CalPERS recently reported earnings for the fiscal year ending June 30th, 2016. The results were disappointing, failing to reach their return goal of 7.5% for the second year in a row. The giant pension fund now only has only 68 cents on hand for every dollar in long-term obligations. They are not alone; many public pension funds are facing similar problems.
In general, pensions are considered “fully funded” when they have 80 cents on hand for every dollar in long-term obligations. Under that somewhat generous assumption, CalPERS funding is still short by roughly 15%. Is this a problem?
Why Not to Worry (Sort Of)
CalPERS is currently making adjustments, recognizing that the long term outlook is unsustainable. Significant increases in employer and employee contribution rates have taken effect, and additional rate hikes are always an option.
In the late ‘90’s the tech bubble led many pension experts to assume that future returns would eliminate the need for contributions altogether. Now such optimism seems misplaced from atop the treacherous peak of another massive asset bubble. Instead, they are looking at increasing excessive costs due to lower returns and an aging labor force.
To address this, CalPERS and others are tapping into their own employee’s paychecks as well as their employer’s budgets. This solution, however, has its limits. In some cases, pension obligations are consuming 40-50% of city and county payrolls.
Municipal and state authorities, in turn, are looking to their constituents to help solve the problems. This is no more clearly demonstrated than in Chicago, where homeowners have had year-over-year increases in their property taxes of as much as 63%, as decades of accumulated pension obligations are coming due. Other municipalities are implementing bond sales and increasing the sales taxes to plug the holes in their budgets. They do so by cloaking their desperation with the manipulative refrain “it’s for the kids”. What they fail to mention is that the additional revenue largely goes to alleviate the pension obligations.
In short, CalPERS and similar pensions are have additional sources of capital – and they are tapping into them. Consequently, for now they will continue to make their payments at the expense of the taxpayers.
The Future Of CalPERS
Although state and local pensions will likely increase their inflows, this is only half the battle. Considering the current state of the stock market and the economy as a whole, the funding gap is likely to get worse. The S&P 500 continues to reach all-time highs in spite of weak economic growth and declining profits. With a significant market correction in the offing, it is a safe bet CalPERS underlying assets will decline in value as well. So even though CalPERS currently estimates 68 cents for every dollar in long-term obligations, that number could easily drop into the 50’s in the next recession – close to the dreaded 50% red line.
Taking into account the broader economic picture, things look even worse. The stock market has suffered through two 50% declines since 2000. However, in short order it subsequently shot to new highs. Is it fair to assume that will happen again? It’s possible, but unlikely. The two “recoveries” since 2000 were driven by Central Bank inflationary mechanisms, driving interest rates to near-zero. This is a strange conundrum for the world of finance where the time-value of money no longer has any substantive meaning. “You mean the bank will pay me to borrow money? Hooray!”
More to the point, if the central banks maintain near-zero rates (or negative rates), future returns will be much lower than CalPERS assumed 7.5% number. Given even a 1-2% point reduction in the stated assumption, their funding gap increases dramatically. In other words, as bad as CalPERS current situation is it is likely to face additional challenges in the future.
Conclusion: What to do?
Here’s a few things to consider:
- Current pensioners are unlikely to have their payouts cut, since they make up the largest voting bloc. Not only is cutting benefits to existing pensioners legally problematic even under bankruptcy laws, politicians always want to be re-elected.
- If you have a pension, and you’re still working, it’s not too late to begin funding your own nest egg. We recommend individuals save 10-15% of their net income. “I wish I had saved less” is something we have never heard a client say.
- Consider yourself informed of the challenges facing pensions now (and that includes Social Security). If you are close to retirement, and you had planned on living solely on your pension, consider your options in light the issues facing you. You may not have anything to worry about, but its best to make informed decisions based on the immediate, intermediate, and long-term future implications.
As always, if you have questions about your current options or just want a second opinion, we would happy to help you make an informed decision.
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