This article was originally going to be titled, “Dying Cities, Dying States, Dying….” I thought that would be correct but too pointy. The key to thinking about pensions is to look at the likely cash flows for current and former employees.
Here’s my scenario: a municipality decides to terminate its overly generous defined benefit [DB] plan, and though it is 30% underfunded, they agree to not let underfunding get greater than 30%. Sadly, the discount rate on the pension cash flows is 8%/yr, but the likely investment earnings rate is 6%/year.
Here’s the graph of pension payments to beneficiaries, and contributions to the plan:
At the beginning of this scenario, pension payments were 10% of the municipality’s budget. Assuming taxes only grow at the rate of 2%/year, contributions to pensions are not less than 10% of the municipality’s budget until 2049. As a share of the budget, it peaks out at 32% from 2032 to 2035. It’s over 20% from 2022 to 2043.
30% underfunding isn’t that uncommon, and discount rate assumptions of 8% aren’t that uncommon either. Would that all municipalities were at discount rates of 6%, or at my more likely view, 4%.
But it doesn’t matter. We can argue over assumptions. The cash flows actually paid to beneficiaries do not rely on assumptions. The assumptions exist to try to allow pre-funding, so that municipalities fund their plans to the same degree that benefits are accrued. Some municipalities have done that with pensions, almost none have done it with retiree healthcare, but the retiree healthcare promise is much weaker one. You can turn it from a Cadillac plan to hospice care, in many cases. In this case the state constitution matters a great deal, so do your own homework here.
Part of my advice to you is to watch weaker states and municipalities, like Puerto Rico, Illinois, Chicago, Pittsburgh, and many others. I don’t have all of the data in front of me. This is one of those cases where relative standing is important. People will migrate out of areas with low funding, and high expected payments, and into municipalities with higher funding, and lower expected payments in relative terms.
You will see municipalities depopulate, because the taxes are disproportionate to the increasingly slim services rendered, because much of the revenue pays for the overly generous past promises to retirees. As a result, you will see more municipal bankruptcies. I would expect that you would see most of the bankruptcies in the 2020s.
I know that’s vague, but I think it is more defensible than Meredith Whitney’s notable statement a few years ago. The pension cost curve is inexorable, and I suspect most municipalities can bear it for the next six years, but will have a hard time with it as the tail end of the Baby Boomers retires in the 2020s.
1) If you are in an area under pension stress, if you at all can, not harming your existing earnings, move to an area not under that stress. Remember, as other people move, it will become increasingly difficult to maintain existing services. Think of the slow police response times in Detroit, and packs of stray dogs that roam the city.
2) If you work for a municipality, consult your state constitution to see what you are guaranteed. In many cases, healthcare will not be covered. Even existing pension benefits in payment now may be under threat in a default. Be aware.
This is one of those cases where the rich will get richer, and the poor will get poorer — better to be on the rich side of the line, and sooner.
All that said, we face the same issues with Social Security and Medicare, though both are unfunded. At present, Social Security’s payments will be cut by 25% or so in 2026, unless some adjustment is made to the system. Medicare is another issue, and the question is what will it cover. It could be stripped back a great deal when the US realizes it can’t fund a generous system that extends life a few years at high cost.
My main point to all of my readers is to be aware of the imbalances in the existing systems, and be ready for the coming adjustments, because the US economy will not be willing to make all of the payments that have been promised to oldsters who have served the public.