(Bloomberg Opinion) -- The shock of U.S. state and local pension fund losses in 2008 led to a flurry of reforms. These may not have actually improved aggregate funding ratios, but they did stop the decline. However, we should remember Alexis de Tocqueville’s maxim, “experience teaches that the most dangerous time for a bad government is usually when it begins to reform.” In the next recession, the reforms of 2008 – 2016 may prove the undoing of a system that has staggered along for decades.
Of course, this might not happen. The next recession could be mild, or perhaps the current system will prove resilient. It would still be very painful, of course, to public sector workers, government creditors and taxpayers, but alternative ways of resolving underfunded pension funds might be more painful. So while there are no clear solutions, it’s plausible enough that we should start making contingency plans if a collapse occurs.
Much of the focus has been on the funding ratio of pensions, which is the ratio between the value of assets in a fund to the present value of its liabilities. But this is a theoretical calculation that depends on several hard-to-estimate parameters.(1) Moreover, it only tells us that at some point in the future either someone will have to kick in more funds or promised benefits cannot be paid. It doesn’t tell us when that will happen. Funds can survive for decades—perhaps forever—without full funding.
I’ve argued before that it is shorter-term cash considerations that pose a danger for pension funds, and that the system will not suddenly blow up, but rather slowly unravel. Looking at aggregate numbers is misleading, as a crisis will be triggered by the funds in the worst financial shape, not the average fund. It is possible for an optimist to hope that aggregate pension assets could cover aggregate benefit obligations with perhaps a few only mildly painful adjustments. But even if that’s true in aggregate, if enough of the 6,300 state and local pension plans fail, it will cause legal and political changes that will likely end the current system of partially funded defined-benefit plans for public sector employees. That could happen in the next recession.
The most fundamental reform after 2008 was to restrict the gold-plated benefit plans to existing employees, and tighten the requirements to qualify. The result is that for many employees, the new rules deny them, or make it less likely they will qualify for, full pensions. That’s a problem because new employees often make contributions that exceed the actuarial value of their benefits—especially if those benefits are discounted for the chance that they will not be paid.
In past recessions, public sector unions have been united behind the current system, deploying potent political weapons from their prestige, strike threats, member votes and money.(2) But as unions accumulate more members who would prefer private-sector style portable 401(k)-type plans or social security, their cohesion may be tested. Moreover, as the system is threatened, even members who qualify for top benefits may prefer the security of cash in a retirement account to the uncertainty of benefits that may be cut or taxed away.
On the investment side, the main change was a movement into alternative assets to reduce exposure to equity risk. Since 2000, about 30% of the S&P 500 Index’s gain or loss has been reflected in pension fund asset returns, based on my calculations from Department of Labor and Pew Charitable Trust data. But starting in 2012, the percentage dropped significantly as pension fund assets were moved from equities to alternatives such as real assets and market-neutral hedge funds.
While this was certainly a good idea, it was unfortunately adopted during a bull market. The reduced exposure to equities caused pension funds to lose about 15% relative to what they could have earned with their old, equity-heavy allocations. Sadly, but predictably, five years of underperformance caused funds to revert back and since 2017 have had more exposure to equities than in 2007. Moreover, this was not accomplished by abandoning alternatives, but by putting more into high volatility alternatives such as private equity with even more exposure to equity than the S&P 500.
Although these changes can be seen in most pension funds, they have gone the farthest in the most desperate plans. Therefore, in the next recession we can expect states such as New Jersey, Illinois, Kentucky and Connecticut, along with cities such as New York, Chicago, Philadelphia, San Francisco and Honolulu, to experience outsized pension fund losses and face disunited public sector unions.
The 2008-2009 recession caused a number of government bankruptcies, including Detroit and Puerto Rico, plus a few dozen smaller ones.(4) These were enough to force reforms on pension plans, but not to overturn the system.
But what if it’s New Jersey, Illinois, New York City and Philadelphia defaulting in the next recession?(5) These are all high-tax jurisdictions with declining middle-class services. When you toss in another reform since 2008, the restriction of federal income tax deduction for state and local taxes, it seems unlikely that taxpayers and citizens can kick in much to solve the problems; or that elected officials will ask them; or that they will stay put if asked. Their pension funds won’t run out of cash in a year, but they might decline so that they will no longer last the decade, at which point union members might be willing to trade benefit cuts for security that benefits would actually be paid. That means the battle will be between united and determined creditors—who are never liked—and disunited public sector unions in some public disgrace for protecting the disastrous plans.
Governments need creditors to continue lending, but they might feel they could survive without the kind of public sector unions that evolved in the late 20th century.(6) Once a precedent is set to cut benefits in enough big cities and states, every city and state will want to take advantage. There will be little opposition, since if the gold-plated benefits are not certain, government employees will prefer safer, if smaller, alternatives.
Of course, it’s possible that the system will survive the next recession. But the slow-acting effect of the reforms of the last decade will gradually erode the foundations of the current system.
(1) Most important is the real return on fund assets and the growth path of fund liabilities.
(2) I don’t discuss it here, but another relevant reform was making it harder for public sector unions to collect money from members for political activities.
(3) Pension fund obligations were just a part of the problems in these places, recessions also cause reduced tax revenues and increased welfare payments.
(4) States cannot declare bankruptcy under U.S. law, but some kind of workout procedure would be followed.
(5) It’s true that government pensions have some strong legal protections in 48 of the 50 states, from state constitutions to being declared some form of legal property. But in Puerto Rico and Detroit these weren’t absolute defenses against benefit cuts. They will likely help public sector unions get a better result than they would otherwise, but I don’t think they will stop the unraveling.
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This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
Aaron Brown is a former managing director and head of financial market research at AQR Capital Management. He is the author of "The Poker Face of Wall Street." He may have a stake in the areas he writes about.
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