Moodys: Public Pension Underfunding to Worsen as Returns Lag

We’ve had plenty of company in warning that protracted central bank policies, ZIRP, QE, and most important, that those represent negative real interest rates, are deadly to banks and long-term investors like pension funds and life insurers.

As a result, one of the things we’ve discussed regularly with CalPERS is how it is continuing to defend the indefensible, namely, its assumption that it will earn 7.5%. It rejected a plan by Governor Jerry Brown to have the giant pension fund lower its return target to 6.5% in return for a cash injection. Instead, CalPERS came up with a convoluted scheme to lower its return…maybe someday. From Reuters last November:

Calpers will reduce its expected rate of investment returns in years after the fund outperforms its 7.5 percent target by 4 percentage points. The goal is to ultimately reduce the rate to 6.5 percent, although that could take decades under the new policy….

In July, CalPers announced that after years of steady returns it missed the 7.5 percent target, returning just 2.4 percent for the fiscal year ended June 30.

Contrast that 7.5% return assumption with Moody’s outlook for fiscal year 2016, which ends June 30, courtesy the Financial Times:

Moody’s, the rating agency, said lacklustre returns in 2015 and 2016 will put severe pressure on the health of US public pension plans and force states and cities to act in order to plug their pension funding gaps.

Tom Aaron, an analyst at Moody’s, said the funding deficit — the difference between the assets a pension fund has and what it has to pay out to current and future pensioners — will grow substantially this year….

In the most optimistic scenario, where average returns totalled 5 per cent, the collective funding gap [for the 56 plans in its study] would still widen by more than $200bn.

Moody’s estimates the scale of the unfunded liabilities is greater than officially reported because of the generous discount rate public pension plans use to value retirement benefits. The rating agency said the schemes collectively have a deficit of $1.7tn, which could rise to $2.2tn this year if the pension plans suffered negative returns.

Now again, in case you missed it: CalPERS’ return assumption of 7.5% exceeds Moodys’ best case scenario of 5% by a full 2.5%.

Mind you, CalPERS, which is 77% funded as of June 30, 2015, is a bit less stressed than the average public pension fund. The most underfunded state plans are those of Illinois, Connecticut, Kentucky, and Kansas. Again from the Financial Times:

A study by Wilshire Associates, the consultancy, published earlier this month, showed that state-sponsored pension plans in the US had just 73 per cent of the assets they needed to pay current and future retirees in mid-2015, down from 77 per cent in 2014. In 2007, this was 95 per cent.

The fact that public pension plans as a whole were adequately funded before the crisis is a stark reminder that the “rescue the banks” plan has come at the expense of savers and retirees. And the optimism of CalPERS and its peers that a higher return environment will eventually bail them out of their problems does not appear warranted. From a post yesterday by C.P. Chandrasekhar and Jayati Ghosh:

Why then are central banks and governments opting for this unusual stance? In a famous 1943 essay on the “Political Aspects of Full Employment”, the Polish economist Michal Kalecki had argued that if the rate of interest or income tax is reduced in a slump (to counter it) but not increased in the subsequent boom, “the boom will last longer, but it must end in a new slump: one reduction in the rate of interest or income tax does not … eliminate the forces which cause cyclical fluctuations in a capitalist economy. In the new slump it will be necessary to reduce the rate of interest or income tax again and so on. Thus in the not too remote future, the rate of interest would have to be negative and income tax would have to be replaced by an income subsidy.”

If you had any doubt that the Great Moderation, which depended in part on the Greenspan/Bernanke put, was responsible for the lousy new normal, that paragraph should help put it to rest.

But it’s also important to recognize that the underlying problem is not that of public pension plans, but that the whole idea of saving and investing to fund retirement has been upended by the economic misrule of the last 40 years. The benefits of productivity growth were not shared with workers, consumer borrowing served to prop up spending levels, and the corporations became net savers, either underinvesting or worse slowly liquidating via stock buybacks. All of that has resulted in stagnant labor incomes and an unprecedentedly high and unhealthy share of GDP going to profits.

