By: Mark Glennon*
If you think pensions for Illinois and its municipalities are in awful shape and worsening, just wait.
Illinois’ five statewide pensions report their positions annually, as of the end of June. Those reports will come out late this year. Most Chicago area pensions and many other municipalities report as of year end, so their 2015 reports won’t come out for another year. They will be uglier than anything we have seen. Most, almost certainly, will show funding levels deteriorating at an accelerating rate. Here’s why:
• The stock market has leveled off. Since the recession, we’ve had an extraordinary bull market. Stocks comprise most of pension assets. They roughly doubled over the last five years, but for the twelve months that ended on June 30, the S&P 500 rose by just three percent. Higher stock prices have mitigated pension problems, but unfunded pension liabilities have soared nevertheless across the state, consistently through the post-recession bull market. Now, that tail wind likely is gone. Sure, the market might soar further, but history says it probably won’t. It could languish for many years or drop, and that would pulverize pensions.
• “Negative amortization” continues. That’s perhaps the most pernicious and least understood feature in most Illinois pensions. Unfunded liabilities grow even if optimistic assumptions turn out true. A guest actuary explained in detail in this earlier article.
• Pension asset managers are being increasingly forced into shorter term, lower return investments. Healthy pensions invest for the longer term, focusing on stocks and illiquid assets like private equity that traditionally produce the best returns. But with badly underfunded pensions, managers must have cash available for shorter terms to pay pension obligations. That means investing in shorter term bonds that don’t pay nearly the 7.5% annual return most of them assume they will make.
• New accounting standards will force more realistic assumptions. New rules from the Governmental Accounting Standards Board went fully into effect for periods starting in July last year. So, we will start to see those disclosures towards the end of this year when the reports for the state pensions come out for the fiscal year that just ended. Those standards require a much lower discount rate assumption — the 7 to 8% most Illinois pensions effectively guaranty they will make on investments. Specifically, the unfunded portion of pension liability will have to be calculated using a 20-year bond rate, which will hit the most underfunded pensions — ours — especially hard. Illinois state and municipal pensions essentially will be keeping two sets of books — one under the new GASB standards and one under the phony standards set by Springfield. They won’t get away with that very well. Reporters and the public will focus on the GASB numbers. We wrote about the insane implications of that in detail in an earlier article.
• The pressure to stop other actuarial shenanigans that understate pension problems is increasing. The New York Times recently wrote about the “bad math” used by some pension actuaries and a standards board hearing on the subject, in which we were quoted. Actuaries are feeling the heat.
• Higher interest rates won’t help much. Rates have been kept exceptionally low by the Federal Reserve since the recession, which has suppressed returns on all fixed income assets. They comprise a large potion of pension investments. The Fed is indicating that an increase this Fall is likely, but significant increases to historical norms is not in the foreseeable future. That’s because we are in a new era of lower rates, even absent central bank interference. Read what both the Fed and the International Monetary Fund have said about that.
• Underfunding continues. Contribution levels are set by state law and are simply too small, in almost all cases. Many politicians continue to claim they are funding pensions on an actuarially sound basis, but that’s nonsense.
• And higher taxes? Raising taxes to anything close to what pensions really need would obliterate the tax base. And the Springfield political establishment knows that voters won’t put up with it. A Democratic super-majority in the General Assembly with a Democratic governor couldn’t pass an income tax increase, a “millionaire’s tax” or anything else. They remain afraid even to propose an increase now on their own, passing just an unbalance budget in an effort to force the governor to propose a tax increase.
Locally, Cook County’s sales tax increase will plow some $450 million of new money into its pension, which will help but by no means stabilize the pension. The county lost tens of thousands of residents and billions of revenue to flight in recent decades, which will worsen now. Chicago undoubtedly will bump up taxes, but the consequences of flight take time to materialize. Longer term, more will flee.
Maybe there will be a few exceptions to further pension erosion. IMRF may hold up because it has a unique funding guaranty that allows it to soak taxpayers directly in whatever-it-needs amounts, explained here. A very few other municipal funds, mostly in prosperous areas, are in good shape and will manage.
The biggest challenge of an accelerating collapse of our pensions may be finding new adjectives to use on this site. We’ve been using ones like impossible, unsustainable and catastrophic, but I can’t think of stronger forms for those offhand.
*Mark Glennon is founder of WirePoints. Opinions expressed are his own.