Municipal Pensions are Now Dead (We Need to Acknowledge That)

There has been no official reporting yet on the health of public pension funds now that the Dow has lost a third of its value. Let me save you the suspense: financially, they are finished. The only thing that remains is the underlying obligation to pay them, and we’ll see how much that is worth in the months and years to come.

I don’t applaud this. In fact, I find it to be a tragedy on many counts. While there are fantastic stories of people rigging the system to receive extraordinary benefits, those are anomalies. Nearly everyone getting a public pension from a local government is receiving a modest benefit earned over a long period of service and, often, sacrifice. Most of those people depend on the pension for their daily needs. This is a tragedy.

The Dow has lost nearly a third of its value in the last month.

In prior years, we could pretend that pension obligations would ultimately be paid. Much like the insolvency of a country like Greece or Italy, on paper it was obvious that there was no way to make good on these promises. Yet, like Greece and Italy, we continued to find ways to patch things together and carry on another day.

One of the ways that patching happened was to take on additional risk within the pension portfolio. My own state of Minnesota, which was one of the better-managed public pension systems, was recently only 75% funded assuming an 8% annual rate of return. In a market environment where the so-called “risk free” rate of return from a government bond was in the 1% range, how would a public pension fund ever achieve an 8% annual return?

There is only one way: By taking on a lot of risk.

We’re already seeing how corporations are asking for bailouts. In the first of what is sure to be many unprecedented moves, the Federal Reserve is stepping beyond their authority to purchase corporate bonds. It is this market—the corporate bond market—where the most fragility seems to sit, and pensions have had a huge role in that.

Following the 2008 financial crisis and the bankruptcy of Detroit, public employee unions began pressuring states to put more money into shoring up their pension funds. Again, nothing nefarious here; it’s logical and exactly what states should have done (although they should have done it decades ago).

Unfortunately, these catchup dollars were being invested at a time when interest rates were manipulated to be artificially low. The billions pouring in from pension funds only drove these rates down further as more and more dollars were competing for places to get a return. It was a negative feedback loop that only made the situation more desperate.

Much of this money was used to purchase corporate bonds. For example, Boeing saw its debt climb from $6 billion at the beginning of 2009 to $20 billion to begin the year. Much of that money was borrowed from pension funds. The pension funds chose Boeing, and other corporations, because of the higher return on offer.

Boeing 737 Max 8. Two crashes within six months led to the suspension of production. Image credit: Wikipedia.

Note that this was very defensible, at least from the pension fund’s standpoint. Last summer, amid the 737 MAX crisis at Boeing, Moody’s still had their bond rating at A2, an investment grade rating with low credit risk. On the surface, this was not exactly a high-risk kind of investment.

I’ll also pause here and state that I’m fairly certain most pension funds were also using leverage here for these purchases. Minnesota (well run) needed 8% returns and could not take huge risks with grandma’s pension. Boeing debt was paying higher than risk free, but at investment grade, was not paying anywhere near 8%. The way you make up that difference is to borrow at a low rate (which pension funds can do) and then lend at a higher rate. This magnifies the return on those bond purchases, but also magnifies the losses when it goes bad.

Back to the story: What did Boeing and other corporations do with that money they borrowed from public pensions? They used it to buy back their own shares. And did they do this because the shares were cheap? No, the shares were ridiculously expensive by almost any measure. They did it because executive compensation was tied to share price and, in the absence of any real growth, borrowing billions to buy your own shares is a great strategy for jacking up your share price (and increasing your compensation).

Federal Reserve Bank in San Francisco. Image credit: Unsplash.

Desperate pension funds loaned corporations hundreds of billions of dollars a year for a decade, money they need to pay pension benefits. Those corporations used that money to artificially juice their stock prices, to the benefit of investors and executives. All that artificial wealth has now been destroyed. Corporations that engaged in these practices are going to go bankrupt—should go bankrupt—and all that debt will be defaulted on. Insolvent pension funds are now even more broke.

The most optimistic scenario at this point is that the Federal Reserve steps in and buys up all these failing corporate bonds, essentially taking the risk off the lenders (including pension funds) and giving them back their cash. That’s the most optimistic scenario, and it’s really not clear if this will work (early indications are that it won’t—there is just too much debt).

So where do the required 8% returns come from? Public pensions are massively underfunded and need those returns to have any hope of extending this run a little longer. Where are those returns?

They don’t exist. They will not exist again for the foreseeable future, at least not in a form a government can invest in good conscience (near risk free). And for the pension funds that took on margin to juice their returns, they are doubly screwed.

Municipal pensions are dead.

We need to admit this for two reasons. First, we need to have an honest and forthright conversation about what to do with all the people who are counting on these pensions. I don’t care what they were promised—those were impossibly bad deals made decades ago, and we can’t fix that now. I’m talking about what the human thing to do is. Some people are going to suffer and way more are going to have their expectations radically altered. The sooner we sit down and have that conversation, the more humane we can be in its resolution. This is no longer a city obligation; it’s beyond that.

Here’s what I wrote in my book, Strong Towns: A Bottom-Up Revolution to Rebuild American Prosperity:

During difficult budget cycles, government employees voluntarily agreed to give up salary and benefit increases. In exchange, they received promises of increased future pension benefits. This was perceived as a great exchange because, of course, the economy was going to continue to grow, the future would be more prosperous than the present, and there would be far more resources to pay those pensions when they came due. Who is now responsible for the failure of that gamble is a question as unsolvable as it is morally ambiguous.

That moral ambiguity can no longer be wrestled with at the local level.

The second reason is that we need to free our cities from these legacy shackles so they can lead us out of this crisis. Our cities are the centers of innovation in this county. And I don’t just say that in a big city context. We are going through a reset we’ve long talked about here at Strong Towns, one that will shrink the footprint of cities big and small back to something financially productive and economically viable. Our local leaders need the flexibility to innovate.

Unpayable public pensions are a legacy of the centralization brought about by the Suburban Experiment. Freeing our local communities of this burden is the quickest way to rebuild our economy. Stop bailing out the top and start shoring up the bottom by letting our local leaders lead us out of this crisis.

Top image via Unsplash.

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