The Next Financial Crisis: Pensions

While you were sleeping, the Grinch came and stole pension money from millions of Americans.

How did it happen? Simple. A mix of union greed, stupidity and political gamesmanship did the trick. To avoid embarrassing strikes that would hurt their election chances, and because they were spending other people’s money, politicians promised government employees pension benefits we can’t afford. To avoid making taxpayers pay more, the pension managers assumed that annual investment returns on pension funds would exceed 8% and sometimes more.

Year after year, the pension fund investments underperformed their targets, resulting in severe underfunding based on future liabilities. But the underfunding wasn’t an immediate problem because workers were not retiring in great numbers, the workforce was young and growing so money flowing in from contributions met the needs of the ones who retired. Like any good Ponzi scheme, the problems lay in the future. The investment return assumptions were not revised so as not to disturb the taxpayers. But now we are getting to the end game.

The poster child of the moment is the Dallas Police and Fire Pension (DPFP). A month ago, the Dallas city council took the unprecedented step of suspending withdrawals from the DPFP. They are now looking to “claw back” what they view as excessive payments made to pensioners to the tune of roughly $1 billion.

What happened here? The city made unreasonable promises to the union. The pension manager covered it up by setting unreasonable targets for investment returns in the pension fund. The pension manger then put money into high risk real estate and other alternative investments to try to make their targets. Some of these investments failed and now it is clear that the fund will not be able to meet its future retirement obligations. The Dallas city council is frantically working with the DPFP board to close what now amounts to a $4 billion funding gap.

Employees have been retiring early to try to grab their share of the money from the fund before it runs out. More than $500 million was removed in this way in a few months in what amounts to a run on the bank. So, the City has had to close down the early withdrawal process. It seems clear that pension payouts will have to be cut and taxpayers will have to pay more money into the fund. It’s a disaster all because the city promised too much and then hid the growing shortfall by committing to unrealistic investment targets.

For those of you who haven’t followed this story as closely as I have, let me introduce you to DROP, a provision in many government pension plans which was created in the early 90s. DROP (Deferred Option Retirement) allows police and firefighters in Dallas to retire while still on the job getting their full salary. Their monthly pension checks are then diverted into DROP accounts which are guaranteed an 8-10% return regardless of how the overall pension fund performs.

The Dallas City Council now views these DROP guaranteed returns as an effort to defraud Dallas. I agree, but where was the City Council when these provisions were negotiated with the union and put into the collective bargaining agreement? The City is now proposing to take back all of the interest police and firefighters earned on Deferred Option Retirement accounts, saving about $1 billion of the $4 billion shortfall. This is going to get very nasty.

Are you naïve enough to think this is a problem in Dallas only? Let me tell you about America’s largest pension fund, CalPERS, the California Public Employees Reserve System. Its investment gains have averaged 5.1% over the past 10 years while the target it must hit to meet its liabilities has averaged 7.5%. CalPERS earned a return of just 0.6% on its investments last fiscal year. And you thought that with a rising stock market, everything would be just fine? Their public equity portfolio lost 3.4 percent in the year ended June 30 while forestland assets declined 9.6 percent.

This is what’s coming dear reader: pension clawbacks, tax increases and civil service strikes of essential services. Not civil at all. It’s another multi-trillion dollar problem that comes from trying to live beyond our means.