democrats who advocate pension reform, such as San Jose mayor Chuck Reed, Chicago mayor Rahm Emanuel, former Rhode Island treasurer and gubernatorial candidate Gina Raimondo, and countless others? Are they all merely puppets? Absurd.
(2) Assume if someone advocates pension reform, they must also want to dismantle Social Security. While there are plenty of pension reformers who have a libertarian aversion to “entitlements” such as Social Security, it is wrong to suggest all reformers feel that way. Social Security is financially sustainable because it has built in mechanisms to maintain solvency – benefits can be adjusted downwards, contributions can be adjusted upwards, the ceiling can be raised, the age of eligibility can be increased, and additional means testing can be imposed. If pensions were adjustable in this manner, so public sector workers might live according to the same rules that private sector workers do, there would not be a financial crisis facing pensions. There is no inherent connection between wanting to reform public sector pensions and wanting to eliminate Social Security. It is a red herring.
(3) “Public sector pension plans would be financially healthy if they had not been invested in risky derivatives, especially mortgages.” This is a clever inversion of logic. Because if pension funds had not been riding the economic bubble, making risky investments, heedless of historical norms, then public employee unions would never have been mislead by these fund managers to demand and get unsustainable enhancements – usually granted retroactively – to their pension benefit formulas. The precarious solvency of pension funds today is entirely dependent on asset bubbles. Most of these funds still have significant positions in private equity investments, which are opaque and highly volatile, and despite recent moves by some major pension funds to vacate hedge fund investments, they still comprise significant portions of pension fund portfolios. What Greenbaum either doesn’t understand or willfully ignores is a crucial fact: if pension funds did not make risky investments, they would have to bring their rate-of-return projections down to earth, and their supposed solvency would vaporize overnight.
(4) “Weakening pensions is a choice, not an imperative. The crisis is political, not actuarial.” This really depends on how you define “weakening.” If you weaken the benefits, you strengthen the solvency. The fundamental contradiction in Greenbaum’s logic is simple: If you don’t want pension funds to be entities whose actions are just like those firms located on the proverbial, parasitic “Wall Street,” then they have to make conservative, low risk investments. But if you make low risk investments, you blow up the funds unless you also “weaken” the benefit formulas.
To drive this point home with irrefutable calculations, refer to a recent California Policy Center study “Estimating America’s Total Unfunded State and Local Government Pension Liability,” where the impact of making lower risk investments that yield lower rates of return is calculated. If, for example, state and local public employee pension funds in the United States were to lower their rate-of-return to a decidedly non-“Wall Street,” low-risk rate of return of 4.33% (the July 2014 Citibank Pension Liability Index Rate), and invest their $3.6 trillion in assets accordingly, their aggregate unfunded liability would triple from today’s estimated $1.26 trillion to $3.79 trillion. The required annual contribution (normal plus unfunded) would rise from today’s $186 billion to $586 billion. The alternative? Lower benefits.
Those who fight against pension reform willfully ignore additional key points. They continue to claim public sector pension benefits average only around $25,000 per year, ignoring the fact that pension benefits for people who spent 30 years or more earning a pension, i.e., full career retirees, currently earn pensions that average well over $60,000 per year. Public safety unions still spread the falsehood that their retirees die prematurely, when, for example, CalPERS own actuarial data proves that even firefighters retire today with a life-expectancy virtually identical to the general population.
Propagandists who oppose urgently needed reform should recognize that pension reform is bipartisan, it is a financial imperative, and it is a moral imperative. They need to recognize that the sooner defined benefits are adjusted downwards, the less severe these adjustments are going to be. They need to understand that for many reformers, converting everyone to individual 401K plans is a last resort being forced on them by political, legal and financial realities, not an ulterior motive. They need to stop demonizing their opponents, and they need to stop stereotyping every critic of pensions as people who want to destroy retirement security, including Social Security, for ordinary Americans. And if they wish to defend Social Security, then they should also be willing to apply to pension formulas the tools built into Social Security – including its progressive formulas whereby highly compensated workers receive proportionally less in retirement than low income workers. Ideally, they should support requiring all public workers to participate in Social Security, so that all Americans earn – at least to the extent it is taxpayer funded – retirement entitlements according to the same set of formulas and incentives.
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Summary: The total state and local government pensions in the United States at the end of 2013 had an estimated $3.6 trillion in assets. They were 74% funded, with liabilities totaling an estimated $4.86 trillion, and an unfunded liability of $1.26 trillion. These funds, in aggregate, project annual returns of 7.75%. If you apply a 6.2% average annual return to recalculate the liability, using formulas provided by Moody’s Investor Services, the liability increases to $5.87 trillion and the unfunded liability increases to $2.27 trillion. Using the 4.33% discount rate recommended by Moody’s for valuing pension liabilities, the Citibank Pension Liability Index for July 2014, increases the estimated liability to $7.39 trillion and the unfunded liability to $3.79 trillion. That is, if America’s state and local pension funds were to no longer make aggressive market investments but were to return to relatively risk free investments, the payment required just to return these funds to solvency would be more than $12,000 per American.
This study concludes with four recommendations to ensure the ongoing solvency of public sector pensions. Based on the principals governing Social Security benefits, they are (1) Increase employee contributions, (2) Lower benefit formulas, (3) Increase the age of eligibility, (4) Calculate the benefit based on lifetime average earnings instead of the final few years, and (5) Structure progressive formulas so the more participants make, the lower their actual return on investment is in the form of a pension benefit. Finally, the study recommends all active public employees immediately be enrolled in Social Security, which would not only improve the financial health of the Social Security System, but would begin to realign public and private workers so they share the same sets of incentives and formulas when earning government administered retirement benefits.
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Introduction and Methodology:
This study relies on the most recent data compiled by the U.S. Census Bureau, combined with recent analysis performed by Wilshire Associates, an investment advisory firm, to estimate America’s total state and local government pension fund assets, liabilities, earnings, contributions and payments to retirees. This study then applies formulas provided by Moody’s Investor Services to estimate how much the unfunded liability deviates from the Census Bureau’s estimate, based on using lower rate of return projections. This study is limited to state and local government pension funds and does not include analysis of the federal retirement pension systems. In most cases, instead of footnotes, citations and links to sources are included within the text. This report concludes with some recommendations intended to stimulate discussion and debate.
