Pension Plans & Chasing Yields

In New Jersey, the pension plan for teachers is badly underfunded, to the tune of $10 billion:

“The state shortfall for teachers’ pensions has grown to $10 billion, an actuary reported Thursday.

“The latest report shows a $1.8 billion, or 22%, increase in the funding gap since the previous report a year earlier. It means the state, and taxpayers, should pay $1.5 billion toward the teachers’ retirement system this year, but the actual contribution will likely be a fraction of that amount. Gov. [John] Corzine has proposed paying half of the state’s pension obligations this year…

“As the state continues putting less money into the pension system than required, the funding gap has grown. New Jersey has failed to contribute some $1.9 billion in recent years, said Scott Porter, an actuary with Millman Consultants and Actuaries. The funding shortfall from last year alone has added $30 million to the latest state tab, Porter said.

“‘The main culprit is the state, for the last six years, underfunding its commitment,’ said Steve Wollmer, a spokesman for the New Jersey Education Association…

“The $35 billion Teachers Pension and Annuity Fund pays for retirements for some 220,000 teachers.”

We are coming off the biggest housing boom in history, with property taxes soaring, tax revenues up, and four good years in the stock market and the N.J. teachers’ pension plan is still $10 billion short, and to top it off, Gov. Corzine wants to fund only half of the state’s pension obligations this year, which will put the plan further in the hole.

Exactly how do they expect to fund this if we have an 18-month recession, and falling stock prices on top of it? Either taxpayers are going to foot the bill or plan promises made to 220,000 teachers will not be met, or some combination thereof.

Illinois

As bad as New Jersey looks, Illinois looks worse. Illinois comptroller Daniel Hynes says, “Illinois State Pensions Continue to Put Pressure on the State Budget”:

“Illinois’ state pension systems continue to be seriously underfunded, with the latest calculations placing the unfunded liability at over $40 billion. As of June 30, 2006, the five pension systems primarily supported by the state…had accumulated $103.1 billion in actuarial liabilities for pension, disability, and death benefits. The systems held assets valued at $62.3 billion, leaving $40.7 billion in unfunded obligations, or a funded level of only 60.5%…

“A key concern for the fiscal year 2008 budget is how to get pension funding back on track with the 1995 funding plan…If the plan is followed, state contributions to the pension systems for fiscal year 2010 will be 2½ times the level of fiscal year 2007 contributions…

“With ongoing demands for increased funding for education and health care, among other state priorities, it will take serious discipline on the part of budget makers to meet the steep funding requirements set by the 1995 pension funding plan based on likely growth of current state general funds revenues.”

Once again, I see a state deep in the hole having failed on a 15-year plan established in 1995 to get out of that hole. One of the problems pension plans faced was the stock market decline between 2000-2003. The same problem is about to hit again. Illinois, as well as every other state, likely has pension returns and revenue growth assumptions that are way too high headed into a recession. The likelihood of negative returns and falling revenues simply is not being planned for by anyone at any level.

Massachusetts

The Boston Globe is reporting, “Assets of 35 Pension Systems Are Targeted”:

“The assets of 35 pension systems, including those of Plymouth County, the Essex Regional Retirement Board, Newton, and Andover, would come under the control of a state trust in a proposal by the [Deval] Patrick administration to boost returns, improve pension management, and provide fiscal relief to cities and towns, according to a new analysis prepared by the state retirement commission…

“Several of the worst-performing systems have begun moving into the state fund. On Jan. 1, the city of Fitchburg, for instance, put $44 million of its total retirement assets of $86 million under state control. For the five-year period ending in 2005, Fitchburg posted one of the worst investment performances in the state, 3.35% a year. By contrast, the state retirement fund posted average annual returns of 7.04% during the same period.

“Richard N. Sarasin, chairman of Fitchburg’s retirement board, said one goal is to reduce the $6 million a year the city currently must commit to future benefits, a significant part of the city’s roughly $90 million annual budget. The greater the returns generated by investment, the smaller the contribution the city must make out of its annual budget.

