Greg's note: In the second and final installment on the looming Baby Boomer Bust Mish continues to astound - and scare the heck out of me. He details the state of local pension plans. Will the PBGC bail them out? Is a bailout even possible? Will we suffer from enormous tax hikes…or benefit cuts? Or both? It's hard to say but let's take a look. Please strap in - if you think Social Security's got it bad, keep reading for the lowdown on the impending miasma of bleeding. Please send your comments to your drowsy managing editor here: greg@whiskeyandgunpowder.com

Whiskey & Gunpowder January 4, 2006
by Mike Shedlock ~ "Mish"Illinois, U.S.A.

Sinkholes Drain City & State Budgets

BACK ON JUNE 13, Businessweek wrote about the Sinkhole!Draining state and city budgets. The public schools in Jenison, Mich., are real gems: Test scores are well above the national average, its autism and special-education program is recognized around the country, and the music program has been honored by the group that hands out the Grammy Awards. But underneath all that success is a looming fiscal crisis. In the past three years, Superintendent Thomas M. TenBrink has surgically cut $4.2 million out of his $39 million budget in a quest to keep Jenison the fiscally responsible district it has long been. He has instituted fees for participating in after-school sports and field trips. He eliminated 30 teaching spots, leaving the district with 287. He hasn't bought a new textbook in three years. He saved $550,000 by turning an elementary school into a self-financing preschool and day-care center. But TenBrink is running out of options.

Jenison is caught in a financial vise. School funds from the state are capped by law at $6,700 per student, a figure that has been frozen for the past three years, but costs are zooming. The fastest-growing outlay of all: contributions to pensions and retiree health care. This year the bill is $1 million. Next year it will jump to $1.5 million. An expense that for years hovered at 12.99% of payroll is now eating up 14.87% of it, and state finance experts predict it will hit 20% within three years. "That is just draining our budgets," TenBrink says. It's not just school districts that are being squeezed. State and local governments, hard hit by the economic downturn of 2001, find themselves in a financial bind. While sharp anti-tax sentiment constrains revenue and governments face new outlays for everything from homeland security to No Child Left Behind, there's a growing feeling that the retirement promises made to everyone from office workers and state patrols to firefighters and legislators may simply be unbearable. For some of the worst-off states, like Illinois, there is a long history of failure to fund pensions, which have snowballed into multibillion-dollar shortfall. Recent anecdotal evidence shows that many towns and cities have bumped up taxes over the past few years as state and federal governments have pushed unfunded requirements like No Child Left Behind and other costs down the ladder. How long that can continue without voter backlash is unclear, however. Meanwhile the cost of retirement has continued its steady climb. According to the U.S. Census Bureau, major public pension plans paid out $78.5 billion in the 12 months ended Sept. 30, 2000. By the comparable period in 2004, that had grown to $117.8 billion, a 50% climb in five years. Beyond hiking taxes and cutting costs, governments have few ways to meet this bill.
One option that many fiscal conservatives find troubling is pension obligation bonds. They are, essentially, an arbitrage bet in which governments borrow at relatively low municipal rates, invest the money, and hope they make enough to cover pension payments and earn a bit on the top. But they can lose money if the market goes south, a situation that New Jersey, which issued $2.7 billion in bonds in 1997, now finds itself in. Over the past decade state and local governments have borrowed approximately $30 billion this way. Don't expect that flood of debt to slow, because there's little relief in sight. Excluding federal workers, more than 14 million public servants and 6 million retirees are owed $2.37 trillion by more than 2,000 different states, cities, and agencies, according to recent studies. As much as states are throwing into pensions, they may owe even more. Despite a 2004 stock market rise that should narrow some of the gap, pension experts at Barclays Global Investors (BCS ) say that if public plans calculated their obligations using the more conservative math that private funds do, they would not be $278 billion under, but more than $700 billion in the red. "It's just ruining the financial picture for states and municipalities," says Matthew H. Scanlan, managing director of Barclays, one of the largest managers of pension-fund investments. "You're looking at a taxpayer bailout of this pension crisis at some point."
There's more bad news.
One major category of cost isn't disclosed at all: how much retiree health care has been promised to public retirees. No one can estimate how much these promises will add up to, but they're sure to be in the tens of billions, and only some states seem to have put aside reserves for them, according to bond analysts. That's chilling, given how quickly medical costs are rising. After a pitched battle, the Governmental Accounting Standards Board (GASB), the independent accounting standards-setter for state and local governments, has finally begun to require states to disclose these liabilities. Numerous unions and state government representatives objected to the change, says GASB member Cynthia B. Green, "not because [unions and states] didn't think these were important, but because they thought once the governments did their studies and found what the price tag was, they would be concerned or, if not concerned, staggered." In 1998 the city of Houston instituted a deferred-retirement option plan, or DROP, that would allow workers to in effect take their retirement when they became eligible for it but continue to work at their salary. The retirement income was put in a side account where it earned an attractive rate of return, and the employee could later have his pension adjusted upward to a higher level. The DROP, along with other pension improvements, drove the city's pension plan down from 91%-funded in 2000 to just 60% two years later.
Houston had gone from contributing 9.5% of payroll toward pensions to more than 32%. Joseph Esuchanko, a Michigan actuary brought in to study the problem, discovered that things would only get worse. According to his calculations, it was possible for employees to become millionaires thanks to the system. Under one scenario, a lifelong city employee retiring with a salary of $92,000 could get $420,000 a year in pension benefits. The citizens of Houston agreed withEsuchanko's conclusion that the system was a "win-win for the employee and a lose-lose for the employer." Last May they voted to end the benefits. San Diego's mayor, Richard Murphy, announced on Apr. 25 he would resign on July 15 after facing a continuing debate over how to solve the problem and probes by the Securities & Exchange Commission, FBI, and the U.S. Attorney for the Southern District of California's office into securities fraud and public corruption in connection with a crippling $1.4 billion deficit in San Diego's municipal pension fund. But San Diego is only the beginning. Citizens of Salinas, Calif., where pension costs are up and revenue is down, are facing the possibility that their public libraries will close this year. Orange County, Los Angeles County, and many other California counties have significant pension deficits. The state itself will pay $3.5 billion into pension and health benefits for retirees this year, almost triple what it paid just three years ago. And California's Legislative Analyst's Office (LAO) expects that to climb another $1.1 billion over the next five years.