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Total Assets – All U.S. State and Local Government Pension Systems:
The most recent compilation of total assets, contributions and payments for America’s state and local government pension funds is the “Summary of the Quarterly Survey of Public Pensions for 2014: Q1,” released on June 26, 2014 by the U.S. Census Bureau. It provides data for the quarter ended March 31, 2014.
In the introduction, the report states “total holdings and investments of major public pension systems increased to over $3.2 trillion, reaching the highest level since the survey began in 1968.” In the footnotes, the report provides clarification that they are only referring to state and local pension systems. They also estimate these “major public pension systems” to only represent 89.4% of all state/local pension system assets, which allows the means to reasonably extrapolate an estimate representing 100% of the total state/local pension system assets, contributions, and payments. They write:
“This summary is based on the Quarterly Survey of Public Pensions, which consists of a panel of the 100 largest state and local government pension systems, as determined by their total cash and security holdings reported in the 2007 Census of Governments. These 100 systems comprised 89.4% of financial activity among such entities, based on the 2007 Census of Governments.”
In table 1, below, the total pension assets are determined by taking the Census Bureau’s reported $3.218 trillion representing the 100 largest state/local pension funds, and dividing by 89.4%, yielding an estimated total assets for all state/local pension systems in the United States of $3.6 trillion.
Similarly, in table 1, using Census Bureau data, the most recent reported quarterly total employer and employee contributions for the 100 largest state/local pension funds are multiplied by four, with the product then divided by 89.4%. The resulting estimates are that during the 12 month period through March 31, 2014, $163.8 billion was contributed into these funds by employers and employees, and $251.6 billion was paid out to state and local government retirees. Presumably the cash flow deficit, $87.8 billion, was covered by investment returns.
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Official Funding Status – All U.S. State and Local Government Pension Systems:
At face value, it would appear that the funding status of these pension systems is quite healthy, since the deficit implied by payments to retirees exceeding contributions by employers and employees, $87.8 billion, represents only 2.4% of the estimated $3.6 trillion in assets. It isn’t nearly so simple, however.
The funding status of a pension system is determined by comparing the value of the invested assets to the present value of the estimated future payments to retirees. These future payments include estimates for people who have not yet retired. Since most state and local government employee participants in their pension systems are still working, the fact that current investment returns easily cover the deficit between contributions and payments to retirees is irrelevant. For a pension system to be 100% funded, payments into the fund, combined with investment returns earned by the fund, need to ensure that the total assets invested by the fund are equal to the present value of the liability. More on this later.
Wilshire Associates, a global investment advisory firm, performs in-depth analysis of America’s public employee pension systems through research papers that are updated annually. Their most recent reports are a “2014 Report on State Retirement Systems,” which primarily discusses data for the fiscal year ended 6-30-2013, and a “2013 Report on City and County Retirement Systems,” which primarily discusses data for the fiscal year ended 6-30-2012. Taking into account the improvement in the investment markets between June 2012 and June 2013, the weighted average funding ratio of the state and city/county pension systems combined, in accordance with the estimates provided by Wilshire Associates, at the end of June 2013 was 74%.
As previously discussed, the estimated total assets for all state/local pension systems in the United States is $3.6 trillion. Assuming that $3.6 trillion in assets represents 74% of the total pension liability carried by these same pension systems, then the estimated total liabilities for all state/local pension systems in the United States is $4.86 trillion. This means the total unfunded liability for these systems is estimated to be $1.26 trillion.
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Funding Status Scenarios – All U.S. State and Local Government Pension Systems:
As part of their analysis of America’s state/local pension systems, Wilshire Associates compiles a “median actuarial interest rate assumption,” representing both the average annual rate of return these systems expect to earn over the next 20-30 years, as well as the discount rate they use to derive a present value for the estimated stream of payments they expect to make to current and future retirees. For both state and local systems, in their “Summary of Findings” in both of their reports, Wilshire Associates estimates this median interest rate assumption to be 7.75%.
As alluded to earlier, to be 100% funded, a pension plan must have invested assets equal to the present value of all future pension payments. For every participating employee, whether they are active or retired, actuaries estimate their salary growth, their year of retirement, their initial pension, their subsequent pension payouts based on COLAs, and their life expectancy. The present value of all these future payments is how much a fully funded pension plan’s assets must be worth.
The rate at which these future payments are discounted per year must be equivalent to whatever rate the pension fund managers believe they will earn interest, on average, over the life of the fund. The theory is that if no future work were performed, and therefore no additional future pension benefits were earned and no additional money was contributed to the fund, the assets currently invested in a fully funded plan would earn enough interest to support every future pension payment until the last participant died of old age.
Since the amount of assets in a pension plan is a known, objective quantity, the debate over how much unfunded liability a plan may have centers on what assumptions are used to estimate the present value of the future payments, i.e., the “Actuarial accrued liability (AAL),” which, as discussed and noted on table 2, is estimated as of 6-30-2013 at $4.86 trillion. In order to assess whether or not that amount is overstated or understated, we can use a short-cut formulated by Moody’s Investor Services in their July 2012 proposal, “Moody’s Adjustments to US State and Local Government Reported Pension Data.”
In order to revalue a pension fund’s liabilities without having access to every actuarial calculation from every fund, what Moody’s does is estimate the midpoint of the future payments stream. They select 13 years into the future, which is quite conservative. Using a longer duration than 13 years will greatly increase the sensitivity of the liability to changes in the projected rate-of-return. As discussed in their July 2012 proposal, here is their rationale:
“To implement the discount rate adjustment, we propose using a common 13-year duration estimate for all plans. This is a measure of the time-weighted average life of benefit payments. Each plan’s reported actuarial accrued liability (“AAL”) is projected forward for 13 years at the plan’s reported discount rate, and then discounted back at 5.5%. This calculation results in an increase in AAL of roughly 13% for each one percentage point difference between 5.5% and the plan’s discount rate. For example, a plan with a $10 billion reported AAL based on a discount rate of 8% would have an adjusted AAL of $13.56 billion, or 35.6% greater than reported.