In the 1960s, government pressure made the sharing of productivity gains normal practice. But with businesses wedded to wage squeezing, companies preferring short-term gimmickry to investing, and the public trained to be hostile to what is most needed, more aggressive government spending, particularly in infrastructure. But with both government and business leaders are increasingly of the “après moi le déluge” school of management, both the young and the old outside the top echelon are set to suffer even more.

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  1. jgordon

    Another question to ask is what exactly are these guys “investing” in to try to get that 7.5% target return? Fracking junk bonds? Considering how things are going, these pension funds are probably in even worse shape than anyone is thinking.

    1. Uahsenaa

      Considering how things are going, these pension funds are probably in even worse shape than anyone is thinking.

      More than likely given how transparency, as we see in the CalPERS case, seems to be the very last consideration… that is until someone presses them on it from without, as Yves has done. Then it becomes painfully obvious that the managers themselves aren’t even certain what it is they’re investing in or how it impacts their bottom line. The fiduciary duty has all but been abandoned, and that is extremely troubling.

    2. Marc Andelman

      Important question. What else would explain who would waste their time putting money into a vile fund that invests in the slave labor state of North Korea, or, that sues Nauru? Nauru is a South Pacific island that destituted itself by selling its actual land off as phosphate rock. It now hosts a high security prison for Australia and a high level radiation dump. See below. It gets much, much worse, but, that is enough for people to ponder for now.

  2. Doug

    Yet one more thread in the tapestry of the financialized as opposed to real economy — namely, the engine of fiction. We might say ‘lipstick on a pig’. But, as the post indicates, the 7.5% is not even real lipstick and the models/etc are not remotely a pig. Neither the lipstick nor the pig are real. Total fiction.

    And, yet nothing is exceptional in this. Rather, fiction is the new normal.

    Look at today’s post from Peter Van Buren about the 5 questions not being discussed. Fiction, folks.

    And that’s but one more of the now infinite number of illustrations.

    It’s the Big Lie of course. But, all fiction all the time also points to the players, the agents, the actors: is there even a single individual in a position of power who even can penetrate this Cave?

  3. Chris Tobe

    As an xboard member of the states worst plan Kentucky Employees (KERS) things are much worse. KERS was 17% funded as of June 2015, and has sunk much lower. Investment returns (Jul-Jan) were reported at a -6% but is probably worse because it includes +3% made up returns from a hefty allocation (15%) of private equity.

  4. DakotabornKansan

    Young and the old outside the top echelon are set to suffer even more …

    Let the hate begin!

    “Wisdom of the multitude,” according to Machiavelli: “A well-organized people that commands is just as stable, prudent and grateful as a prince, in fact, more so than a prince, even one considered wise; conversely, a prince unshackled by laws will be more ungrateful, inconstant and imprudent than a people … I declare that a people is more prudent, more stable and is capable of better judgment than a prince.”

    Machiavelli on the Germanic city-states pure hatred of the rich: “That Republic, whose political existence is maintained uncorrupted, does not permit that any of its citizens to be or live in the manner of a gentleman, instead maintain among themselves a perfect equality, and are the greatest enemies of those lords and gentlemen who are in that province. And if, by chance, any should come into their hands, they kill them as being princes of corruption and the cause of every trouble.” – Machiavelli, The Discourses

    1. diptherio

      I’d never read those quotes before. Thanks! Maybe old Niccolo got a bad wrap, eh? Sounds like a radical anarcho-sydicalist to me. Gives a whole other meaning to “Machiavellian.”

      1. Uahsenaa

        Machiavelli’s own politics were markedly small r republican, and there’s not a small whiff of irony in the fact that Il Principe is dedicated to Lorenzo di Piero de’ Medici, when Machiavelli led the Florentine militia against them in the failed defense of 1512. He was later tortured by Medici agents under the suspicion of his fomenting a conspiracy against them.

        As a result, many later political theorists, Rousseau, for instance, read The Prince as a satire, or, a more common view nowadays, as a text that appears to be a manual for proper dictatorial rule but is actually a means to lift the veil for ordinary citizens as to what politics actually are. That would explain why the Vatican, a close ally of the Medici, officially censored the work.

