We have watched with trepidation as the stock market declines and along with it the value of our retirement accounts. Yet with our personal accounts, it’s our own problem. When it comes to public pensions, it’s the taxpayer’s problem. Underfunded pensions could cut two ways, leading to much higher taxes and/or cuts in government spending.
This is a particularly big issue here in my home state of Illinois. The Chicago Sun-Times just reported the Land of Obama has earned the dubious honor of having the most underfunded public pension plan in America.
According to Professor Jeremy Siegel, the above-average returns of the stock market in the recent past have attracted the attention of public pension fund managers.
The prospect of bigger returns has led managers to pour billions in public pensions into stock. Finance Professors Deborah Lucas and Stephen Zeldes report that the share of state and local (S&L) plan assets held in equities has greatly increased over time from an average of about 40 percent in the late 1980s to about 70 percent in 2007.
In the current market environment, this exposure led to a loss of an estimated $1 trillion dollars over the past year. Are stocks likely to average annual returns of 10% for the next 20 years? Not likely, and that’s a big problem for both public pension funds, and for the poor taxpayer.
Equity investing will see many challenges in the coming years. Here are some issues to consider. The reaction to Enron’s bankruptcy was much tighter regulation on corporate accounting. This led to the infamous Sarbanes-Oxley law which has made it far less desirable to run public investment funds and slowed the development of new IPOs. The result, as Joe Weisenthal reported in February of 2007, was a spectacular rise in private equity funds, such as the infamous hedge funds, which contributed mightily to the recent financial meltdown.
Successful IPOs eventually join the major indexes which help the long run drive equity returns. Fewer IPOs mean less opportunity for investing in listed equities. This will make it harder for pension funds to enjoy higher returns.
And then there are some demographic concerns. In 2008 the first cohort of baby boomers retired. Many more will follow. This will put increasing strains on all equity investors. Eventually, pension fund managers will have to be net sellers of equities to raise cash for the retiring boomers. No one can say with certitude when this trend will hit critical mass, but when pension funds become net sellers stocks are almost certain to go down.
The giant bull market of 1982-2000 was driven not only by favorable demographics but also lower marginal income tax rates, cuts in capital gains taxes, and lower inflation. All three conditions could very likely be much higher in the next 20 years. President Obama has openly talked about higher capital gains taxes and the rich being obligated to fund expanded government programs. Recent increases in the money supply by the Federal Reserve Board point to potentially much higher rates of inflation and interest rates. Equities will perform poorly in such an environment.
American equity investors are in a new era with the federal government making direct investments in private companies. What are the likely results of the federal government controlling an industry? Not good. The TARP program quickly expanded to taxpayers funding car companies that under normal market conditions would have been forced into bankruptcy. What other industries does the federal government have in mind for taking over? Is the medical industry next? Drug companies? Until recently these scenarios were unimaginable.
All this uncertainty, at very least, is quite bad for equity investing.
The TARP program is likely to have profound long-term affects on capital markets. With the government having a big stake in major banks, future business loans could potentially be influenced by politicians who regulate the banks. This will lead to a massive misallocation of resources. Will the federal government encourage more homeownership when the housing market has a huge supply? Only time will tell. Will a bank branch be allowed to close in a powerful Congressman’s district?
As equities lose their attractiveness, public pensions may have to look to corporate bonds and real estate to get investment returns. Are these investments likely to produce historical rates of return that equities have? It’s very unlikely. Governments may be forced to conduct fire sales of their properties just to raise cash to meet their pension obligations.
Something will have to change. Without a restored boom in stock prices, public pension funds will have a very hard time meeting their obligations. Either governments will have to increase taxes – perhaps dramatically – or force public employees to endure the same risks and potentially anemic returns the rest of us may be up against. Given the size of these funds, and the enormous political power of government workers, this may create one of the major political conflicts of the coming decade.
Steve Bartin is a resident of Cook County and native who blogs regularly about urban affairs at http://nalert.blogspot.com. He works in Internet sales.
Comments
7 responses to “Public Pension Troubles Loom for State and Local Governments”
Good food for thought. However, if politicians have a choice between cutting public pension benefits and raising taxes, I think they will have little difficulty choosing the former.