We recognize this duration estimate may be higher than warranted for some plans and lower than warranted for others. Each pension plan has a unique benefit structure and demographic profile that affects the time-weighted profile (duration) of future benefit payment liabilities. However, plan durations are not reported, and calculating duration individually for each plan is not feasible. Our proposed 13-year duration is the median calculated from a sample of pension plans whose durations ranged from about 10 to 17 years. Plans with shorter durations usually are closed or have a preponderance of older or retired members.”
Here is the formula that governs this recalculation of the present value of the liability (“PV”):
Adj PV = [ PV x ( 1 + official %i ) ^ years ] / ( 1 + adjusted %i ) ^ years
As made explicit in the above formula, along with duration (years), the other key variable in order to use Moody’s formula to evaluate funding status scenarios, of course, is the “%i,” the discount rate, which is also the rate of return projection. It is worth noting that the discount rate and the rate of return projection don’t have to be the same number. In private sector pension plans, the discount rate is required to differ from the rate of return projection. Private sector pension plans are required to use a lower, more conservative discount rate in order to calculate the present value of their future liabilities in order to avoid understating the present value of the liability. Public sector pension plans have not yet been subjected to this reform regulation, and the rate used to project interest is invariably the same as the rate used to discount future liabilities. This puts enormous pressure on these funds to adopt an aggressively high rate of return projection.
Here are explanations for the various alternative rate of return projections applied in Table 3.
Case 1, 6.2% – here is the rationale for this rate-of-return, excerpted from the report “Pension Math: How California’s Retirement Spending is Squeezing The State Budget” authored by Joe Nation, a Ph.D., Stanford Institute for Economic Policy Research, and former California Democratic assemblyman: “This 6.0 to 6.5 percent figure is based on the performance of a hypothetical fund containing 80 percent equity and 20 percent income instruments between 1900 and 1999. It assumes an equity rate based on the 20th-century Dow Jones industrial annual average of 5.3 percent, plus 2 percent in dividends, less 0.5 percent in fees. Combined with income instruments with a net rate of return of 4.5 percent, this hypothetical fund would have earned an average annual rate of 6.2 percent.”
Case 2, 4.33% – the rationale for this rate-of-return comes from Moody’s Investor Services “Moody’s Revised New Approach to Adjusting Reported State and Local Government Pension Data,” released in April 2013: “For adjustments to pension data, Moody’s will use the Citibank Pension Liability Index (Index) posted on the date of the valuation instead of its original proposal to apply a single rate for all plans each year.” Citigroup Pension Discount rate as posted by the Society of Actuaries in July 2014 was 4.33%.
Table 3, below, shows how much the unfunded liability for all of America’s state/local pension systems will increase based on various alternative rate-of-return projections, all of which are lower than the official composite rate of 7.75% currently used by America’s state/local pension funds. As can be seen, if a rate of 6.20% is used, reflecting the historical performance of U.S. equities, the total liability for America’s state/local pension systems rises from $4.86 trillion to $5.87 trillion; the unfunded liability rises from $1.26 trillion to $2.27 trillion; the funding status declines from 74% to 61%.
If the relatively risk-free rate of 4.33% is used, reflecting Moody’s recommendation to adhere to the Citibank pension liability index rate, the total liability for America’s state/local pension systems rises from $4.86 trillion to $7.39 trillion; the unfunded liability rises from $1.26 trillion to $3.79 trillion; the funding status declines from 74% to 49%.
Please note the above table can be downloaded here . It is a useful tool for quickly estimating how much the unfunded liability may increase for any pension fund if the projected rate of return is lowered from the official rate. In this table, and on the spreadsheet, the yellow highlighted cells represent assumptions, and require input from the user. The green highlighted cells depict key results from the calculations.
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Observations and Recommendations
The data gathered for this study, combined with reasonable assumptions, allows one to estimate the pension fund assets for the total state and local government pension systems, combined, to equal $3.6 trillion, with an attendant liability of $4.86 trillion. In turn this means the total unfunded liability for these pension systems is estimated at $1.26 trillion. Using formulas provided by Moody’s investor services, one may apply lower rate-of-return assumptions to the official total liability estimate, and calculate how much the liability – and unfunded liability – will increase based on lower projected returns. While none of these various estimates can be considered precise and indisputable, the credibility of the source data and formulas strongly suggest they are reasonably accurate.
Not beyond serious debate, however, are financial questions and policy issues relating to pensions that are of critical importance to the solvency of America’s state and local governments. For example, even if the 74% funded ratio is accurate, it is a best case scenario that still raises troubling questions. Because the $183 billion in reported annual contributions must include not only the “normal contribution,” representing the present value of future pensions earned by workers in the most recent fiscal year, but also the “unfunded contribution,” the catch-up payment designed to pay down the unfunded liability. Even if the total unfunded liability for all of America’s state/local government pension systems is only $1.26 trillion, to eliminate the underfunding over 20 years at 7.75% interest would require annual payments of $126 billion per year. That would leave only $63 billion to cover the normal payment.
Although consolidated contribution data that breaks out the normal and unfunded contributions separately is not readily available for America’s state/local government pension systems, it is possible to impute the normal contribution – an exercise that leaves wide latitude for interpretation. Nonetheless, in a 2013 study, “A Method to Estimate the Pension Contribution and Pension Liability for Your City or County,” the California Policy Center did just that. The worksheet showing the assumptions and formulas can be downloaded here, ref. the tab “normal contribution (imputed).” As it is, assuming 16 million full-time equivalent active state/local government workers, accruing pension benefits at an aggregate rate of 2.0% of final payroll per year worked – keeping the rate-of-return assumption at 20 years, the imputed normal contribution is $120 billion per year.  By this logic, the total contribution of $183 billion is inadequate. The normal contribution of $120 billion plus the unfunded contribution of $126 billion suggests an adequate contribution should be $246 billion per year.
