“The New Normal” aka Ruin Nation

I have a phrase that I use to describe the current difficulties within state and local governments; I call it “The New Normal.”  The phrase is cribbed from PIMCO, but with me this phrase has a different meaning.  It starts with the difficulties that states and municipalities are having in meeting their budgets.  Much of this stems from pension and retiree healthcare promises.  Much of it stems from a loss of revenues from home sales, sales taxes, and lower income taxes.  In any case, it is a mess, and it is a mess that will get worse.

I suspect that lower sales and income taxes will persist for a little while.  Home prices and sales will be subdued for around 3-5 years.  The oversupply is that great.

But the difficulties from pensions and employee healthcare will last for decades.  States made generous promises that they did not fund.  Like profligate private corporations, the assumed that they could grow their way out of the promises that they had made.  But few considered the possibility that state or local tax revenues could shrink for a protracted period.  Also, few considered that the current cost of pension promises would eventually force its way into government funding.

So now state and local governments are faced with the perfect storm.  With pension and retiree healthcare costs rising, and tax revenues either falling, or not rising so rapidly, that squeezes out money from other public services.  As Roger Lowenstein wrote about in his book While America Aged, the NY Subway system got to the point where pension costs were equal to the cost of wages.  Thus for every employee working, there was another person or more being paid a pension.

That is the present of many American municipalities, and the future of most of the rest.  Few municipalities and states set their pension and healthcare assumptions in a conservative way.  Rather, they let those soft costs slip into the future, compounded with interest and survivorship, while they spent money in other areas that were more pressing.

The bill has come due in some municipalities, and will come due in far more before long.  Here’s that problem: if you engaged in this hopeless game of pushing pension and retiree healthcare costs into the future, it will not do to merely make cuts to meet the present shortfall.  You must get ahead of the curve and fund benefits, or, you can play a colossal game of chicken and say that you won’t pay benefits unless workers and retirees compromise and accept less.  Aside from states, I know that means chapter 9 of the bankruptcy code.  As for states, that could be a constitutional crisis, because states can’t go broke.  But would the Federal Government enforce it?  How?  What if a state decided to secede?  (Oh, wait.  We’ve been through that.  But does Obama have the guts of Lincoln?  No, but who does?)

I’ve seen many articles on this topic recently.  Here are a few:

  • The Union Pension Bailout — Multiemployer private plans are underfunded, and unions are making a grab for taxpayer funds.  Remember that the PBGC guarantees less of the benefits on multiemployer plans.
  • Public Pensions Headed for Disaster — Megan McArdle sounds a theme that I have been sounding for five years or more.   (I have one piece written in 1992, but it is not on the web.)
  • An excellent example of liberal accounting for pensions is California.  I would not want to be the next governor.  The choices will get harder over the next ten years, as retiree benefits overwhelm the budget, and all manner of services get cut, necessary or not.
  • This applies to teachers as well, and pity aspiring younger teachers who can’t get jobs, and middle-aged teachers that have trouble with larger class sizes.  Their agonies support retired teachers with generous pensions — generous because governments would not pay up with salaries in the past.
  • Now, cities can take on unions, but they are limited.  They can’t eliminate past promises, but they can reduce current promises.  Current employees can yell foul, but what can they really do?  Most governments are in this pickle, so bargaining power is not strong.
  • This article is three months old, but it is comprehensive.  It compares the troubles at GM to those of the states and municipalities, and concludes that many unthinkable things are happening today.  Who can tell what will happen?
  • This is not a time to raise risk in pension funding, but many are doing so.  And they accuse actuaries of driving through the rearview mirror?  The pension consultants are worse; the models of investment risk are not as stable as those of insurance risk.  It is rewarding in the short run to take more investment risk; the reward is often short-lived, but the risk has a much longer tail.  The funds that raise risk now will regret it.
  • Though it is long and somewhat wonky, this post by Keith Hennessey is worth reading.  He argues, as I would, that promises to fund pensions should not be watered down.  If you don’t want  larger future insolvencies of pension plans, oppose the efforts to extend payment terms.  It may mean more terminations of pension plans in the future, but that is better than extend and pretend.

