Public Employee Pensions: The Next Black Swan?

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In our post-Financial Crisis world, the term, “black swan” is not uncommon.  It gets tossed about by financial pundits frequently, typically to describe future scenarios that have the potential to rock financial markets.  The phrase was used as far back as the 2 century to describe an impossibility, as it was believed at the time that black colored swans did not exist.

Later, when black swans were actually observed in the wild, the phrase took on new meaning, instead connoting the idea that a perceived impossibility may, in fact, be possible.

Author Nassim Taleb brought the phrase into common parlance in 2001 with his “black swan theory,” which he used to explain rare but disproportionately impactful events that are extremely hard to predict.  Some of the most famous events that have been described as “black swans” include the start of World War I, the dissolution of the Soviet Union, the September 11, 2001 attacks, and of course the collapse of the housing market that triggered the 2008 Financial Crisis.

Interestingly, the latter example was only a “black swan” to some.  For more astute observers in the financial markets, it was an obvious inevitability.  The imbalances that developed in the run-up to the 2008 Financial Crisis were difficult to ignore, and for some market participants, the situation offered a “can’t lose” opportunity to profit from the correction of these imbalances.  It wasn’t so much a matter of “if” but rather a matter of “when.” 

The next “black swan” event may be even more obvious.

I am referring to the impending public employee pension crisis that is currently gathering steam in states and municipalities across the country.  While it may or may not be the next major event to roil financial markets (who knows what could happen tomorrow?), there is no doubt that the underfunding of public pensions will ultimately have a major effect on the U.S. economy and the markets at some point in the future.

But what makes this situation so peculiar is that there really is no uncertainty regarding the probability of this eventual reckoning.  Like the housing market collapse, it seems mathematically unavoidable, and the question remaining is just a timing question.  And yet, the markets, politicians, and the general public seem to be ignoring it as though it simply can’t or won’t happen.

Black swan indeed.

Much has already been said and written by some about the large and growing danger that underfunded public employee pensions pose to the U.S. economy.  A colleague of mine has written extensively on this topic, examining the broader issue here and delving into the specific issues facing the state of Illinois and the city of Chicago here and here.  If you wish to take a more in-depth look at the issue, I encourage you to read my colleague’s work.

Whether you are an investor, pensioner, or taxpayer, I think the following considerations regarding public pension underfunding are worth remembering.

The problem is bigger than everyone thinks.

Politicians and government officials have finally begun to talk about the underfunding of public employee pensions in recent years.  The size of the problem necessarily demands some amount of attention from those tasked with managing it.  However, the numbers that these officials typically use when describing the problem would make a snake oil salesman blush.

Officially, the current underfunding of public employee pensions in the United States is approximately $2.0 trillion, a truly staggering figure to be sure.  But even this gargantuan number likely understates the true size of the problem.

Pension obligations are calculated by actuaries who make various assumptions – life expectancy of pensioners, wage growth, inflation, and future investment returns, among others.  Future investment returns are an especially important input in these calculations, as they play a major role in determining how much states and municipalities must contribute to pensions now in order to fund future benefits.  Higher investment return assumptions result in lower contribution requirements on behalf of governments.

Currently, state and local governments use an average expected return assumption of 7.0% to 7.5% to calculate pension funding needs.  Given that we are more than nine years into a bull market and the second longest economic expansion in U.S. history, and with interest rates still low by historic standards, assuming annualized returns of 7.0% to 7.5% seems almost reckless.

I have little confidence (maybe none at all) that future returns will come anywhere close to these assumptions.  Using a more conservative and realistic expected return of 4.0%, the underfunding of public employee pensions explodes to the mind-boggling level of roughly $8.0 trillion.  That represents nearly 40% of the current GDP of the United States.

There is no fix for a problem that big.

The situation is getting worse with time, not better.

With Baby Boomers retiring at accelerating rates and retirees living longer, the underfunding of public employee pensions is getting worse each year.  Despite efforts by some state and local governments to bridge the pension funding gaps via tax increases, this slow-moving freight train of a problem is moving in the wrong direction, and it is gathering momentum. 

There is pain ahead for everyone involved.

There is no avoiding the fact that the resolution of this crisis will be painful for a great many Americans.  Indeed, the pain has already begun in many areas in the form of cutbacks in public services and increased taxes.  While I cannot predict how and when this crisis will ultimately play out, I do feel confident in saying that there is likely to be some combination of benefit reductions for pensioners, municipal bond defaults, and, potentially, a Federal bailout of the public pension system.

The public employee pension problem doesn’t really have any silver lining.  It is bad, it is getting worse, and it is effectively unsolvable by conventional means.  However, I write about it because I believe investors need to recognize and fully understand the problem and its potential consequences in order to ready themselves for the fallout.  When the pension crisis finally does come to the fore and begins wreaking havoc on the economy and markets, many will deem it a “black swan” event that couldn’t have been predicted.

But make no mistake; this black swan is standing right in front of our eyes, plainly visible to anyone willing to pay attention.  I strongly encourage investors, taxpayers, and pensioners to face up to the problem and begin preparing for its consequences before it’s too late.

The views are those of Matthew Blume as of the date of publication and are subject to change and to the disclaimers of Pekin Hardy Strauss Wealth Management.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.