To summarize the immediately preceding paragraphs, if one continues to assume these funds will earn 7.75% per year, annual contributions were $67 billion short of the $246 billion total necessary to pay not only the normal contribution, but enough of a catch-up “unfunded contribution” to restore 100% funded status within 20 years. Aspiring to at least do this much is crucial, because the 7.75% rate-of-return projection may not be achieved. As already shown, the amount of a pension system’s liability is highly sensitive to the assumed rate of return. So are the normal and unfunded contributions. Here is the impact of lower rates of return on those payment estimates:
On Table 3, above, the impact of a 6.2% rate-of-return projection is shown to increase the unfunded liability from $1.26 trillion to $2.27 trillion, and lower the funded ratio from 74% to 61%. Using the tools and assumptions summarized in the preceding paragraphs, the impact of a 6.2% rate of return – representing the historical performance of U.S. equities over the past 60 years – on the unfunded contribution is to increase it from $126 billion to $201 billion; the normal contribution increases from $120 billion to $176 billion. Put another way, if realistic repayment terms are adopted for the unfunded liability, at a rate-of-return of 6.2% the total required contribution for America’s state/local government pension systems could rise from the current $183 billion to $377 billion.
Similarly, at a hopefully risk-free rate-of-return of 4.33% (the July 2014 Citibank Pension Liability Index Rate recommended by Moody’s), the normal contribution estimate rises to $281 billion and the unfunded contribution estimate rises to $287 billion – a total of $586 billion vs. $183 billion being actually contributed today.
These figures are not outlandishly inflated. They merely indicate how extraordinarily sensitive pension fund solvency is to rate-of-return projections, and how perilously dependent pension funds are on investment returns.
This, again, brings up the most salient question of all: What rate of return is truly achievable over the next 2-3 decades?
To at least recap this economic debate is necessary because this one assumption is central to policy decisions of extraordinary significance. If the optimists are right, rates-of-return will rise into the high single-digits and stay there, rendering pensions financially sustainable. The states and locales who offer them can therefore keep their contributions flat and allow a few more good years in the market to wipe out their unfunded liabilities. If the pessimists are correct, rates-of-return are going to shrink into the low single digits and stay there, making aggressive paydowns of a swollen unfunded liability a mandatory proposition. Required contributions will rise to untenable levels, crowding out other government services, causing taxpayer revolts, union lawsuits, and a string of bankruptcies.
The case for pessimism – or realism – is strong. Economic growth over the past 30 years has been fueled by debt accumulation; economic growth creates profits, profits create stock appreciation. Debt accumulation stimulates consumption, low interest rates stimulate purchases of real estate and durable goods, driving prices up. Debt accumulation and easy credit causes an asset bubble, and asset bubbles create collateral for additional debt. Total market debt in the U.S. is now higher than it was in 1929, immediately before the great depression. We are at the point now where there is no precedent in economic history that enables us to assume we can continue to use debt to stimulate economic growth.
The other economic headwind facing investments is the aging population. In 1980, 11% of the U.S. population was over 65. By 2030, over 22% of the U.S. population will be over 65. This means that compared to 1980, when America’s current era of of debt accumulation began, by 2030 there will be twice as many people, as a percentage of the U.S. population, selling assets to finance their retirements. The impact of so many sellers in the markets, combined with interest rates having now fallen to near zero – meaning a primary method to stimulate debt formation has been exhausted – will at the very least take the growth out of asset bubbles, if not cause their collapse. The state/local pension funds, based on current data as presented here, are already net sellers in the markets. All of this augers poorly for returns-on-investment. And while, as noted in the next paragraph, America’s economy remains extraordinarily resilient, especially compared to the rest of the world, a collapse of collateral values would trigger a global financial meltdown, and that would take America down with it.
The case for optimism is not unfounded. To stave off recession, or worse, the U.S. has pursued a policy in recent years of injecting trillions of dollars of new money into the system through massive Federal Reserve Bank intervention. But the only way this impetuous gambit can backfire is via a global loss of confidence in the U.S. currency. Despite wails of panic from predictable quarters, that isn’t likely, since every other central bank in the world is playing the same game, with less success. The largest currency group apart from the U.S. dollar is the Euro, and the Eurozone, unlike the U.S., faces a demographic crisis that is genuinely alarming, and their debt burden combined with their level of structural entitlements is much worse than in the U.S. China’s economy is far more dependent on trade, they face a demographic crisis similar to Europe’s, their society is the most likely among the major economies to experience social upheaval in the future, their real estate bubble is worse than in the U.S., and despite the opacity of their banking system, their debt burden is quite likely more severe than in the U.S. Japan is still reeling from a generation of deflation and crippling debt. No other currencies are supported by economies that are big enough to matter. Especially since the energy boom began in the U.S., no other country has anywhere near America’s capacity to domestically source raw materials and manufactured goods for export. The U.S. is basically daring the world to depreciate the dollar, because currency depreciation might actually help the U.S. economy more than it would hurt.
And so the debate over realistic rates of return rages on.
There is another question, however, which considers not the economic issues, but the issue of equity and fairness. A recently published book “Capital in the Twenty-First Century,” by Thomas Piketty, has become a favorite among leftist intellectuals who provide thought leadership for, among others, the public sector unions who control most public sector pension fund boards and who advocate tenaciously for keeping pension benefits as they are. Piketty makes the following claim:
“The rate of capital return in developed countries is persistently greater than the rate of economic growth, and that this will cause wealth inequality to increase in the future.”
Piketty is certainly correct that the rate of capital return exceeds the rate of economic growth. But his moral arguments fail when it comes to public sector pensions. Because public sector pensions have provided the means whereby public sector employees are granted immunity from the very forces that Piketty is arguing have empowered the oligarchy at the expense of ordinary workers. Public sector pensions have essentially creating a common cause between government workers and the oligarchy they allege is exploiting ordinary workers. This point cannot be emphasized enough. Government workers, through their pension funds, benefit from all policies designed to elevate asset values, including bubble levels of asset appreciation, because that is essential to the solvency of their funds. Their interests are aligned with those of central bankers, international corporations, and individual billionaires, whose self-interests impel them to support policies to keep interest rates artificially low, heap additional levels of debt onto the economy despite diminishing returns, and push asset values to even higher, more unsustainable levels. Because to stop doing that will crash these pension funds.
Is it equitable for government sponsored investment entities to control over $3.6 trillion in market investments, investments made in an economic environment which, if successful, perpetuates the gains of productivity flowing disproportionately to the wealthy elite, yet which, when unsuccessful, hits up taxpayers to cover the losses?