A few notes:

  1. Discount rates change the timing of costs, but not the ultimate costs.  A low discount rate forces costs into the present.  A high rate pushes them out into the future.  (“We can earn more over the long haul, so we don’t need to fund as much today…”)
  2. The “New Normal” affects everything municipal.  Budgets will continue to be cut, and employees laid off.  Services will be cut, and morale will fall, but budgets will still rise, as funding for employee benefits expands because it was not properly prefunded.
  3. Learn to do without your local government’s optional services.  Aid that was not dreamed of 50 years ago will slowly be eliminated, and people will need to pay their own way for what they need.

That’s the “New Normal” as the Aleph Blog sees it.  State and municipal governments starve, as pension payments grow.

6 Comments

  • David,

    I did some digging into the rise of ‘New Normal’ last year that you might be (vaguely?) interested in. The conclusion – Pimco took a phrase that McKinsey and WalMart were already peddling.

    If you are interested:
    http://www.datadiary.com.au/2009/10/19/memecheck-the-new-normal/

    Cheers
    Rohan

  • JL says:

    A good (highly opinionated) blog for the real-time death spiral of the pension system is Pension Actuarial by John Bury, a pension actuary in New Jersey:
    http://blog.nj.com/njv_johnbury/pension_actuarial/index.html

  • Rebecca Burlingame says:

    “Aid that was not dreamed of 50 years ago will slowly be eliminated” -The sooner everyone reallizes this, the easier it will be to devise new means of taking care of one another whether money is available or not…ways that do not force people to do this or that, but voluntary structures that do not take away human freedoms.

  • matt says:

    David:

    Why is there a broad impression that States can’t renege on obligations, or that the outcome is so uncertain? We know that Mississippi and Florida officially voided their bonds in the 1840s and a host of other States defaulted.

    I understand that pension obligations are a different animal because they affect people’s lives far more than bond haircuts, but I just don’t understand the frequently argued point about bankruptcy code not being prepared for State defaults. There is precedent.

    As for underfunded pension plans, all I can say is that either the actuaries, portfolio managers, or politicians (or some combination of these) are disgraceful. Defined benefits are NOT this difficult/complicated to fund. Corporations have failed to do it and so has the public sector. I have a suspicion that it has a lot to do with the short term orientation that is being pumped out of American business schools.

    Unfortunately, the solution will be extinction of defined benefits and a total migration to defined contribution.

    That is, the solution on which policy makers will settle is to have people who are poorly equipped to invest, manage their financial capital.

    Imagine if someone came out and said that the solution to health care costs is to have people operate on themselves. Why do we accept this solution for financial health?

  • Matt, good points — there are a confluence of factors that encouraged this malfeasance to occur. The portfolio managers aren’t so much to blame as the fund management consultants, who rely on MPT and past returns of managers being indicative of the future to earn their pay. Thus they tend to underperform, because it is better to fail conventionally, than try to succeed unconventionally.

    The actuaries get some blame, but they are placed in a tough spot. The plan sponsor can tell him the most important assumptions — the actuary could argue with them, but they want to stay employed.

    The politicians and their appointees deserve most of the blame, as they are the ones with responsibility over the finances of the government entity. It is their desire to pander to the public and not pay the full costs in the short run, in order to be more easily re-elected, that is the chief problem — if that weren’t so, the actuary would pick more realistic assumptions, the plan sponsor would pay more in, and investment policies could be less aggressive.

  • Spence says:

    Matt —

    Thanks for a good article.

    As you pointed out, our financial system especially how it relates to pension funding is in serious jeopardy. The high-taxation states seem to be the hardest hit as their tax revenue continue to decline without any spending reductions.

    The net effect is that these states cannot support their looming and immediated debt burden and the pension advisors are caught in pickle. They need higher investment returns to compensate for the lack of additional funding yet it requires an increased amount of risk.