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Public Pension Plans Face Insolvency

February 1, 2013 5 minute Read by Ike Brannon
The Federal Reserve’s unprecedented policy of lowering interest rates to nearly 0% and promising to keep them there indefinitely has certainly had an impact on the economy, although not nearly as much as the fed initially expected or desired. Badly damaged balance sheets at banks and newly empowered regulators, hoping to evade blame should another financial crisis occur, have combined to create a situation where even interest rates near 0% fail to have much of an impact on business loans.  While it’s impossible to measure the precise change in economic activity that has resulted from the historic monetary expansion, few would dispute that it has been relatively slight. However, as with any grand policy experiment, there are always unanticipated impacts. The Fed’s expansionary policies are no different, and one of the unintended impacts has been on the long-term solvency of the various state and local pension plans that are currently underfunded, a category much larger than the one labeled “fully funded.” The vast majority of these were already under-funded prior to the Great Recession, in many instances owing to short-sighted governments inflating benefits for retirees at the peak of the stock market bubble in the late 1990s.  The ridiculously early retirement ages that come with most plans (for instance, in Illinois most teachers retire before age 55) and the lengthening of longevity for senior citizens have only made these problems worse. The Great Recession cratered the stock market, and along with it the value of most pension plans in the U.S. whether public or private, leaving all but the strongest state and local pension plans well short of what is needed to meet the promised benefits to current and future retirees. A number of municipalities in California have already turned to Chapter 9 bankruptcy protection because of oppressive pension obligations, and these are merely the first of many that will likely occur across the country. States do not have recourse to bankruptcy, at least not right now, which could result in a future administration and Congress facing some uncomfortable choices a few years from now if California and Illinois continue on the path to perdition. How have states addressed this shortfall thus far? The operative word would be “timidly.” A few states have implemented minor reforms that mainly serve to reduce pension obligations for future employees, but that is of scant help in the next 30 to 40 years, when most of these pensions are due to fall. Plan B for public pensions has been to chase returns by investing in hedge funds. Rather than passively investing in various stocks or bonds, they have been paying handsomely for the privilege of having various high profile investors attempt to beat the market, usually in vain. While some hedge funds are always wildly succeeding, virtually none of them manage to do that consistently despite the exorbitant cost of their services. Since 2008 the stock market has almost returned to its pre-crash levels, although this is scant consolation for investors who have plans on retiring any time soon. With the stock market roughly in the same place it was in 2000, most people who owned stock during that time have a right to be disappointed with returns below inflation for a 12-year period. The problem that the Fed’s monetary expansion creates for pensions — and many others to boot — is that there is no way for anyone to get decent returns without accepting considerable risk.  Pension managers who attempt to match their pension obligations with the term structure of their investments are going to be forced to buy a whole lot of low yield, short-term government bonds and slightly-higher-yielding long-term bonds, neither of which generate anything near the amount necessary to get back into the black. If states aren’t going to reduce their obligations for the next generation or two, then all that’s left to stave off insolvency is to take some chances — or to hire managers to take those chances on the behalf of the pension. If there is another financial crisis that comes remotely close to the 2008 debacle, we may see no small number of pensions simply going broke, with a tanking stock market (and a surfeit of retirees) making short thrift of their remaining assets. And then we’ll have a problem on our hands that makes the 2008 crisis look like small potatoes.

Author

Ike Brannon
Ike Brannon

Ike Brannon served as an Economic Growth Fellow of the George W. Bush Institute from 2012 to 2015. He has a Ph.D. in economics from Indiana University and a B.A. in math, Spanish, and economics from Augustana College. View his full bio

Full Bio