When considering solutions to both the financial challenges and issues of equity and fairness surrounding public sector pensions, it is important to understand that even if these systems are able to recover fully funded status based on surprisingly good and sustained market performance, it does not follow that their performance is something that can be extended to the entire population, because if so, instead of 20% of the retired population funding their retirement income through selling assets on the markets, 100% of the retirement population would be doing so, exerting far more downward pressure on asset values.
A relevant question to ask is therefore whether or not pension systems that are funded by taxpayers and bailed out by taxpayers should be investing in the market at all – why aren’t government employee pensions funded through a combination of low risk investments such as T-Bills and contributions from current workers?
The example of Social Security provides several instructive points which should be considered in any discussions of pension reform, or the larger question of what the government’s role should be in providing financially sustainable retirement security to Americans. Social Security, unlike state/local government worker pensions, has a positive cash flow. As seen here from this table on their website “Fiscal Year Trust Fund Operations,” during 2013 Social Security collected $851 billion from active workers and paid out $813 billion, primarily to retirees. The so-called Social Security “Trust Fund” had a balance at the end of 2013 of $2.76 billion.
If public sector pensions are indeed facing serious, potentially fatal financial challenges, they should consider adopting five elements from Social Security:
(1) Make it possible to increase employee contributions – Social Security withholding can be increased or decreased at the option of the federal government. If collections into public employee pension funds are inadequate, increase the withholding from employee paychecks – not only for the normal contribution, but also to help pay the unfunded contribution.
(2) Make it possible to decrease benefits – nothing in Social Security is guaranteed. Benefits can be cut at any time to preserve solvency. Decreasing benefits may be the only way to preserve defined benefit pensions. Equitable ways to do this must be spread over as many participant classes as possible. For example, the reform passed by voters in San Jose (tied up in court by the unions) called for suspending cost-of-living increases for retirees, and prospectively lowering the annual rates of benefit accruals for existing workers.
(3) Increase the retirement age. This has already been done several times with Social Security. Pension reforms to-date have also increased the age of eligibility for benefits.
(4) Calculate benefits based on lifetime earnings. Social Security calculates a participant’s benefit based on the 35 years during which they made the most. Public sector pensions, inexplicably, apply benefit formulas to the final year of earnings, or the final few years. These pension benefits should be calculated based on lifetime earnings.
(5) Make the benefit progressive. The more you make and contribute into Social Security, the less you get back. At the least, applying a ceiling to pension benefits should be considered. But it would serve both the goals of solvency and social justice to implement a comprehensive system of tiers whereby highly compensated public servants, who make enough to save themselves for retirement, get progressively less back in the form of a pension depending on how much they make.
These suggested reforms are meant to be taken to evolve defined benefit pensions into a plan that provides a minimal level of retirement security. The government should not be in the business of providing retirement benefits to anyone, private or within government, that go beyond providing a minimal safety net. The government certainly shouldn’t be in the business of providing pensions to government employees that are many times better than what they provide to private citizens in the form of Social Security. And the government, or government employees through their union controlled pension funds, should not be playing the market with $3.6 trillion of taxpayer sourced dollars, then forcing taxpayers to bail out these funds when they don’t meet projections.
A unique and elegant way to provide equitable, minimal, government administered and financially sustainable retirement security to all American’s would be to immediately require all active government workers to join Social Security. These workers, and retirees, would keep whatever pension benefits they’d qualified for so far, subject to reductions per the five options just noted in order to preserve solvency for the fund. They would begin to pay into the Social Security system, with the employer contribution into their pension funds proportionally reduced to make it an expense-neutral proposition. Since government workers are relatively highly compensated compared to private sector workers, the participation, for example, of 16 million active state/local government workers would immediately improve the solvency of the Social Security Fund. The five options available to preserve Social Security, as noted above, would be far less onerous in their implementation over the coming decades if tens of millions of highly compensated government workers were to participate. And since their unions purportedly speak for the common man, they should have no objection to the highly compensated among them getting less back in retirement than those less fortunate.
Who knows, maybe the much vaunted, potentially real Social Security “Trust Fund” assets could be used to purchase Treasury Bills. Such a policy would have the twin virtues of taking pressure off the federal reserve, and augmenting Social Security collections with modest investment returns.
* * *
(1) The tables in this study are all found on this spreadsheet, State-and-Local-Pension-Liability.xlsx. The spreadsheet also contains additional notes on the assumptions used, as well as links to the source data.
(2) To estimate a fund’s required normal pension contribution using the Impact-of-Returns-and-Amortization-Assumptions-on-Pension-Contributions.xlsx spreadsheet, “normal contribution (imputed)” spreadsheet, the assumptions used and referenced above were as follows:
– Average Salary = $70,000
– % cola growth/yr = 2.0%
– % merit growth/yr = 1.0%
– avg years till retire = 17
– proj % discount (fund’s assumed annual rate of return) = 7.75%
– base year 2000+ = 11
– avg years retired = 20
– pension formula/yr = 2.00%
– pension cola % = 2.0%
– elig # workers = 16,000,000
Please note this spreadsheet does not default to these values. They have to be entered in the yellow highlighted input cells. The spreadsheet is designed to calculate results for whatever set of assumptions the user wishes to enter. This spreadsheet also contains tabs, similarly highlighted with yellow to denote cells to input user assumptions, to recalculate estimates for the unfunded liability and the unfunded contribution. On this spreadsheet, as noted above, there are tools to recalculate the normal contribution based on having that information, or imputing it if that information is not available.
Editor’s Note: Consistent with our ongoing determination to publish in-depth analysis along with the more digestible tidbits that should never be an exclusive source of political and economic analysis and commentary, here is a 2,400 word piece that exposes and dissects the sources of instability and speculative excess in global financial markets. Anyone who has a strong opinion on the sustainability of, for example, 7.75% projected average annual returns for the Los Angeles Fire and Police Pension system, or, for that matter, any other public employee pension system, needs to wade through material like this. Because global financial markets, as author Doug Noland states, are now driving the economy, instead of the other way around. The result are assets that are artificially inflated; to quote Noland, “Contemporary central banking has regressed to little more than a scheme intent upon bolstering securities and asset prices.” Central banking policies, and the ecosystem of financial special interests that exploit them, are creating a global pricing bubble of dangerous proportions, across all classes of assets.
