How Government idiocy steals future prosperity for all: The Underfunded Pension scandal

The fix for all underfunded pension liabilities (Scial Security included) is to use a realistic assumption for return on investment. Thomas DeMarco, CFA, FCM Market Strategist in a Market Note today discusses this in some detail.

His analysis is to the point and a must read for all citizens concerned about their financial future and that of their children:

"In a recent Market Note I highlighted the abysmal condition of State pensions and the inappropriate (my opinion) discount rate used to measure those liabilities. At the risk of being overly repetitive I thought I would highlight a few items from another report on the topic, this one titled ‘Valuing Liabilities in State and Local Plans’ from the Center for Retirement Research (CFRR; Boston College).

1. The author agrees that the generic 8% assumed rate of return on investments is inappropriate to PV pension liabilities and instead argue for use of a risk free rate. The paper succinctly raised the following points: “…adopting a riskless rate has clear advantages: it would accurately reflect the guaranteed nature of public sector benefits; it would increase the credibility of public sector accounting with private sector analysts; and it could well forestall unwise benefit increaseswhen
the stock market soars” . I can’t stress the last two points enough.

2. Furthermore, “Benefits promised under a public plan are accorded a higher degree of protection than those under a private sector plan because, under the laws of most states, the sponsor cannot close down the plan for current participants”. Investors should pay attention to this as a recent issue of The Economist bluntly points out that several state constitutions (including Illinois and NY) make state pensions senior to bond debt.

3. In my prior note I mentioned that pension benefit obligations were no longer a distant worry – that a peak in obligations was coming around 2020 (only 10yrs from now).
4. To hammer the point about accurately measuring liabilities and forestalling unwise benefit increases the author points to CalPERS as a poster child: “in 1999, the California Public Employees’ Retirement System (CalPERS) reported that assets equaled 128 percent of liabilities, and the California legislature enhanced the benefits of both current and future employees. It reduced the retirement age, increased benefit accrual rates, and shortened the salary base for benefits to the final year’s salary. If CalPERS liabilities had been valued at the riskless rate,the
plan would have been only 88 percent funded. An accurate reporting of benefits to liabilities would avoid this type of expansion for current employees” (emphasis mine).

5. The author also brings up the point that the discipline of making state and local governments pay the annual costs discourages governments from awarding “excessively generous pensions in lieu of current wages”. I agree in theory, but the problem is a number of states/localities do not make the required annual payments and some even use the most brazen gimmickry to make said “payments” that bondholders should be insulted, repulsed, and afraid (I am thinking of a recent New York proposal to allow the state and municipalities to borrow about $6B from the state pension fund to, wait for it, make their payments to the same fund!).

6. The authors did point out one system that appears to be run more conservatively (outside of the discount rate question): Florida. “Despite being more than fully funded from 1998 through 2006, Florida succeeded in restraining benefit increases through statutory stabilization methods. Article X of the Florida constitution, passed in 1976, requires that any proposed benefit increase must be accompanied by actuarially sound funding provisions. The subsequent addition of Part VII of
Chapter 112 of the Florida statutes stipulates that total contributions must cover both the normal cost and an amount sufficient to amortize the unfunded liability over no more than 40 years. What is more, the combination of an employee’s pension and Social Security benefits cannot exceed 100 percent of final salary. As a result of this legislation, Florida has not increased benefits substantially since the late 1970s”.

Its far past the time for State Legislatures and the Congress to take the obvious lessons from this and reform all Government pension practises.

Mid-Year Update: Taxation should be about raising the maximum amount of revenue for the government in the least economically disruptive way.

Equities of all persuasion saw mid-year losses after a first quarter surge.

MARKET RETURNS

Year-to-date (1/1/10-07/02/10)*
Dow Jones Indus Avg. -7.38%
S&P 500 -8.44%
NASDAQ -7.96%
Russell 2000 -4.23%
MSCI World Index -11.33%
DJ STOXX Europe 600 -6.55%

Year-to-date (1/1/10-07/01/10)
90 Day T-Bill 0.09%
2-Year Treasury 1.46%
10-Year Treasury 5.91%
ML High Yield Index 2.79%
JPM EMBI Global Diversified 5.40%
JP Morgan Global Hedged 4.42%

Year-to-date (1/1/10-07/01/10)
U.S. $ / Euro (1.26) -11.9%
U.S. $ / British Pound (1.52) -6.2%
Yen / U.S. ($ 87.74) -5.7%
Gold ($/oz) ($1,210.68) 10.4%
Oil ($72.01) -9.3%

*Returns reported as of 9:15 a.m. Pacific Standard Time

What accounts for the second quarter downturn?