Take a look at Illinois. The fifth-wealthiest state in total income, Illinois nevertheless has a 30-year history of shirking its pension promises. According to an analysis by the Civic Federation, a Chicago research group sponsored by the business community, since 1970 Illinois has not once paid its annual pension bill in full. Over the next 40 years the state will have to contribute $275.1 billion if it is to reach its goal of 90% funding -- and that's presuming no benefit changes are made. Through bull markets, bear markets, and sideways markets, the state has consistently lagged, and over time those delays have become more and more expensive. The culprit: reverse compounding. A pension plan's obligations are determined in part by the expected investment return on its assets. In the case of Illinois, that is 8%. So for every dollar not added to assets in time, the state is effectively borrowing from the pension plan at 8% interest. That's a high price in today's market, wheremunicipal bonds typically pay closer to 6%. Illinois Governor Rod R. Blagojevich says that if the state follows its current spending plan, it will have paid $220 billion in interest before it fills the hole.
Is there a fallback for state and local plans? Only now is anyone looking into the problems of State and Local pension plans. Unfortunately it is far too late. Unlike corporate pension plans with the ability to fall back on the PBGC, state and local governments do not have anyone to dump their problems on. That is probably a blessing, at least for some states whose plans are close to being funded. It may be potential nightmare for those in problem states. Will there be an exodus of people moving from problem states like Illinois with notably bad pension problems if taxes are raised to cover shortfalls? US Senate passes Pension Bill On November 16th the Senate passed a bill to shore up private pensions. The Senate on Wednesday approved far-reaching pension legislation meant to assure that companies with traditional pension plans live up to the promises they make to their workers. In the face of new warnings about the future solvency of the nation's private pension system, the bill passed 97-2. Debate now moves to the House, which is expected to take up its version of the legislation next month.
Gain Sharing
The SeattleTimes is reporting a Gain Sharing perk may cost state billions. A state pension perk passed by the Legislature nearly eight years ago, with the expectation that it would cost nothing, could sock taxpayers for billions of dollars. The state actuary estimates that Washington has about a $4.9 billion hole in its pension system. State and local governments are on the hook to make up the shortfall. Nearly half of what's owed can be tied directly to the benefit in question, called gain-sharing.
The cost of the gain-sharing benefit irks legislators because they thought it would be free. Gain-sharing "seemed like a good idea at the time. For some reason, we did not understand it was going to cost us," said House Appropriations Chairwoman Helen Sommers, D-Seattle. "Given my background and experience, I must say I don't know how I could have ever believed that it wouldn't cost something. ... It's expensive," said Sommers, one of the sponsors of the law creating gain-sharing and an expert on the state pension system.
State worker and teacher unions are lining up to defend the benefit, which beefs up retirement checks when pension-fund investments do better than expected. The pension system has paid out more than $1 billion since 1998 because of gain-sharing. Gain-sharing was approved by lawmakers in March 1998 near the peak of the stock-market boom, when double-digit returns from pension-fund investments seemed commonplace. So the Legislature OK'd a proposal that increased public-pension benefits when investment returns exceeded expectations. Basically, the law says that when the average rate of returns exceeds 10 percent over four years, half of any excess over 10 percent goes to state workers through the pension system. The way the gain-sharing law was written also created problems. Instead of making any excess cash a one-time distribution, lawmakers essentially allowed it to become part of the base pension benefit for certain public employees. In other words, for thousands of workers, the money wasn't sent out as a one-time bonus. It became a permanent part of their retirement check.How the hell could anyone think that proposal was a "free lunch"? Some of these pension ideas are staggering stupid.