        It’s sad that he is so often facilely associated with a kind of brutal realpolitik, when his own life shows him to be a staunch defender of democratic rule.

      2. Procopius

        I first found out that Niccolo was more interesting than just a backroom schemer at Ex Urbe. His modern reputation is far, far less than he deserves.

    2. cassandra

      Besides the unexpected success of Trump & Sanders, in Europe we find GO, UKIP, SDP, Wilders, LePen, Orban…and, speaking of Germans, Pegida and AfD. As Barry would say, some folks are unhappy with how their technocratic elites have been handling things. Ya think? We need a better class of oligarchs.

  5. cnchal

    What about the pensions of all the people that have had their jawbs stripped and shipped to China or Mexico. Cat food will have to be an acquired taste for them.

    Who’s pension won’t suffer? Oh that’s right, the useless eaters on their throne at the policy table.

    1. Marc Andelman

      If you get sick, while at the pet store shopping for cat food you can also buy fish mox. it is probably the same stuff pharmaceutical firms sell to people

  6. flora

    “But it’s also important to recognize that the underlying problem is not that of public pension plans, but that the whole idea of saving and investing to fund retirement has been upended by the economic misrule of the last 40 years. ”

    Yes. The only glimmer of sunshine in this is that NC is doing real reporting on the issue. Facts, even ugly facts, when known can let individuals make prudent decisions. Thanks again for your reporting.

  7. Jim Haygood

    ‘the underlying problem is not that of public pension plans’

    … but rather of their regulation. The principles of prudent pension management are well understood, and are codified in the ERISA law of 1974.

    However, both federal and state pensions are exempt from ERISA, under the theory that sovereign governments will regulate themselves, with democratic supervision from the people. How’s that workin’ out for us?

    As could easily have been predicted, self-regulation is a blank check for politicians to spend today while leaving a dusty cupboard full of worthless IOUs scribbled on lipstick-stained cocktail napkins for the victims beneficiaries.

    With Cali’s marginal income tax rate already at an eye-popping 13.3% (highest in the U.S.), press-ganging Hollywood and Silicon Valley moguls to bail out Calpers a decade down the road is going to be a tough row to hoe.

    So Adios to California
    Nothin’ to do but turn around
    Always thought there’s someone comin’ for ya
    Only way you’d leave this town

    — John Hiatt

    1. Yves Smith Post author

      State and public pension funds manage themselves in accordance to ERISA even though not formally required to. Their return assumptions, for instance, are in line with those of private pension plans. They go through exactly the same drill of hiring outside consultants for asset allocation, determining benchmarks within asset classes. having experts consult on which “alternative” managers to use.

      1. Jim Haygood

        Right. But ERISA generally requires funding shortfalls to be made up over seven years. As this report points out, states grant themselves vastly more leeway:

        There is no federal law binding states to actually make their ARC [Annual Required Contribution] payments, and many states do not. New Jersey has failed to pay its full ARC for nearly all of the past 20 years.

        States can also choose the length of the period over which unfunded pension liabilities will be paid off. Some states choose conservative, short horizons (such as New York, which amortizes unfunded liabilities over a period of approximately 12 years).

        Other states show far less discipline. The Governmental Accounting Standards Board suggests an amortization period of no more than 30 years. But Illinois, for instance, has gone with periods as long as 50 years.

        “Suggestions” barely leave a mark on the rum-soaked boodlers in state legislatures. Thirty years = IBGYBG (I’ll be gone, you’ll be gone).

  8. FluffythObeseCat

    Thank you for this post. great work.

    “All of that has resulted in stagnant labor incomes and an unprecedentedly high and unhealthy share of GDP going to profits”

    I’m not knowledgeable about pension management, or finance in general as I’ve mentioned in the past. However, I have one question in re “where the money has gone”: has the unhealthy share of GDP that hasn’t gone to labor in the past 15+ years truly been shunted to ‘profits’? Or has much if not most of it been squandered? ‘Disappeared’, in the 1970s Argentine sense of the word?

    What percentage of what would have been public* wealth in the past isn’t there anymore? Or never came to be?

    *(Including non-government pension funds and other pots of wealth that are nominally private, but which serve the people as a whole?)

