Greece is not Germany, and California is not Vermont
Last week Gillian Tett of the Financial Times picked up Meredith Whitney’s municipal bond doomsday flag and started waving it for an international audience. Her article, entitled “Pension gap spells trouble for muni bonds,” broadly painted the entire municipal bond market as having unacknowledged, long-term issues. Her closing line seemed to be a call for investors to shift their concerns from European sovereign debt to the debt of muniland:
Fiscal woes, in other words, are not just a matter for the eurozone; investors had better keep watching that American periphery too.
I agree with Ms. Tett that it is important for investors to dig down into the affairs of municipal bond issuers. Like the nations of the European Union, the quality of fiscal management varies by state. The U.S. has a number of well-run Germanys and we also have a handful of Greeces.
The problem with Tett’s piece is that it both used some less-than-credible sources to assert that unfunded public pension liabilities are an enormous problem and failed to distinguish California from Vermont. For example, this graph shows the combined state and local pension fund expenditures of the country overall and the nine states that devote the highest share of their annual budgets to their pension plans (source: U.S. Census Bureau via the National Association of State Retirement Administrators, page 3):
According to the National Association of State Retirement Administrators (NASRA), the national average for state and local government pension contributions is 3 percent:
Based on the most recent information provided by the U.S. Census Bureau, approximately three percent of all state and local government spending is used to fund pension benefits for employees of state and local government… pension costs since 1980 have been reliably stable, declining from around four percent to nearly three percent in 2009.
That said, there are states and local governments that have severe pension problems. Unlike Greece, which was forced to make pension changes to receive a bailout, almost all state and local governments are taking voluntary steps to reduce their pension liabilities. The case law for reducing and removing pension benefits is becoming well established. A lot of adjustments to pensions and state budgets are being made already. This was a great comment on the FT piece:
Pensions can be renegotiated, as most debt is often renegotiated. A couple of years ago several analysts were predicting multiple state and municipal bond bankruptcies with massive dislocation in the financial markets, but there have only been a few bankruptcies. It will be painful, but states are making big cuts in their expenditures in order to balance their budgets. Many of the states will end up telling their pensioners that they can only pay them 50 to 75% or another percentage of what they are owed.
At this point the pensioners would have the choice of taking what is offered or suing in federal court. The barriers for an individual to sue a state are massive, but it is possible that a class action lawsuit could be brought against one of the states. But there would be strong motivation for both sides to settle, as the risk of leaving a decision in the hands of the court would be too risky for either party. A lot of this debt will jut [sic] be erased, to the detriment of the citizens but probably not the bond holders.
My biggest beef with Tett’s piece, though, is the use of the research of Joshua Rauh of Northwestern University. Rauh insists that when projecting pension fund returns, the interest rate for 10-year Treasuries must be used. Pensions do not allocate their assets 100 percent into Treasuries, though. The Public Fund Survey found that 99 of the largest pension systems allocated only 28 percent of their assets to the entire fixed income market. Because pension portfolios have diverse assets, their returns can fluctuate quite a bit. NASRA reports that for fiscal year ending June 30, 2011, state and local government retirement systems had a median investment return of 21.6 percent.
Here is the core problem with Rauh’s work, according to NASRA, page 1 (emphasis mine):
Over time, a majority of public pension fund revenues come from investment earnings. [Rauh’s] paper assumes state and local pension trusts, which currently have $3 trillion in assets, will generate investment returns roughly commensurate with bond investments rather than the diversified portfolios actually in use.
Public pensions typically assume that such diversified portfolios will earn a real (after inflation) return of 4.0 to 4.5 percent annually, depending on their asset mix. Long-term investment returns actually exceed this assumption, even after incorporating losses from the 2008 market decline. Yet, the Rauh-Novy-Marx paper assumes these portfolios will generate a real return of only 1.71 percent, well below not just historic norms, but also below projections made by investment experts, as shown in Figure 1. The result of this bearish assumption for pension plans is lower investment earnings and higher required contributions.
It is appropriate to point out individual states and municipalities with pension problems. But given that over 50 percent of municipal bonds are held by retail investors, a broad-brush criticism of muniland can easily spook the market and create a sell-off. Dig down and do the analysis. Greece is not Germany, and California is not Vermont.
Public Fund Survey: Scorecard
Government Accounting Standards Board: Fair Value Measurement
Morningstar: States Positioned to Avoid Default
Storms and Nation: More Pension Math
Sacramento Bee: Dan Walters: Pension battlefield shifts to San Jose and San Diego
Bloomberg: Cuomo Urges New York State Mayors to Take Fight on Pension Overhaul Home