I’ve been detailing the plight of U.S. municipalities and states in these pages. Unfortunately, the situation can only deteriorate from here.
The main problem facing all states and municipalities is the budget deficits with their pension funds. I believe what the states and municipalities are not telling us is that they have not changed their future projection of earnings for their pension funds.
Put another way, in this low-interest-rate environment, the average pension fund in America is still projecting average annual returns of seven percent to eight percent on their investment portfolio (source: The New York Times, May 27, 2012).
This return is fantasy in this low-interest-rate environment and with an incredibly volatile stock market. If we look at the past, the National Association of State Retirement Administrators has stated that, over the last 10 years, the return for public pension funds has been 5.7%.
This 5.7% return occurred during times of higher interest rates!
So why won’t states or municipalities allow their public pension funds to take down their unrealistic rates of return? The answer: higher taxes and bigger budget deficits.
In Rhode Island, for instance, the state treasurer lowered her pension rate of return from 8.25% to 7.5%. This move increased the budget deficit by $300 million.
This $300-million budget deficit is not paid for by additional government debt, but by union members who must increase their contributions to the pension fund. If Rhode Island were to propose returns in-line with the past 10 years at 5.7%, then the budget deficit would increase by $600 million more, bringing the total to $900 million members who would have to pay to fill the pension budget deficit!
In New York, there is a proposal to lower the pension return and it is being contested by the unions. The proposal is to reduce the return of the public pension fund from eight percent to seven percent.
This one-percent change results in an additional budget deficit hole of $1.9 billion, which will not be financed through government debt. The union members would have to pay higher contribution rates to make up the difference. If returns are five percent, it would mean an additional budget deficit of $3.8 billion that members would have to pay into!
In San Jose, California, the city wanted to lower the unrealistic 7.5% return from the public pension fund there. The unions contested it, because they do not want to pay the difference in taxes to plug the budget deficit.
As if states and municipalities didn’t have enough to deal with concerning their own government debt, they will eventually have to deal with a reality that will explode their budget deficits: the low rates of return from their pension investments.
There’s no way unions will stand for these higher contributions either. Wait until these government debts and budget deficit protests make their way to the White House; then the problems will really begin.
Where the Market Stands; Where it’s Headed:
We are living in the most troubled economic times in our history. Spain asked for a $125-billion bailout this weekend, as its crisis deepens (magnifying the problems in Europe). We learned on Saturday that China’s inflation rate fell to three percent in May; that’s the lowest rate in two years. China’s big economy is slowing fast.
Worldwide, economic growth is stalling quickly. The U.S. is on the cusp of falling back into recession (see: The Inevitable U.S. Recession: Part II Starts). The bear market rally that started in March of 2009 is near the end of its rope.
What He Said:
“If the U.S. housing market continues to fall apart, as I predict it will, the stock prices of major American banks that lend money to consumers to buy homes will come under pressure—these are the bank stocks I wouldn’t own.” Michael Lombardi in PROFIT CONFIDENTIAL, May 2, 2007. From May 2007 to November 2008, the Dow Jones U.S. Bank Index of the world’s largest bank stocks was down 65%.