The “economic sphere” versus “financial sphere” analytical framework has in the past been a focal point, but over recent years I have not given this type of analysis the attention it deserves. Conventional analysis holds that the real economy drives the performance of the markets. During bull markets, pundits fixate on every little indicator supposedly corroborating the optimistic view. These days, the bulls trumpet strong underlying profit growth as supporting ever higher stock prices.
Especially in this Age of Unfettered Finance, I’m convinced that the “financial sphere” commands the “economic sphere.” Profits are generally a byproduct of strong underlying growth in finance – hence a lagging indicator. Corporate earnings will appear absolutely stellar at market peaks – as Credit flows freely and financial conditions remain ultra-loose. Profits will be lousy at market bottoms, when risk aversion and attendant tight financial conditions dominate.
Going back now more than twenty years, one of my primary analytical objectives has been to identify, study and monitor the underlying finance fueling booms in markets and economic activity. Fundamental analytical issues include: What is the nucleus of the underlying Credit expansion? Whose balance sheets/liabilities are growing? What is the nature of prevailing financial flows? How stable are the underlying Credit and flow dynamics? What is the role of policymaking and government market intervention? Are there major market misperceptions and resulting mispricings?
Today’s consensus view holds that the economy and markets are sound – robust even. The economy is finally emerging from a difficult post-Bubble period, with the markets appropriately valued based on improving fundamentals. Central bankers and pundits alike assure us that markets have not succumbed to yet another Bubble. Top officials at the Fed and ECB have both recently stated that underlying Credit growth and market leverage are inconsistent with a problematic Bubble backdrop.
I have repeatedly identified troubling parallels between the past twenty year cycle and the protracted boom that ended with the 1929 stock market crash. Having extensively studied the late-twenties period, I was repeatedly struck by how virtually everyone was caught unaware of acute underlying financial and economic fragilities. “How could they have not seen it coming?,” I often asked myself. It all makes clearer sense to me now.
Importantly, this has been a particularly prolonged Credit and speculative cycle (exceeding even the historic 1914-1929 boom). Similar to 1929, everyone has become numb to the scope of Credit excess, speculative leveraging and economic maladjustment. Back in the sixties, Alan Greenspan was said to have pointed responsibility for the financial collapse and resulting Great Depression on a misguided Federal Reserve that had repeatedly placed “coins in the fuse box” to sustain the Twenties boom.
Clearly, a protracted period of repeated central bank market interventions will solidify the notion that adroit policymakers have everything under control. And given enough time – and sufficient inflation in Credit and financial asset markets – price distortions will become deeply systemic – if not commonly appreciated. Importantly, protracted booms create cumulative deleterious effects that, by the nature of things, go completely unappreciated even in the face of precarious “terminal phase” Bubble excess.
I titled a presentation back in early-2000, “How Could Irving Fisher Have been so Wrong?” Only days before the great 1929 crash, the leading American economist at the time famously stated: “Stock prices have reached what looks like a permanently high plateau. I do not feel there will be if ever a 50 or 60 point break from present levels…”
Fisher and about everyone else at the time were oblivious to underlying financial and economic fragilities. With this in mind, I will touch upon what I believe are sources of potential vulnerability. In particular, my focus is on potentially unstable Credit and financial flows – the “financial sphere”.
First of all, Credit financing asset speculation is inherently unstable. Broker call loans and various leveraged structures proved catastrophic in the 1929 crash and subsequent financial meltdown. During booms, speculative leveraging engenders their own self-reinforcing liquidity abundance. But as we saw firsthand during the 2008/09 fiasco, the cycle’s vicious downside, with the forced unwind of speculative leverage, pressures market liquidity and asset prices in a self-reinforcing market crash. Contemporary central banking has regressed to little more than a scheme intent upon bolstering securities and asset prices.
It is my view that the current amount of global speculative leverage across securities and asset markets is surely unprecedented – stocks, bonds, EM, real estate, collectables, etc. The global leveraged speculating community has grown significantly since the ’08 crisis, while there has been a proliferation of instruments, vehicles and funds that boost returns through the use of embedded leverage. Anecdotes suggest global “carry trade” speculative leverage has inflated to unprecedented extremes, certainly bolstered by central bank currency/liquidity manipulation (the U.S., Japan and China at the top of the list). And I worry that booming markets for ETFs and derivatives (of all stripes) ensure the utilization of massive amounts of leverage (along with trend-reinforcing “dynamic trading” hedging strategies).
At the same time, record margin debt and booming “repo” markets suggest speculative leverage from traditional sources remains as prominent as ever. What are the ramifications for system stability from record quantities of stocks and bonds at record high prices underpinned by record amounts of speculative leverage?
Sheila Bair penned an interesting op-ed in Friday’s Wall Street Journal: “The Federal Reserve’s Risky Reverse Repurchase Scheme.” I appreciate the analysis and particularly the notion of a “scheme.” I actually believe that there is a critically important evolution that occurs during protracted Credit and speculative cycles. In simple terms, over time runaway financial and economic booms transforms from a Bubble dynamic to one more akin to a sophisticated financial scheme.
Importantly, mounting financial and economic fragility fosters progressive government intrusion throughout the markets and real economy. Resulting market instability and poor economic performance then provoke only more meddlesome government “activism.” As we’ve witnessed over the past six years, massive fiscal spending has bolstered the economy and inflated corporate profits. Meanwhile, central bank interest-rate manipulation, market intervention and massive “money” printing incited risk-taking and incentivized speculative leveraging. If the great American economist Hyman Minky were alive today, he would undoubtedly label this one of history’s most outrageous episodes of “Ponzi Finance.”
It’s certainly no coincidence that we’ve been witnessing a proliferation of financial jerry-rigging. The loosest financial conditions imaginable have spurred record stock buybacks that have bolstered equities prices, while goosing earnings-per-share (EPS). Other popular methods of financial engineering include “tax inversions,” master limited partnership and various other tax avoidance schemes that work to inflate equity market valuation. Government and central bank largesse has also incited a historic M&A boom that will leave a legacy of problem debt.
