The firestorm among UK pension funds is a wake-up call for their peers across the Atlantic. The end of an era of cheap money is exposing an industry that’s chronically underfunded and overexposed to market turbulence.
Imagine a meeting of executives of a typical public pension fund following last quarter’s rout.
Chief investment officer: 2022 has been brutal. 60% of our fund is invested in equities, they’re down 25%. Another 20% is in bonds, which are down 15%. 20% is in alternatives. Commodities and hedge fund strategies have done well overall, but real estate and private equity are down. Overall, we’ve lost 15% of our asset value.
Chief accountant: Not to worry. 30-year interest rates have almost doubled from 1.90% to 3.71%. Since we have long-duration liabilities, the present value of our pension obligations has declined 20%.
Head actuary: Not so fast. With inflation running at 8.3%, we’re going to see large cost-of-living adjustments in liabilities. Plus, inflation and a tight labor market mean wages will increase. Higher wages mean higher future pension benefits.
I will leave these professionals to thrash out the net effect on their pension fund though clearly, they face numerous crosscurrents. Investment returns, discount rates and inflation all affect the reported funded status of a pension plan — or the assets currently held relative to long-term obligations — an abstraction based on unknowable assumptions. Whether the average fund will pay out its promised liabilities or not is something we won’t know for decades.
What matters in the knowable here and now is whether some of the worst-funded large plans will collapse in the next year or two. If yes, we’ll have to deal with a major financial crisis soon. If no, pension funds can continue to muddle along — whether the officially reported statistics around their funded status look good or bad — until the next crisis.
Public pension funds are on pace for the biggest annual decline in assets since the fallout of the global financial crisis, according to estimates from the New York-based nonprofit Equable Institute. The effect of higher market discount rates and inflation — both observed and anticipated — on liability valuations depends on work actuaries are doing now. But it’s possible 2022 will increase funding gaps by half a trillion dollars or more. State and local governments will be faced with hard choices.
Many people think of state and local employees as having gold-plated benefits, but there is a catch. First, you generally must put in long service with a single employer to collect full value. Moving around or taking time off means you lose coverage. Second, many public employees, especially newer and lower-paid ones, are excluded from the most generous plans.
Public employee unions have historically managed to present a united front in negotiations. This made them extremely powerful. They had lots of members who voted. They collected lots of dues for donations and advertising. Their members were dispersed throughout the voting community — with families and friends. Many were respected -- teachers, police, firefighters, EMTs. Union employees could cause major political headaches with job actions. The people who collected the highest benefits were politically influential — university presidents, long-time senior public administrators and the like.
I don’t think this describes the future. Not in places with troubled pension financing. Older and retired workers will want benefit increases to keep up with inflation. While a few places do this automatically, most have tight caps — 3% or less — or make only partial adjustments or require legislative action.
Younger workers are mostly excluded from those benefits, and few believe pension funds will be around to pay them at retirement time anyway. So younger workers want salary increases rather than promises. Also, portable, employee-directed accounts like 401(k)s rather than large and ever-increasing contributions to black-hole public pension systems. The fight in 2023 may be more between younger and older public employees than between united public employees and taxpayers.
I think young employees will score their first victory after many years of getting pushed down. It will be short-term inflation then that applies lethal pressure in a tight labor market, not stock prices, interest rates or even longer-term expectations of price increases. Wages will have to be raised for public employees, who will refuse burdens from past underfunding or benefit cuts that apply only to them. The alternative is unacceptable declines in public services as the best employees quit, job openings go unfilled and qualifications for new hires are lowered.
The most heavily indebted states, with the worst credit ratings and biggest pension funding shortfalls, may not be able to pay these increases. While 2022 should be a good revenue year for a majority of state and local governments, heavily indebted states with big pension-funding gaps need to brace for some serious headwinds. Illinois already spends 11% of its revenue to service debt. Increased yields on its bonds could double that to 22% as debt is refinanced, even if the state runs balanced budgets.
The temptation to cut benefits for retirees may be overwhelming. While these people can (and will) yell and scream, that’s easier to accept than a teachers’ strike or a police slowdown. Current employees can be offered generous wage increases and portable pensions. Reducing actuarial pension liabilities will please creditors and rating agencies. Taxpayers will appreciate being spared. In many states, cutting benefits will require a constitutional amendment or other legal heavy lifting, but with enough incentive, that can be done.
I expect something like Social Security reforms. A cap will cut benefits for people receiving the highest pensions, and states will put tax surcharges on benefits for high-income people even if they have moved out-of-state. Copays and deductibles will be increased for health coverage.
The first state to try this will face strong legal challenges, a nationwide union counteroffensive and significant in-state political resistance. But with enough fiscal pressure it may happen. If state administrations can keep current public employees on the sidelines, via wage increases and benefit restructuring, it might succeed.
If one state accomplishes this, a handful of other fiscally challenged states would likely follow suit. Warren Buffett famously said, “Only when the tide goes out do you discover who's been swimming naked.” People usually think of a stock market decline exposing skinny-dippers, but inflation works just as well. States with rickety finances that have avoided exposure via decades of low interest rates and inflation may finally have to face up to hard choices. If so, someone — taxpayers, creditors, public employees or retired workers — will get squeezed. Of those groups, retired workers are least able to retaliate. Politics is never about what’s fair, only about how hard groups can hit back.
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