An article in today's Wall Street Journal says that California's three biggest public employee pension funds may be currently underfunded by 500 billion dollars. Like all such calculations, the results from this Stanford University study depend on the assumptions used to obtain future assets vs liabilities. However, there is no debate that, after a decade of poor stock market returns America's public pension system is deep in the hole. The chances of getting out of this hole via improved returns are slim.
Take a look at some simple numbers. Say a pension fund contains $100M in April 2000. For simplicity, assume no employee contributions or payouts will occur over the next 20 years. The fund manager projects compounding 8% returns for his assets, not unreasonable given the massive 20 year bull market in US equities. To ensure that 8%, he is invested half in the S&P 500, half in 10 year Treasuries. On April 1, 2010, he expects to have $216M available, and on April 1, 2020, he expects to have $466M, which will be the present value of his future liabilities on that date, thus the fund is 100% funded.
After 10 years, the treasuries are now mature and the fund has $90M from the principal and coupons. The S&P component, including dividends, is worth about $50M, right where it started. Total value of the fund is $140M, $76M less than the earlier estimate. The plan is 35% underfunded. That is a rough estimate of what has actually occurred over the last decade.
What can the manager do to get back to 100% funding, keeping in mind that his is one of many funds in the same situation? Well, he can lobby his local taxpayers to pay more into the plan, but that seems unlikely. The taxpayers are already strapped, and they don't see why they should pay more to support public employees who make significantly more than they do on average. Furthermore, the private sector has to eat any underperformance in their own retirement plans, which are defined contribution rather than defined benefit. So, the taxpayers say, "Hell no, we won't pay more!"
Maybe the manager can ramp up the investment returns to get back to 100%. What return is required to turn $140M to $466M in 10 years? Turns out to be a little over 12% per year, compounded. That seems steep, but maybe doable? There are a couple of problems. Ben Bernanke has driven interest rates down to 4% on a 10 year Treasury note. If the fund manager uses his previous allocation of half and half, he'll need a 16% annual return on the equity side to average 12% return in the fund. In an economy where government debt is crowding out private investment and taxes are rising and health care costs are soaring, 16% seems impossible unless inflation kicks up to about 10% a year. Then only a 6% real return would be required from the stock side, which is more doable. As long as the plan benefits aren't indexed for inflation, 10% inflation over the next 10 years might do the trick. Of course, pensioners would get their check, but it would have lost 70% of it's purchasing power over the last two decades, assuming 3% inflation for the first decade and 10% for the second decade.
Third option; change the fund's allocation with a heavier weighting of risky assets, like stocks or junk bonds. The problem with that is risk increases commensurately and the fund could end up in worse shape than before. Most plans aren't comfortable with increasing risk in search of higher returns, and wisely so. Some may take the chance, and some of those will completely blow up.
Fourth option; the plan defaults on its obligations and pays out whatever is available to members. Kick the plan over to the feds and let them bail it out for the rest. Only problem there is the federal government is in no better shape to pay than the local/state government, unless once again inflation has rendered those payouts less valuable.
So, what's going to happen. Will young workers agree to pay even more onerous taxes to bail out pensions, on top of spiralling healthcare and debt service costs from other government entitlement programs that have ballooned since the year 2000? Not only will they refuse, the demographic curves make them unable to support the larger cohort of retiring baby boomers. It's not possible. Will state, local, and federal governments default, tell public employees, "Sorry, you were lied to and we can't pay?" That would lead to serious discontent among a large group of voters and politicians hate unhappy voters.
Inflation, however, seems very attractive for politicians and younger voters. The retirees would gripe about it, but who do they blame for their loss of value? Ben Bernanke's long gone. Politicians say, it's not my fault, they caused this 10 years ago. Young people aren't as concerned, since their income keeps pace with inflation. They adapt to a world where savings are to be avoided and debt embraced. High inflation will impoverish almost all of the elderly and make them dependent on the state for everything. Over time it will destroy America's savings and capital base, and thus ultimately the work ethic that made America a dynamic economy. But, due to inability to face the tough choices up front, this is the course that Ben Bernanke and the federal and state governments have chosen.