In December of 2010, banking analyst Meredith Whitney predicted a coming wave of defaults by municipalities totaling hundreds of billions of dollars. Her forecast of urgent problems did not come to pass, so municipal bonds recovered during 2011. There have been some bankruptcy filings, including several high-profile ones by three California cities over the past month, but nothing huge. We will eventually know whether her prediction was wrong or just a little early. Either way, the fundamental financial issues that she outlined for cities and states are certainly true. The cities and states over-promised benefits, pensions, and other goodies to their employees over the years, and are only now beginning to recognize the folly of their actions (though, of course, they will always blame someone else).
A good example of the flawed thinking has been the public employee pension fund in California. Calpers (California Public Employees’ Retirement System) is the nation’s biggest public pension system and is often considered a bellwether for retirement systems across the country. The agency manages pension and health benefits for over 1.6 million California public employees, retirees, and their families. Calpers has long been accused of being both incredibly corrupt and incompetent. In early 2011, several board members (including the former chief executive) were accused of insider trading and pressing subordinates to invest billions of dollars of pension money with politically-connected firms.
Calpers is deeply underfunded, having just 55-75% (depending on the measure used) of the money needed for future expenses. An absolute minimum of 80% is considered safe. Calpers made news last March when they lowered their expected future returns from 7.75% to 7.5%, both of which are considered unrealistically high by nearly everyone with a double-digit IQ. Earlier this week, the $233 billion system announced a 1% return for the year ended June 30, 2012. Over the same time period, the Dow Industrial Average scraped together a 3.8% return.
Are you thinking that these low returns mean the retirees may have to sacrifice a small percentage of their overly generous pensions and benefits? Ha, ha, ha … didn’t I mention that this is California? The unions don’t pay for mistakes, as they think that is the sole responsibility of the taxpayers. State law requires that any shortfall in market returns by the overpaid Calpers investors must be paid for out of state and city coffers, many of which have no money. The current governor has promised to reform the pension system … someday, when pigs fly and that high-speed rail system is done. The public sector unions carry so much political weight that nothing material would happen even if the governor did want it to. Only the taxpayers will pay for the shortfalls.
Mish’s Global Economic Trend Analysis did a series of interesting charts that show what will happen if Calpers has future annual returns in the more realistic range of 2.5 – 5%. The bottom line is that even if Calpers has annual returns of 5% — a high figure given current economic conditions – they will be short more than $80 billion over the next ten years. If the returns are only 2.5% annually, that deficit nearly doubles.
The situation is less dire but still severe in a number of other states. Get ready to open your wallet even wider.
Alan Noblitt is a mortgage purchaser in California. As a mortgage purchaser, he buys mortgage notes and deed of trust notes nationwide.