What Blows Up Next? Part 2: Pension Funds With Nowhere To Hide
Faced with spiking volatility in pretty much every market, it's natural and reasonable to sell some risky assets and hide out in cash until the dust settles. So it's not a surprise to hear that pension funds are doing just that.
U.S. public pension plans and mutual funds are sheltering more of their holdings in cash than they have in years, a sign of growing stress in financial markets.
The ultradefensive stance reflects investors' skittishness about global economic growth and uncertain prospects for further gains in assets. Pension funds have the added need to cut more checks as Americans retire in greater numbers, while mutual funds want cash to cover the risk that investors spooked by volatile markets will pull out more of their money.
Large public retirement systems and open-end U.S. mutual funds have yanked nearly $200 billion from the market since mid-2014, according to a Wall Street Journal analysis of the most recent data available from Wilshire Trust Universe Comparison Service, Morningstar Inc. and the federal government.
That leaves pension funds with the highest cash levels as a percentage of assets since 2004. For mutual funds, the percentage of assets held in cash was the highest for the end of any quarter since at least 2007.
The data run through Sept. 30, but many money managers say they remain very conservative. Pension consultants say some fund managers are considering socking even more of their assets into cash as they wait for the markets to calm down.
"Some clients are asking us, 'Would we be crazy to put 10% or 15% of our assets into cash?'," said Michael A. Moran, a pension strategist at Goldman Sachs Asset Management.
Unfortunately for pension funds, hiding out in cash doesn't work the same way as for you and me. Most of these funds (set up to give teachers, firefighters and other good people a decent retirement) are required to generate returns of 8% to avoid stiffing their beneficiaries. And since cash earns zero these days, every dollar invested this way drops these (in many cases already woefully undercapitalized) funds deeper into a hole from which most will never escape.
Just to be clear, pension funds -- the last remaining link to middle class money for millions of Americans -- aren't to blame for any of this. The culprits are the mayors and governors who bought off their public sector unions with promises that would never be kept, and a federal government that's papering over its own malfeasance by lowering interest rates to levels that make it impossible for anyone to generate a reasonable low-risk return.
But however they got here, it's now all but certain that pension funds will soon start blowing up, either defaulting on promised benefit or bond payments, leveraging themselves for one last roll of the dice, or demanding new taxes that cause local political chaos.
When they do, they'll add their own brand of crazy to the mix of imploding junk bonds, derivatives and equities that will make 2016 such a fun year to watch from a safe distance.
For a glimpse of the future for dozens of state and local pension plans, pay a quick visit to Illinois:
Home to the least-funded state retirement system in the nation, Illinois has $111 billion of pension debt, which breaks down to more than $8,000 per resident. Partisan gridlock has produced the longest budget impasse in Illinois history. The stalemate has not only weakened state finances, it has kept lawmakers from finding a fix for those mounting liabilities.
Illinois's fiscal health will deteriorate further without a budget, hindering its ability to mend its pension system. Moody's Investors Service dropped Illinois, already the worst- rated state, to the lowest investment-grade tier in October as the budget stalemate dragged on. Last month, Moody's warned that pensions are Illinois's "greatest challenge."
It's been seven months since the Illinois Supreme Court rejected the state's solution. Justices threw out the 2013 restructuring that took six attempts over 16 months to pass, despite one-party rule at the time. The measure was projected to save $145 billion over 30 years by limiting cost-of-living adjustments and raising the retirement age.
Illinois enters 2016 snarled in partisan bickering as Gov. Bruce Rauner, the state's first Republican chief executive in 12 years, and the Democrat-controlled legislature can't agree on annual appropriations, much less an overhaul of a retirement system that must withstand an inevitable legal challenge. The state constitution bans reducing worker retirement benefits.
In July, Rauner laid out a plan to create a tiered system to cut retirement liabilities. At the time, he said it would save taxpayers billions of dollars. The proposal, which included a measure to allow municipalities to file for bankruptcy protection, was never introduced, according to Catherine Kelly, his spokeswoman.
Illinois is set to pay about $7.5 billion to pensions this fiscal year, and another $7.8 billion in the year that starts July 1, according to the Civic Federation, citing preliminary estimates by the retirements systems.
Even with the record budget impasse, about one of every $5 from the state's general fund coffers is going toward pensions, according to a Civic Federation report that cites estimates from Illinois Senate Democrats published on Aug. 13. The state's four plans are only 42 percent funded based on the market value of assets, according to the Commission on Government Forecasting and Accountability. That compares to 60 percent a decade earlier.
The lack of a budget forced the state comptroller to delay a $560 million November payment to the state retirement system. Illinois's unpaid bills totaled $7.6 billion as of Dec. 18, according to that office. The November retirement payment will be paid in the spring when the state has more revenue from income tax collections, according to the comptroller's staff.
While Comptroller Leslie Geissler Munger has said bond payments are prioritized, the lack of budget has shaken some investors' confidence. Illinois hasn't sold bonds since April 2014, a record borrowing drought. The spread on its existing debt has widened. Investors demand 1.8 percentage points of extra yield to own 30-year Illinois bonds, the most among the 20 states tracked by Bloomberg. When the spread climbs, that's reflecting that investors think the problem is getting worse, said Richard Ciccarone, Chicago-based chief executive officer of Merritt Research Services.
"What's the root cause of why we're in the problem we're in?" Ciccarone said. "It's down to the pensions."
Illinois is like a patient in the emergency room, said Paul Mansour at Conning, which oversees $11 billion of munis, including Illinois securities. The budget stalemate is the crisis at hand, and the unfunded pension liabilities is the chronic disease that's only getting worse. The budget standoff is hurting future negotiations on pension changes, he said.
If this sounds a little like what Greece went through in 2015, that's because it is. Both Illinois and Greece are failed states destined to default on their bonds unless bailed out by the central government. And since bail-outs are unpopular, it takes a crisis to focus enough minds to get one done.
In Illinois' case the crisis will take the form of a bond default by Chicago or one of its sub-units, which sends the muni bond market into turmoil -- just as several other markets (energy junk bonds, sub-prime auto loans, emerging market US$ loans come to mind) are blowing up.
And this is just the beginning. The US has plenty of other Illinois-level pension crises waiting to happen. So depending on the form they take (defaults or bail-outs or some combination there-of) pensions will spice things up in the coming year.