It’s surprising that there has not been more concern regarding conspicuous excess throughout the corporate debt market. Corporate borrowings are notoriously cyclical and potentially disruptive. One can look back to the late-eighties corporate debt boom and resulting early-nineties bust. Then there were late-nineties excesses that left a legacy of problematic telecom debt, along with a severe tightening of Credit conditions. Yet those excesses were left in a trail of dust by the 2006/07 corporate lending fiasco that played prominently in the subsequent financial crisis.
So let’s take a brief look under the hood of today’s corporate debt boom (beyond record issuance of bonds – risky and otherwise). From the Fed’s Z.1 “flow of funds” report we see that non-financial corporate borrowings increased at a seasonally-adjusted and annualized rate (SAAR) $873bn during Q1, up sharply from 2013 Q4 and at a pace surpassing even 2007’s record $862 growth in corporate debt. It is worth noting that the two-year 2012-2013 corporate debt expansion of $1.45 TN surpassed the $1.42 Trillion gain from 2006-2007. And while we’re at it, the 1998-1999 lending boom saw corporate debt increase $801bn and the 1987-1988 Bubble posted growth of $395bn. Some would argue that the 9% (or so) pace of corporate debt growth over the past nine quarters remains below 2007’s 13.6%, 1998’s 10.8% and 1987’s 10.4%. I would counter that today’s record low corporate borrowing costs work to somewhat temper overall growth in corporate Credit. Excesses – including issuance and mispricing – are greater than ever.
The cyclical boom and bust dynamic saw Credit expansion slow rapidly during the early nineties, with corporate debt actually contracting 2.3% in 1991 (and growing only 0.8% in ’02). Booming corporate debt growth was cut in half by 2001, and then expanded only 1.3% in 2002 and 2.0% in 2003. Corporate borrowings were also cut in half in 2008, before contracting 3.1% in 2009 (expanding only 1.7% in 2010). Importantly, corporate debt is prone to cyclicality and instability.
Returning to “financial sphere” analysis, I discern latent fragility. Sure, Q1 total non-financial sector Credit expanded SAAR $2.113 TN (up from 2013’s $1.812 TN), surpassing my $2.0 TN bogey for Credit sufficient to drive a maladjusted economic structure. But the federal (SAAR $874bn) and corporate (SAAR $873bn) sectors accounted for the vast majority of system Credit expansion. And I believe both Credit booms have been heavily impacted by central bank QE liquidity injections. After all, Fed holdings expanded SAAR $911bn during Q1, after surging $1.086 TN in 2013. Importantly, we’re now only a few months away from the end of QE.
July 25 – Financial Times (Vivianne Rodrigues and Michael Mackenzie): “Junk bonds are on track for their worst monthly return in nearly a year, with investors fretting the era of easy US central bank money is at an end and calling time on a bull run for one of the market’s riskier asset classes. Years of quantitative easing by the Federal Reserve have driven investors into bonds, real estate and equities, sparking concerns of looming asset price bubbles. Junk-rated debt, in particular, has attracted record inflows and generated robust returns for investors prepared to bet on bonds sold by companies with the lowest credit ratings.”
July 25 – Wall Street Journal (Katy Burne and Chris Dieterich): “Investors are selling junk bonds at the fastest pace in more than a year, as fresh interest-rate fears and geopolitical turmoil amplify valuation concerns following a long rally. Prices on bonds issued by lower-rated U.S. companies tumbled to a three-month low this week… Investors yanked $2.38 billion from mutual funds and exchange-traded funds dedicated to junk bonds in the week ended Wednesday, the largest weekly withdrawal since June last year, said… Lipper. That came on the heels of $1.68 billion that poured out the week before. Companies have taken note, with some borrowers delaying scheduled debt sales and others canceling planned deals. New issuance is on track for its slowest month since February, according to… Dealogic.”
I suspect that the end of QE could very well send shudders throughout the corporate debt marketplace, and I would furthermore expect the initial tightening of financial conditions to manifest with the marginal “junk” borrowers. Especially after hundreds of billions have flooded into high-yielding vehicles (certainly including the ETF complex), an abrupt reversal of flows would spell Credit tightening trouble. Further, any meaningful deterioration in corporate Credit Availability would have negative ramifications for an overextended stock market Bubble. As I have written previously, with QE winding down the securities markets are increasingly vulnerable to a destabilizing bout of “risk off.” It wouldn’t require a major de-risking/de-leveraging episode to dramatically alter the marketplace liquidity backdrop.
There is another element of “financial sphere” analysis that I believe could play a major role in unappreciated latent fragilities: Integral to the “global government finance Bubble” thesis is that excesses today encompass the world and virtually all asset classes. While not readily apparent, I believe there are various international financial flows that today stoke asset inflation and Bubbles – flows that could prove especially destabilizing in the event of globalized financial tumult. Myriad flows originating from the likes Japan, China, overheated EM Credit systems and elsewhere unobtrusively inject liquidity and drive price gains throughout our stocks, bonds, real estate and the real U.S. economy more generally.
July 16 Wall Street Journal (Min Zeng) “China Plays a Big Role as U.S. Treasury Yields Fall – Record Chinese Purchases of Treasurys Help Explain U.S. Bond Rally.” “Investors wrestling with the mysterious U.S. bond rally of 2014 got a clue about where to look: China. The Chinese government has increased its buying of U.S. Treasurys this year at the fastest pace since records began more than three decades ago… The purchases help explain Treasurys’ unexpectedly strong rally this year… The world’s most-populous nation boosted its official holdings of Treasury debt maturing in more than a year by $107.21 billion in the first five months of 2014… “
July 9 – Los Angeles Times (Tim Logan): “A record amount of foreign money is flowing into the U.S. housing market… Overseas buyers and new immigrants accounted for $92 billion worth of home purchases in the U.S. in the 12 months ended in March… That’s up 35% from the year before, and the most ever. Nearly one-fourth of those purchases came from Chinese buyers. And the place they’re looking most is Southern California… The report highlights the growing effect of global capital on some local housing markets. The $92 billion amounts to 7% of all money spent on homes in the U.S. during those 12 months, and nearly half of it was concentrated in a handful of cities, including Los Angeles.”