Even if stock prices are forced down because pensions liquidate more of their holdings, do you think there will be revived interest in owning stocks because of their dividend payments?
Not little difficult, i think it will be so difficult.
stock market
Matt:
“…if politicians have a choice between cutting public pension benefits and raising taxes, I think they will have little difficulty choosing the former.”
If I interpret you correctly, you think the pols will cut pensions?! No way. They will hide the increased cost of pensions. Then they’ll simply tell us critical functions involving “public safety” will have to be cut unless taxes are raised. They will do whatever is necessary to hide the fact that the new taxes are going into public employees’ pockets (including their own).
If you’re talking about states with heavily unionized public employees, such as California, maybe you’re right. But in a right-to-work state like mine with no public employee unions, politicians don’t fear the backlash from pensioners as much as they fear being labeled tax raisers.
If pension funds want to make more money from their investments over time, they need to encourage the federal government and state governments to make the United States of America a better place to invest.
The federal government and state governments should immediately stop taxing interest from savings accounts, dividends, capital gains, and estates. Wealthy americans and others will be less likely to take money out of US companies and invest the money in countries that tax capital less.
If capital gains taxes are increased, expect Americans and foreigners to invest less money in US companies. The less money invested in US companies the worse that pension funds that invest in US companies may do. Many Americans and foreigners may sell stock in US companies and invest the money in other countries which may harm pension funds that own stock in US companies. Government employees need to realize how much HARM may be done to them by an increase in the capital gains tax and an increase in income taxes. The higher taxes that businesses pay the less likely that Americans and foreigners will invest in US companies. If taxes are lowered on businesses, many businesses may increase dividends. It makes more sense to increase sales taxes on wealthy people.
I hope people will read
“A 545 Billion Private Stimulus Plan
Let’s bring home foreign earnings without tax penalty.” by Allen Sinai
http://online.wsj.com/article/SB123310439653922291.html
I do NOT think it ever makes sense to tax “foreign subsidiary earnings” of US companies. If the federal government does NOT tax “foreign subsidiary earnings” of US companies, many US companies may invest more money in our country and may pay more money in dividends. Pension funds that own stock that pays dividends may benefit. Many companies that pension funds invest in may increase in value over time helping pension funds benefit from capital gains.
It makes more sense for the federal government and state governments to increase many of their sales taxes.
If the highest federal corporate tax rate is NOT greater than 15 percent, many businesses may hire more people, increase wages of many people, and increase dividends. Many people might obtain more money from capital gains. Pension funds of government employees may do a lot better. Many businesses may have an easier time obtaining loans and investments for hiring workers, research and development, and plant and equipment. More innovation and manufacturing may take place in our country. There may be less need for food stamps and Medicaid.
I mention the Securities Turnover Excise Tax and other sales taxes on my profile.
I recommend people read
“Government Spending Is No Free Lunch
Now the Democrats are peddling voodoo economics.” by Professor Robert J. Barro.
http://online.wsj.com/article/SB123258618204604599.html
I discuss dealing with the financial crisis in greater detail, manufacturing, and other topics on http://www.newgeography.com/users/kenstremsky
My website is http://www.myspace.com/kennethstremsky
Sincerely,
Ken Stremsky
Pension reforms have gained pace worldwide in recent years and funded arrangements are likely to play an increasingly important role in delivering retirement income security and also affect securities markets in future years..However, there are really heartless individuals taking advantage of a single opportunity like this one.Bernie Madoff ripped off a lot of people. It comes as small consolation that Madoff is going to jail for the rest of his life, because he ruined the lives of so many. An entire Connecticut town has filed suit against him, his family, his estate and all of his holdings, and also Fairfield Greenwich Group. The allegations is that after people in the town invested money from their pensions into the fund, and therefore to Madoff, he stole the money. To retirees, pension is their lifeline – they cannot rely on payday loans alone. If things go well and fortune smiles on them, they may be able to recover half their funds. Let us hope they can get enough to not have to rely on payday loans instead of their pensions.
Pension funds are long-term investments, not short-term.Every investment choice has a consequence.What is the point of making great returns if fewer members get to benefit from it because they’ve lost their jobs to privatization?
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