The public pension crisis is massive, and it’s only getting bigger. Yet state and local governments are slow to address the problem, and the solutions they’re implementing could result in even larger issues down the road.
We recently spoke with pension expert Lawrence McQuillan on our podcast to better understand this impending crisis, discover what steps are being taken to address the issue, and find out who, if anyone, will ultimately have to take responsibility for this mess (see Public Pensions Have Loaded Up on Risky Investments, Says Lawrence McQuillan for audio).
Why Is the Pension System in Crisis?
The biggest concern facing pensions right now is that the debt keeps growing. Public pensions across the country are already burdened by significant unfunded liabilities, estimated at $3.5 - $4 Trillion. This is money that should be in the bank, earning interest, but it’s not.
As a result, pension managers are having to take more risk with their investments to make up this shortfall, as well as achieve their unrealistic rate of return targets.
Perhaps the saddest part about the whole situation is the moral dimension; it is our kids and grandkids that will ultimately have to pick up the tab. We’re using our future generations as piggy banks to manage these plans.
And through it all, public officials continue to act in a financially irresponsible manner, which means the issue could get even worse.
Chicago – A Perfect Example of What’s Wrong
McQuillan notes that what’s going on in Chicago right now is a perfect example of this crisis. They currently have a $28 billion shortfall, and have chosen to address this by issuing pension obligation bonds.
The money raised from these bonds will be given to the pension funds to invest, in hopes that these managers will earn a high enough rate of return to offset some of the shortfall.
But issuing bonds to invest in higher returning assets is like buying stocks on margin … almost any investor knows that this is extremely risky. If the investments don’t work out, the pension could end up saddled with even more debt than it had to begin with!
According to McQuillan, these are the “hail mary” type of initiatives that pensions take when they are getting desperate. And historically speaking, they don’t work.
Loading Up on Risky Investments
Pension plan officials want you to believe they can invest their way out of this. They keep telling the public not to worry. But the debts are just too extreme and the rates of return needed to meet current obligations are sky high.
As a result, pension plan portfolios are getting more and more risky. Whereas pension plan investments used to be focused primarily on bonds, that is shifting. In order to reach for higher returns, CALPERS and others are now invested heavily in real estate, common stocks, and alternative investments. The Orange County Investment Plan even invested millions in small overseas companies that banks wouldn’t lend money to.
The net result is that these pension plans are exposed to major risk. While their gains could be spectacular, so could their losses. And remember, much of this game is being played with borrowed money.
Are There Any Positives?
Yes and no. While there is no easy way for these underfunded pensions to magically come up with the money they need to meet current and future obligations, the overarching issues that got us into this mess are slowly being addressed.
Back in 2016, California’s UC system agreed to create an optional 401(k) plan for new hires. Incoming employees could choose this option in lieu of the standard pension. So far, the option is garnering some attention, as about a third of new hires have chosen the self-directed 401(k) plan, McQuillan said.
Why? Because it allows employees to control their investments – they don’t have to go along for the ride with risky pension managers – and if they leave down the road, they can take their money with them.
So the real positive here comes not necessarily from closing the current unfunded liability gap, but from shifting away from pensions in general. By switching to a self-directed model, this eliminates the issue of unfunded liabilities down the road because compensation is provided to these employees immediately.
Listen to this full interview with Lawrence McQuillan by clicking here. For more information about Financial Sense® Wealth Management and our current investment strategies, click here. For a free trial to our FS Insider podcast, click here.