Various theories are being put forward.
One is that corporations are pulling pro fits forward into 2010 to avoid the higher taxes coming in 2011. Yes, it is still possible to manipulate earnings despite Sarbanes-Oxley, you just have to be smarter than before.
Another possible reason for the decline is the fear of a double dip recession starting early next year. This is supported in part by numerous factors including robbing 2011 results by the earnings manipulations described above, expiration of the Federal economic stimulus (yes, even bad stimulus has some effect on the economy) and uncertainty arising from the fallout expected from the financial reform legislation now pending in Congress and the actual fallout from the health care legislation.
Finally, there is the expectation that corporate earnings and competitive position internationally will be negatively affected by the higher corporate tax rates
in 2011. The often repeated mantra that ‘the more you tax something the less of it you get’ is running into opposition by the Obama administration which is more concerned with ‘fairness’.
Taxation should be about raising the maximum amount of revenue for the government in the least economically disruptive way. Fairness should be addressed on the spending side of the ledger. To mix the two politicizes revenue raising and invites special interests to corrupt the taxation process with social engineering thereby doing greater harm to the economy.

Individual investors have still to be heard from since they are expected to take profits on their holdings before year-end to avoid higher tax rates.
Such individuals may well opt to sit on the cash proceeds from such tax sales until the outlook clarifies. This will only add to short term market weakness.

Despite the fact that Congress seems to be playing a losing hand, they seem unlikely to change course before the November elections.
Should the Democrats lose control of the House of Representatives, we can expect a major market rally since a stalemated Congress would be a welcome relief for the markets.
This may be short lived, however, since a lame duck Congress may well try to finish their agenda before leaving office (think carbon tax or a VAT). In short, equities don’t look promising between now and November and don’t look all that great for next year.

A healthy position in cash and gold still look like safe bets.

Interest Rate Outlook

At mid-year we see ten year Treasuries below 3% and thirty year Treasuries below 4%.

What would possess an asset manager to buy 30 year Treasuries with a locked in yield of 4% when the outlook for inflation over the next few years promises to make this a loosing proposition if not a disastrous one?

The only answer I can devise is fear and special situations.

Fear by those who have gotten burned in the financial crisis and therefore consider credit risk in the short term more important than market risk over the longer term.

Special situation buyers include insurance companies who are matching long term
payout commitments on annuities with the interest payments on the Treasuries.
Other special situation players would be hedge funds playing the carry trade game where they buy these Treasuries with short term loans at 25 basis points. It is this group who represent the greatest threat to the interest rate outlook since they
will unload their positions en masse the moment they see a turn in rates.
This is why I feel an interest rate rise will come suddenly and not be dependant on actual inflation. It may in fact be a cause of the inflation.

Considerable media attention has been given to the municipal bond market in recent weeks.
We see yields on ten year AAA munis going from 3.91% at year end 2008 to 3.25% at year end 2009 to 3.13% at mid-year 2010.
Much of this decline is due to the high demand for tax free munis by individual investors in high tax states as well as generally, given the pending tax rate rises in 2011.
The decline in muni yields is also influenced by the continued perception that munis are safe because they have always been so. This perception is due some re-evaluation.

Municipalities have rarely faced the kind of budget pressures they are experiencing today because of the revenue declines resulting from the recession. Added to this is the retirement of government employed baby boomers, whose pension liabilities have gone mostly unfunded.

This is an increase in current expenditures which is not discretionary and growing rapidly. It promises to create a budget crisis at the city and county level since these entities now face a cash expense they can no longer ignore.
Warren Buffet, who rushed into the bond insurance business during the financial crisis has since backed away. He notes that in the coming budget crunch, municipalities will likely stiff insurers or bondholders before firing employees. Bankruptcy filings may also prove to be more palatable politically than cutting services.
In any case, don’t think that past history is the best indication of what the future holds for municipal bonds.

Thanks to Richard Lehmann at incomesecurities.com and Payden & Rygel [paydenrygel@payden.com]for the data tables

Allstate CEO Says State Borrowing 'Out of Control

This should be no surprise to you, dear reader. “Nobody has the intestinal fortitude to actually move forward to try to change anything,” CEO Wilson said of government debt at the federal, state and local levels. “They’re just sort of sitting there waiting for disaster to happen.” And disaster is exactly what they're going to get.

Read the whole story here:
http://www.bloomberg.com/news/2010-07-07/allstate-ceo-says-government-borrowing-out-of-control-munis-may-suffer.html
or just click on the headline above