“‘If you can’t beat them, join them,’ Sarasin said…

“Boston’s retirement system would remain under local control if the Patrick administration standards were applied to its performance from 2001-2005. Boston had 20,456 active members and 14,034 retirees, according to its most recent figures as of Jan. 1, 2006. Its funded ratio, the money needed to cover future payments to retirees, was 62.4%, well below the 80% level required to remain independent by Patrick’s proposal. It also earned significantly less on its $3.7 billion portfolio — 4.96% a year over the five years — than the state’s return of 7.04%. But under Patrick’s proposal, only those systems earning 4.79% or less over those five years would have to be taken over…

“Pension attorney Michael Sacco, who represents more than 10 of the boards on the list, including Natick, Plymouth County, and Andover, defended the performance of the boards. He called the administration’s method for weaning out poor-performing systems ‘an overly simplistic approach to a complicated issue.’

“For one thing, he said, the smaller boards are restricted from certain types of riskier, high-return instruments that the state can invest in, such as hedge funds or real estate portfolios…

“Officials in Arlington say they are in talks with the state board to take over retirement assets. Citing the state’s healthy returns, Town Manager Brian F. Sullivan said, ‘You have to question why wouldn’t it be to the town’s advantage to do that.'”

Chasing Yields

Massachusetts is taking a different approach to the problem: “If you can’t beat them, join them.” That plan has an alias name of “Chasing Yields.”

As we have seen with subprime lending, chasing yields works until it doesn’t. And somehow, in just a few short years, the memories of 2000-2001 have faded away. The current consensus is that subprime woes will not spread, housing has bottomed, there will be no recession, and any pullback in the stock market will be temporary.

I guess everyone is listening to Mr. Bubble (Greenspan) when he says, “Subprime Spillover Unlikely”:

“‘I think it’s important to recognize that what we’re dealing with…is more an issue of house prices than it is mortgage credit,’ Greenspan said at a Futures Industry Association conference in Boca Raton, Fla.

“Greenspan said that as home prices dipped, ‘subprime borrowers have not been able to build up enough equity.’

“If home prices drop in a year, he predicted that could cause the problems to ‘spill over into other areas.’

“At the moment, we’re not seeing this,’ he said. ‘The spillover is just not there’…

“However, Greenspan said if home prices ‘would go up 10%, the subprime mortgage problem would disappear.'”

If home prices would go up 10%, the problem would not go away. The problem is people bought houses they cannot afford at prices that were ridiculous. If home prices rose 10%, there would still be no one able or willing to afford them. It’s comments like those from Greenspan that seriously make me wonder if he is senile. Just when I am convinced he isn’t, he actually says something that makes some sense:

“On another matter, Greenspan repeated a warning about the massive strain on the U.S. budget and the economy in the future from the looming retirement of 78 million baby boomers, who will draw benefits from Social Security and Medicare.

“He called the pending retirements ‘one of the seminal events in the first part of the 21st century in the United States’…

“‘There is a significant probability that under existing law, we have overpromised what will be available to Medicare recipients,’ he said.”

Yes, we have not only overpromised, but we have also underbudgeted, and pension plans are starting to chase yields in a foolish attempt to catch up. I find it amazing how quickly even recent lessons are forgotten and current lessons (subprime) are dismissed outright.

Advice From Mom

Here is some practical advice from someone who goes by the name of “PolymerMom” posting on my board on TheMarketTradersabout the risks of chasing yields. It seems a pension plan change where she works caught her by surprise…

“Earlier this year, I received a note saying the core bond fund in my 401(k) was changing to a new bond fund this year. They nicely transferred the old holdings to the new fund without any cause for action on my part.

“The return looked impressive: ~4.5% vs. ~1.6%. Both were int. term (2.5-5 years duration).

“They finally got around to posting the new fund’s top 10 holdings and percent asset categories. The new fund is almost 37% invested in mortgage securities. The old was only a tad over 1%.

“So I moved my holdings to a money market fund from the new bond fund today. Imagine my surprise when the value of the [new] fund had dropped almost 13% from Friday to today! [March 2-5]

“The HR analysts were chasing yields without a thought as to risk. I wonder how many will even realize what is happening…”

Advice from Mom:Always check a new 401(k) fund ASAP!

Thanks, Mom!

Unfortunately, those in state pension plans do not have the luxury of spotting mistakes like that. If someone managing a government plan decides to chase yields, invest in swaps or emerging markets or real estate, or even if the state chooses not to fund the plan at all, there is little one can do about it. This adds up to yet another huge problem that is coming our way as returns over the next few years are unlikely to be anywhere near as good as those plans expect.

Regards,
Mike Shedlock ~ “Mish”

March 19, 2007