How the Fed Pushed the Nation’s Pension Plans and Local Government into Insolvency

How the Fed Pushed the Nation’s Pension Plans and Local Government into Insolvency
(Of Two Minds – Charles Hugh Smith)

A key player in the nation’s unfolding pension debacle is rarely fingered–The Federal Reserve.

If you reckon state and local government have created their own guaranteed-to-go-bankrupt pension problem, you’d be half-right: the Federal Reserve’s policies of the past two decades are the crumbling foundation beneath the nation’s unsustainable pension plans.

Here’s a precis of how the nation’s local government pension plans were set to implode.

1. Public unions formed an unholy alliance with elected officials (in effect, an oligarchy) to establish politically untouchable protected fiefdoms. (Please see Survival+ for more on asymmetric stakes in the game and protected fiefdoms.)

In a typical labor-management nexus, labor negotiates with capital for a slice of the profits from the enterprise. In local government, the unions lavishly funded the election campaigns of state and local politicos, who then awarded unions lavish pensions and other benefits. There was no “push-back” against union demand except elections, and the unions stupendous “investment” in buying politicos ensured elections were never a threat to the fiefdom’s rising share of the tax swag.

Here is an MSM (mainstream media) summary of the public-union/politico oligarchy:

The Bankrupting of America We have a ruinous collaboration of elected officials and unionized public workers.

2. As the stock market bubbled ever higher in the 1990s, managers of pension plans ratcheted up their expectations of future “permanent” growth, giving politicos the go-ahead to ramp up pension pay-outs.

In essence, pension plans which were once constructed on the long-term expectation of 4-5% returns on capital now based future earnings and pay-outs on the stock market’s “average return” of 8% annually.

As any reasonable person might have foreseen, the bubblicious stock market of the 1990s was not a “new permanent plateau” but in fact a bubble which imploded. Real returns in the past decade have been literally half what was anticipated, and as a result state and local governments are having to make up the difference with cash out of general fund tax receipts.

Going for broke in L.A.?

Currently, Riordan says, the city is struggling to meet its pension obligations, and that’s assuming it will receive 8% annually on the money invested on retirees’ behalf. In fact, the average return over the past decade has been just 4%. As tax receipts plummet in the “slow-growth,” jobless recession, then state and local governments are forced to gut their programs to fund the oligarchy/fiefdom’s pension promises.

Pension issue balloons with soaring costs:

Los Angeles officials say Riordan’s prediction is overstated. But pension costs are soaring to $800 million, tripling during the last decade, as Los Angeles faces years of projected budget deficits even with deep cuts in services and staff. Since the pension pay-outs were based on plump stock market returns, the pension plan managers had no alternative but to gamble in the stock market on a massive scale. With “safe” bonds paying so little in the Fed’s low-interest universe, the only way to get an 8% yield was to speculate in real estate or stocks. As the sharpy behind the three-card-monte card table could have told you, the pension fund sheep got sheared along with all the other marks:

The main driver of higher pension costs is the stock market crash. CalPERS gets about 75 percent of its revenue from investment earnings. Its portfolio peaked at $260 billion in 2007, fell to $160 billion last year and now is about $204 billion. Now that the stock market is setting up for a long-term crash, CalPERS will be lucky to have $100 billion in its coffers in two years. And that won’t be enough to fund the bloated promises made in the go-go 1990s:

A political issue is benefit increases enacted a decade ago, when pension systems had surpluses during a strong economy. A major increase for state workers, SB400 in 1999, even included retirees. A typical state worker can retire after 40 years of service with a pension equal to their final pay. The formula for the Highway Patrol, 3 percent of final pay for each year served at age 50, became a statewide trendsetter for police and firefighters.

In the usual gaming favored by gutless politicos desperate to cling to their diminishing power to channel tax funds to their cronies and masters, elected officials are setting aside their pension fund contributions until next year, in the hopes that “growth” will magically save them next year. As this article explains, that is a vain hope without foundation in the real world:

Why economic growth isn’t enough to fix budgets:

But under the laws now dominating government budgets, many expenditures essentially are or will be growing faster than both revenues and the rest of the economy. In fact, in many areas of the budget, automatic expenditure growth matches or outstrips revenue growth under almost any conceivable rate of economic growth. Now, so much spending growth is built into permanent or mandatory programs that they essentially absorb much or all revenue growth. Meanwhile, we’ve also cut taxes, widening the gap between available revenues and growing spending levels.

Consider government retirement programs. Most are effectively “wage-indexed” insofar as a 10 percent higher growth rate of wages doesn’t just raise taxes on those wages, it also raises the annual benefits of all future retirees by 10 percent. Meanwhile, in most retirement systems, employees stop working at fixed ages, even though for decades Americans have been living longer.

Today, so much of government spending is devoted to health and retirement programs that their growing costs tend to swamp gains we might achieve in holding down the ever-smaller portion of the budget devoted to discretionary spending. Still other programs add to the problem, such as tax subsidies for employee benefits, the cost of which grows automatically without any new legislation.

In other words, the entire system of state and local government is now based on the same 8% “permanent high growth” of the 1990s speculative market. Funding increases are wired in, regardless of how much tax revenues fall. That is a recipe for insolvency.

Now we get to the heart of the matter. Which institution engineered and enabled the heady stock market bubble of the 1990s that created the illusion of “permanent high returns” and growth of tax receipts? The Federal Reserve.

The Greenspan-era Federal Reserve’s policy of low interest rates, abundant liquidity and lax oversight directly created the incentives and the wherewithal for malinvestment and speculation on a scale heretofore unknown. Under the phony guise of “boosting productivity and home ownership” with essentially free money and splendid opportunities for embezzlement, fraud and gaming of the system, the Fed studiously avoided any policy which might have offered some modest restraint on the asset bubbles it inflated.

As the dot-com era market foamed into an unmistakable bubble, wiser heads implored Greenspan to increase the margin requirement for borrowing funds to play the market–he steadfastly refused. Whatever barriers remained to rampant speculation were dismantled under the false banner of deregulation in the service of free enterprise.

Thus the Glass-Steagall divide between commercial and investment banking was effectively dismantled in 1980 (under President Carter) the late 1990s (under President Clinton). (So much for the blame being placed solely on the evil Republican lackeys of the bankers– the “liberal” Democrats were just as craven and slavish.)

Thanks to these long-standing Fed policies favoring exponential expansion of credit and low interest rates, pensions funds were forced into speculating in the stock market to “reach” for their required return on capital.

This certainly suited Wall Street and the deeply politicized leaders of the supposedly independent Federal Reserve, but it set in motion a set of policies, expectations and incentives which fatally undermined pension plans.

In a richly ironic playing out of unintended consequence, the Fed’s “zero interest rate policy” (ZIRP) and endless creation of credit for speculation in asset bubbles will in effect bankrupt all the states and local governments which foolishly based their pension plans on 8% yield in a low-inflation environment.

But one last pernicious Fed-created self-destruct awaits pension managers scrambling for both safety and yield. As they pour into long-term Treasuries based on low inflation and low interest rates as far as the eye can see, the pension fund managers will find their remaining capital decimated as interest rates rise later this decade.

The Fed’s policy of pushing zero interest rates and abundant credit has undermined not just pension plans and local government, but the entire U.S. economy. Asset bubbles and incentives for embezzlement, fraud and gaming the system are not productive. While Bernanke et al. issue ponderous promises that the “nascent recovery” is not just a house of cards flying apart in the rising wind of global volatility and malinvestment, high above his head the chickens are coming home to roost at the Fed.