Total unfunded liabilities in state and local pensions have roughly quintupled in the last decade.
You read that right—not doubled, tripled, or quadrupled—quintupled. That’s nice when it happens on a slot machine, not so nice when it’s money you owe.
You will also notice in the chart that much of that change happened in 2008.
Why was that?
That’s when the Fed took interest rates down to nearly zero, meaning it suddenly took more cash to fund future payments.
According to a 2014 Pew study, only 15 states follow policies that have funded at least 100% of their pension needs. And that estimate is based on the aggressive assumptions of pension funds that they will get their predicted rate of returns (the “discount rate”).
Kentucky, for instance, has unfunded pension liabilities of $40 billion or more. This month the state budget director notified local governments that pension costs could jump 50–60% next year.
That’s due to a proposed reduction in the system’s assumed rate of return from 7.5% to 6.25%—a step in the right direction but not nearly enough.
Think About This as an Investor: How Can You Guarantee 6–7% Returns These Days?
Do you know a way to guarantee yourself even 6.25% average annual returns for the next 10–20 years? Of course you don’t. Yes, some strategies have a good shot at doing it, but there’s no guarantee.
And if you believe Jeremy Grantham’s seven-year forecasts (I do: His 2009 growth forecast was spot on), then those pension funds have very little hope of getting their average 7% predicted rate of return, at least for the next seven years.
Now, here is the truth about pension liabilities. Let’s assume you have $1 billion in funding today. If you assume a 7% compound return—about the average for most pension funds—then that means in 30 years that $1 million will have grown to $8 billion (approximately).
Now, what if it’s a 4% return? Using the Rule of 72, the $1 billion grows to around $3.5 billion, or less than half the future assets in 30 years if you assume 7%.
Remember that every dollar that is not funded today means that somewhere between four dollars and eight dollars will not be there in 30 years when somebody who is on a pension is expecting to get it.
Worse, without proper funding, as the fund starts going negative, the funding ratio actually gets worse, sending it into a death spiral. The only way to bring it out of the spiral is huge cuts to other needed services or with massive tax cuts to pension benefits.
The Situation Is Dire Even in the Best-Case Scenario. But What If…
The unfunded pension liabilities for state and local governments are $2 trillion. But that assumes an average 7% compound return. What if we assume 4% compound returns?
Now the admitted unfunded pension liability is $4 trillion.
But what if we have a recession and the stock market goes down by the past average of more than 40%? Now you have an unfunded liability in the range of $7–8 trillion.
We throw the words a trillion dollars around, not realizing how much that actually is. Combined state and local revenues for the U.S. total around $2.6 trillion.
After the next recession (whenever that is), the unfunded pension liabilities for state and local governments will be roughly three times the revenue they are collecting today, and that’s before a recession reduces their revenues.
Can you see the taxpayer stuck between a rock and a hard place? Two immovable objects meeting? The math just doesn’t work.
We are starting to see cities filing for bankruptcy. That small ripple will be a tsunami within 7–10 years.