<< Read Part 4: Angst in America: Disappearing Pensions
“The ship of democracy, which has weathered all storms, may sink through the mutiny of those on board.”
– Grover Cleveland, the 22nd and 24th president of the United States
“It is your concern when your neighbor’s wall is on fire.”
– Horace
“The biggest mistake investors make is to believe that what happened in the recent past is likely to persist. They assume that something that was a good investment in the recent past is still a good investment. Typically, high past returns simply imply that an asset has become more expensive and is a poorer, not better, investment.”
– Ray Dalio, Founder, Bridgewater Associates
When you spend a couple of decades writing weekly letters to hundreds of thousands of people you think of as friends, your readers naturally come to associate you with a few key ideas. I have certainly become known for at least one. My longtime regular readers think of me as the “Muddle Through” guy. That’s not an image I have tried to cultivate, but I have it anyway.
I have to confess that it’s usually accurate. In a typical letter I will describe some sort of potentially scary problem, explain what might happen, then conclude that we’ll probably avoid the worst and muddle through. That has almost always been the right call. The worst doesn’t happen, and we all survive. “Muddle Through” can mean widely varying outcomes for individuals, but for the world at large, things generally work out OK.
As a statistical matter, this stance makes sense. The extreme tails of any distribution curve comprise outcomes that almost certainly won’t occur. The most probable outcomes cluster around the fat middle.
Yet there is one problem that is very definitely coming our way that I really don’t think we can Muddle Through and where even the middle-of-the-road scenarios are terrible, and that’s the public pension crisis. I really see no way it can end well. It’s going to hurt just about everyone.
“But wait,” my Canadian and German friends will say, “that’s an American problem. Leave us out of it.”
I wish I could. The sad fact is that the US is the big fish in the global economic pond. One way or another, our problems affect everyone. You catch cold when we sneeze. The “Disappearing Pensions” crisis I described last week will hurt you, too. The only question is which transmission mechanism will bring it to you. Further, most developed countries have their own version of the pension crisis in the form of government promises that can’t be kept. Same song, different verse.
Today I want to delve a little deeper and explain why pension angst is completely reasonable and not at all overblown. If anything, it has been understated.
But first, it’s getting close to the last call if you want to attend my Strategic Investment Conference, May 22–25 in Orlando, Florida. I am told we are down to 35 spots still available. When those are taken, we will create a waiting list, as we have done the past two years. There are always a few last-minute cancellations, but there are not enough to allow everyone on the waiting list to attend.
If you haven’t yet secured your spot, you seriously need to take a look at who’s going to be speaking. Some of the best geopolitical, economic, and social commentators from around the world will be joining us to focus on how the world is going to evolve over the next 1–5–10 years. The theme of the conference is “Paradigm Shift: A Destabilizing World.”
And this is not just a series of lectures: We have designed the program to be interactive between the speakers and the audience. There is no other conference that I am aware of that so aggressively encourages such interaction with the speakers. So stop procrastinating and arrange to take a look.
Most pension fund analysis focuses on funding levels, i.e., the assets a plan actually has versus how much it should have at a given point, based on actuarial analysis of future liabilities and assumptions about future contributions and investment returns.
Funding levels are important. They are a useful canary in the coal mine – but only to the extent that the responsible parties pay attention to them and respond correctly. No such thing is happening. Worse, the assumptions that are being made mean that funding levels probably understate the coming disaster.
Yes, disaster. I use that word because I don’t have a stronger one that I can use in a family-friendly letter.
Let’s make this simple. The “defined benefits” that any DB plan will eventually pay its beneficiaries come from two sources:
1. Cash contributions, mostly from the employers but often from workers, too
2. Interest, dividends, and capital gains earned on the investments into which those cash contributions are placed.
That’s it. There is no pot of gold at the end of the rainbow. There’s not even a rainbow. Every penny that every retiree receives from every DB plan comes from those two sources. Unlike the federal government, cities and states can’t mint currency by fiat. No magical ponies will come pulling carts full of cash to bail out the pension plans. (We do that only for banks.)
The problem is that, with few exceptions, neither source is producing at the level necessary to deliver the promised benefits. In many cases there is a vanishingly small chance they ever will produce enough. And the longer we go without fixing the problem, the smaller the chance becomes.
In each municipality and state, a few hardy souls are jumping up and down and screaming about the coming crisis in their locales. But when politicians do pay attention, the required actions are so painful that they conclude there is very little chance of anything substantive being done. And so they do nothing. The sad fact is that even actions that would fix part of the problem are often pushed away.
There is a perverse logic to this failure to act, and it has to do with the Merciless Math of Loss.
We’ll start with contributions. The amount a city or state agency must donate to its pension plan(s) is a function of the promises made to its workers, typically in union-negotiated contracts.
The unions naturally want as much as possible. The employer wants to contribute as little as possible. Fair negotiations should produce a number acceptable to both sides – but that assumes negotiations are fair. Often, they aren’t.
Here we must recognize a practical distinction between public and private. In theory, a city council is responsible to its voters just as a corporate board is responsible to shareholders. Yet the relationships are quite different.
Corporate board members are generally themselves shareholders, who share in the gains or losses their choices cause the company, and there is actually quite a bit of legal liability attached to being on a corporate board. The more happy and productive the board can keep the workers, the more valuable their shares will be. City council members, while residents in the communities they represent, don’t gain or lose monetarily from the contracts they approve. Their incentive is to garner political support that leads to re-election or advancement to higher office.
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