12/4/13 – The Pension System Starts to Stop

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Dec 4, 2013 10:36:51 AM

and tagged Commentary, Politics and the Economy

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“If something cannot go on forever, it will stop.” — Herbert Stein

I’ve been using this quotation in speeches for years. Like several of Churchill’s, it is so wise in its generality that it just keeps suggesting itself.

Today, I’m prompted to use it by a couple of developments in the rationalization of the U.S. pension system. To start with a bit of context, much of the pension system—public and private—is broken. The promised benefits are too large, the available funds are too small, and the investment assumptions are just plain ridiculous. There’s no way everyone can get what they expect, which brings us back to the Stein quote.

The private system is much further along in recognizing the necessary stop and writing down its obligations to what might actually be payable. The public systems, on the other hand, have been notoriously resistant to doing so. Until recently, the political consensus has been that the issue was too hot to touch and the problems were far enough out that they could be punted to the next administration.

Which, unfortunately, happens to be now. Two landmark events have just taken place to start the incredibly long—and (to many current and prospective retirees) damaging—process of matching the benefits paid out to the available resources and returns.

The first is a federal court ruling in the Detroit municipal bankruptcy case that the city could in fact file, and that pension benefits would be subject to reduction as part of the bankruptcy process. This directly contradicts the perception that state laws would protect such benefits, as Michigan’s state constitution explicitly does. The Detroit ruling states that pensions are a contractual right and not subject to any special protection.

This is not the final word, and the ruling will certainly be appealed all the way to the Supreme Court. If it is upheld, though, the decision will represent one tool that municipalities can use to match their liabilities, promised in better times, with their current resources. The need to match them is even greater because the longer the mismatch persists, the bigger the ultimate cuts required.

The other landmark event, the Illinois legislature’s approval of retiree benefit cuts in the state pension system, is in many ways more hopeful than the Detroit ruling. While Detroit states that benefits can be cut in extremis, the Illinois system, which was about $100 billion behind, is moving proactively to match future benefits with existing resources—before the crisis hits.

Sacrifices were made on both sides, with increased state contributions and lower benefits, and both parties’ leaders pushed the compromise bill. The changes included lower cost-of-living adjustments and privatized options for workers, as well as higher retirement ages. No one loved the deal, and no one celebrated, but the vote to approve wasn’t even close.

If the changes above sound familiar, they should; they’re the ones proposed for the federal social security system.

For change to happen, two things are necessary:

  • An unbearable situation that cannot continue. Detroit was clearly there financially, but in Illinois, the pain was political. This suggests that there is a level of political pain that could drive compromise in Washington, DC.
  • A forcing agent. The Detroit case, if upheld, could be what makes the different parties come to the table for a deal that everyone hates.

These two different events have just defined the beginning of the end of the U.S. pension crisis. We will see many headlines—and many damaged lives—between now and then, but the reality is that there was never enough money to pay for the promises made, and the least damaging time to start solving the problem is now.

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