Perhaps it’s coincidence that the ECB is commencing a major new liquidity operation just as the Fed’s QE winds down. Clearly, the “Draghi plan” to bolster fragile European peripheral debt markets should be viewed as a sophisticated financial scheme. Thus far, the Bank of Japan (BOJ) shows no indication that its “money” printing scheme is ending anytime soon. And despite all the talk that the Chinese were serious about financial and economic reform, they apparently took one alarming look at rapidly unfolding systemic fragilities and opted to let their historic Bubble run. The Chinese Bubble is a government-dictated financial scheme of epic proportions.
So it’s become an equally fascinating and alarming global dynamic: a multifaceted global scheme to support massive amounts of debt, inflated securities markets and a grossly maladjusted global economic structure. Worse yet, it’s a global scheme held together by various governments that are increasingly engaged in heated geopolitical strife. In the end, “Ponzi Finance” financial schemes boil down to games of confidence.
So I’ll attempt the briefest responses to the above noted key questions: What is the nucleus of the underlying Credit expansion? Answer: Non-productive government debt, speculative leverage and borrowings to support financial engineering. Whose balance sheets/liabilities are growing? Answer: The Fed’s and Treasury’s, along with corporate America. What is the nature of prevailing financial flows? Answer: Financial speculation – chasing yields and inflating securities prices. How stable are the underlying Credit and flow dynamics? Answer: I believe highly unstable and susceptible to changing market perceptions and faltering confidence. What is the role of policymaking and government market intervention? Answer: Profound impact on all markets and the real economy. Are there major market misperceptions and resulting mispricings? Answer: Confidence in both ongoing liquidity abundance and the power of central banks has fostered profound systemic mispricing throughout securities and asset markets on a global basis. Is the backdrop consistent with a momentous financial scheme? Absolutely.
About the Author: Doug Noland has been the Senior Portfolio Manager of the Federated Prudent Bear Fund and Federated Prudent Global Income Fund since December 2008. Prior to joining Federated, Mr. Noland was employed with David Tice & Assoc., Inc. where he served as an Assistant Portfolio Manager and strategist of Prudent Bear Funds, Inc. Prudent Bear Fund and Prudent Global Income Fund from January 1999. From 1990 through 1998, Mr. Noland worked as a trader, portfolio manager and analyst for short-biased hedge funds including G. W. Ringoen & Associates from January 1990 to September 1996, Fleckenstein Capital from September 1996 to March 1997 and East Shore Partners, Inc. from October 1997 to December 1998. He earned a B.S. in Accounting and Finance from the University of Oregon and a M.B.A. from Indiana University. This post originally appeared on the economics website “The Prudent Bear” and is published here with permission.
“You can’t build a society on artificially inflated asset values, because that accelerates the class division. Immigrants know that even if they work in a low-paying job in a hotel in Houston the chances they can save and buy a house are infinitely better than in California. If you want to have an asset based economy then accept we’re going to have feudalism because the price of entry is just too high.”
– Joel Kotkin, CPPC Interview, January 4, 2014
What Kotkin is referring to is the result of decades of increasing legislative restrictions on cost-effective land and energy development, combined with Federal Reserve policies designed to minimize the cost of borrowing. In the first case, prices for land and energy, the building blocks of a healthy economy, are artificially inflated through constraints on supply. In the second, the supply of borrowed money is artificially increased via ultra-low interest rates.
This so-called “asset economy” might also be called a “bubble economy,” because it cannot be sustained indefinitely. For a while, inflated values of real estate, privately owned natural resources and business inventories provide collateral for additional borrowing at low interest rates, which puts even more money into circulation, bidding the price of assets up even further. Meanwhile, environmentalist legislation of increasing severity continues to restrict supplies of land and energy, driving prices of marketable land and energy higher still. And the bubble grows.
This is the real reason California is unaffordable for working families. Anywhere within 100 miles of the California coast, homes “priced to sell” at $400,000, cost more than six times California’s median household income of $61,400. Thanks to their inflated price, these homes will come with a hefty property tax bill – including local assessments – of over $5,000 per year, and if they were built anytime in the last 20 years or so, there’s a good chance you can tack another several thousand per year of “Mello Roos” assessments – property taxes by any other name.
Who benefits from the asset economy? The answer may surprise you.
The obvious beneficiary of inflated asset values is the proverbial Wall Street crowd. Every time the closing bell rings on an uptick, the trading minions in lower Manhattan clink their martini glasses and bellow with predatory glee. We get that.
Who else benefits from the asset economy? Consider this statement, courtesy of the SEIU, found on their “Fact Check on Public Employees’ Pensions” website page:
“Are taxpayers the ones who foot the bill for public workers’ pensions?
In a word, no. The modest amount the average public worker takes home is covered largely through investment returns–not the emptying of taxpayers’ pockets.”
This quote, “investment returns,” lies at the crux of the disagreement over both the financial sustainability of public sector pensions, and whether or not they constitute an unfair burden on taxpayers. Because in this low-interest rate economy, where the prime lending rate is 3.25% and the 30 year fixed rate mortgage is 4.25%, public employee pension funds are investing all over the world, essentially loaning money at 7.5% interest.
You heard that right. They are loaning money at 7.25% interest. Because the only real difference between an investment and a loan is when investments don’t return the expected rate to the investor, the “borrower” doesn’t have to pay the money back.
One primary reason pension funds have the expectation they can earn 7.5% interest per year is because they are placing more and more of their investments with private equity firms and hedge funds, whose charter is to beat the market – at great risk. Most of the rest of their funds are invested in publicly traded equities or real estate assets – i.e., profitable corporations and corporate holdings whose values currently appreciate at unsustainable rates, thanks to ultra-low interest rates and artificial constraints on supplies in markets where they have monopolistic power.
And in one very important sense, pension funds may be explicitly considered lenders, not investors, because if they fail to earn 7.5% per year on their investments, they have the power to increase the required contributions from the government employers of their beneficiaries. The taxpayers, you see, guarantee those 7.5% annual returns.
It would be hilarious if it weren’t so dangerously prolonging an honest reckoning – the ability of public sector union spokespersons to demonize pension reformers as “tools of Wall Street.” Because it is their pension funds who pour more money into Wall Street than any other financial special interest, and who carry the unique power to cover their losses on the backs of taxpayers. Equally significant, but far more subtle, is that pension funds depend on artificially high costs of living, through artificially appreciating asset values, to ensure their high returns and continued precarious solvency, also on the backs of working people.