  9. rfam

    If the pension obligation is pari passu with the debt the assumed rate of return should be the same as the rate on muni bonds of the issuer (pre tax).. I think.

    1. Jim Haygood

      Barclays Municipal California Index has a 2.66% yield to maturity, and a 1.98% yield to worst (assuming that call provisions are exercised, which they probably will be). See “Index Characteristics” in link:

      If Calpers’ obligations are discounted at such miniscule rates, the results are just too awful to contemplate. So we won’t go there, okay?

  10. MikeNY

    Good piece.

    Politicians keep kicking the can while Mrs Magoo keeps flogging the carriage horse till its hide falls off.

  11. perpetualWAR

    All the talk of pension funds on this blog has ignored one very obvious fact: the pension funds are heavily invested in the mortgaged-backed securities. Why is this important? Because all judges pensions are tied to the performance of these toxic mortgages sold by the crooks. So, what does that mean? It means that every single homeowner is prejudiced by where the judicial pensions are vesting their money. No one is writing about this.

    Many WaMu mortgaged-backed securities were sued by Washington State Investment Board (and other pension managers from multiple states).

    How many homeowners are getting truly unbiased and fair judicial decisions= NONE.

  12. polecat


    Hey Mad-Eye Moodys**…here’s one…….’.WATER IS WET’

    **warren’s step-spawn

  13. Sluggeaux

    Thank you for this thoughtfully written post. The central problem here is that American society has abandoned the rule of law and the sanctity of contract.

    This is the way of the spoiled, entitled, petulant, and narcissistic children who have inherited the control of our institutions without making the slightest sacrifice or struggle. Four-time bankrupt Donald Trump’s likely running-mate, Chris “Pugsley” Christie, has already successfully asserted that pension promises are made to be broken. His New Jersey government bargained with state workers to mutually increase pension contributions, but failed to uphold the state’s end of the bargain. Christie’s flaunting of contracts negotiated with employees who were acting in good faith was validated by the New Jersey courts; the U.S. Supreme Court has denied cert.

    FluffythObeseCat has it right — strategic bankruptcy, legislative corruption, and judicial laziness will cause America’s wealth to simply go “poof” — up in smoke. Rounds of golf, fractional jet ownership, old cars, ostentatious homes, and dans-le-vent works of “art” are not going to be worth their weight in potatoes when liquidated to rebuild our vanished industrial infrastructure.

  14. Paul Tioxon

    Considering the Great Downsizing preceded the Great Recession by decades, wages, benefits in addition to pensions, have all contributed to corporate growth rates, if not employment rates and income equality. Yet, productivity continued to climb as shareholder value and management claimed a disproportionate share of the wealth produce creating the financial inequality. And one of the worst aspects that seems to almost guarantee underfunded pensions is corporate cash horde going towards shareholder buybacks. While it certainly makes no sense to add capacity when your business can make all the market can absorb and there are no new markets to open that allow for expansion and the jobs that would bring, it is the death warrant for wages and pensions to send cash into share buybacks.

    One answer, to balance out this inequality, would be to pay a national productivity dividend, NPD tied to productivity gains and cash that was diverted from wages or job growth. We have an existing channel for just this purpose based on labor participation, it’s called Social Security. The US Treasury can deposit on a quarterly basis a NPD into the Social Security Trust Fund, for immediate disbursement, not something that can be securitized and used to mask revenue shortfalls of the Federal Government. Share buybacks represents the destruction of capital by the corporation that transfers cash off of its balance sheet and pays it shareholders in exchange for surrendering shares to the corporation. This would be an income subsidy raised without taxation but based upon the very real cash value of destroyed shares bought back by business, which annually has exceeded over $Trillion in recent years. Real productivity gains, no taxation, real money placed directly into the hands of Social Security participants, looks like a way forward!

  15. NotSoSure

    The fact that public pension plans as a whole were adequately funded before the crisis is a stark reminder that the “rescue the banks” plan has come at the expense of savers and retirees.

    But isn’t it also true that the 95% figure was also an illusion enabled partly by irrational exuberance of the banks?

    What the banks giveth, the banks taketh away?

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