The federal government will likely face another round of massive bailouts if the current state of pension funds persists.
A recent study by the Pew Center on the States found that at the end of fiscal year 2008, there was a $1 trillion gap between the $2.35 trillion states and participating localities had set aside to pay for employees’ retirement benefits and the $3.35 trillion price tag of those promises.
According to the study, to a significant degree, the $1 trillion gap reflects states’ own policy choices and lack of discipline: failing to make annual payments for pension systems at the levels recommended by their own actuaries and expanding benefits without fully considering their long-term price tag.
But besides all the politics, a basic problem is an assumed 8% or greater expected investment return over time – the most common assumption for state pension funds. Simply put, it is unrealistic to count on such investment yields, especially during this extended period of high unemployment and lack of global aggregate demand.
According to Bill Gross, we are in a “new normal” which consists on slow growth in the developed world, insufficiently high levels of consumption in the emerging world, and “seemingly inexplicable low total returns on investment portfolios – bonds and stocks –lie ahead”.
But just how low?
Gross says that 4-6% annualized returns for a diversified portfolio of stocks and bonds is the likely outcome. If he is correct (I presume he is) states will be forced to go to the federal government for help. The State of New Jersey’s pension fund (which assumes a 8.75% investment yield) would run out cash for benefits by 2020 if there were no new contributions. But we would first hear from the Illinois Pension Funds, as it would run out of cash by 2017.
The price of promising pensions that states cannot afford will probably lead to the federal government stepping in. On a positive note, it may force us to move back to basics: we might only get as much money as we put into the system, and no more.