Pensions – Not So Boring Anymore…

In my deep past I wrote a paper for a college economics class.  I recall it was on a solid but boring topic for the time (mid – 70’s), related to pensions and the effect on budgets of mis-forecasting rates of return.  Now this was in an era when interest rates were boring, but soon they would not be so.  In the Seventies the big issue became inflation, or stagflation, which after the ’73 oil shock, started heading towards double digits.  At a time when inflation revolved around 10%, the question was can a pension then earning 9% keep up?

The yield problem, particularly for public sector pensions, has come home to roost in the current era of minimal inflation.  With nominal interest rates near zero, it is hard to achieve a return above 7%.  This is causing political problems for many municipal entities, a problem foreseen several years ago.

Responses have varied, but have come from both the right and left.  With the Tea Party behind him, Wisconsin Governor Scott Walker attacked the unions on collective bargaining rights, going after pay and pensions.  The left has taken up the call, as noted by Democratic advisor David Crane of California in 2010, “I have a special word for my fellow Democrats,” Crane told a public hearing. “One cannot both be a progressive and be opposed to pension reform.”  All this rancor over a bucket of money which has been promised to our public servants (teachers, fire, police, etc.).  But as Crane implied, in the current environment, keeping up with these fixed return obligations is threatening basic services like public schools and social services for the needy, not to mention fire, police, and garbage collection.

All this is being revisited across the country now, as an example New York City faces the prospect of an additional $1.9 billion in annual pension contributions due to a reduction in the assumed rate of return from 8% to 7%.  Its pension contributions currently make up 10% of the total operating budget.

With the majority of American workers now facing retirement with a combination of maybe a 401K yielding 2% and Social Security looking dicey, the public sphere is living in the past.  It is time for them to share the risks of the markets that we all do.  A promise to pay is one thing, a promised return is another.  It is time to put to bed traditional pensions for municipal employees, and the arcane activity of forecasting reasonable returns.

Rob Cannon is a frequent guest contributor at SMBmatters and is a principal at Cannonomics.  He is a virtual CFO for hire.

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