More State Pension Woes

The Asbury Park Press is reporting States face pension shortfalls.

As the debate grows over the future of Social Security, officials in most states are struggling with a $260 billion gap in another frayed retirement safety net: public pension programs. More than 5.1 million retired teachers, judges, law enforcement and other public employees now rely on public pensions, with another 15 million workers expecting benefits when they retire. But a period of poor investment returns, rising benefits and states' failures to properly fund their plans have created a gap between assets and benefits in 45 states, according to the National Association of State Retirement Administrators. In 13 states, the unfunded liabilities exceed their annual general revenue budgets. For half the states, pension fund shortfalls top $3 billion, NASRA said.

The worst-funded plan: the older of West Virginia's two retirement programs for its teachers. For every dollar it has on hand, it owes $3.50 in promised benefits. West Virginia Gov. Joe Manchin took office in January and immediately called lawmakers into a special session to pass several measures including a proposal to sell $5.5 billion in bonds to fix the state's teachers, state police and judicial pension programs. Voters must approve the bond sale in a special election scheduled for June. If approved, the state's bonded debt ratio would increase from $859 in revenue-supported debt per state resident to $3,900. In Maine, lawmakers passed a state budget that proposes to sell $450 million in bonds for state pension and social service programs. Kansas, Illinois and New Jersey have also sold bonds. "This is a very popular strategy," said Sujit M. CanagaRetna, senior fiscal analyst for The Council of State Governments who recently completed a study of state retirement plans. "It's a very favorable interest rate environment, so it's a good time to borrow." It's also "a little bit like using a credit card to pay your mortgage," NASRA's Brainard said.
Stock Market Woes
According to John Wasik, author of "The Kitchen-Table Investor," and columnist for Bloomberg News the S&P 500 May Drop If Full Pension Debts Disclosed.
Let's assume that the U.S. Congress cuts through a political briar patch and passes a law that forces full disclosure of pension debts. The consequences might be stunning. Companies with poorly funded pension plans might have to contribute billions of dollars more to their retirement plans and touch off worker demands that employers pony up even more money for their retirement security. Just as surely, investors would punish companies with the highest retirement debt, according to a study by David Zion and Bill Carcache, analysts for New York-based investment bank Credit Suisse First Boston. They examined the effect of fully disclosing and accounting for the pension liabilities of the 374 companies in the Standard & Poor's 500 Index with defined- benefit plans. ``We estimate that would cause the total shareholder's equity for the companies in the S&P 500 to drop by $255 billion, or 7 percent,'' they wrote in their Nov. 10 report. The 18 most underfunded companies would fare worse, suffering a 25 percent reduction in shareholder's equity.
Equity Wiped Out
Zion and Carcache figure that shareholder equity -- a company's total assets minus total liabilities (which should include what it owes its pension program) -- would be wiped out at the seven S&P 500 companies with the biggest funding gaps in their pension plans. This accounting muddle is huge.

The Credit Suisse analysts said that pension assets and liabilities are treated as ``off- balance sheet'' items, which distort how much a company really earns and holds in corporate assets. They estimate that only 21 percent of the $1.3 trillion in S&P 500 pension fund assets are currently reported on balance sheets. There is no way that employees or investors now can discern total pension debts since companies don't have to report their so-called 4010 liabilities to the public. That's the amount owed if a company terminates its defined-benefit plan and has to buy annuities for workers. Full disclosure usually illuminates boardroom secrets and in this case might lead to changes. Companies that conclude that their defined-benefit plans are too expensive might trigger freezes or shutdowns of old- style pensions. Pension-fund managers may even sell stocks to reduce the overall risk profile of their portfolios and buy bonds or other securities. Once the market gyrations subside, I think the outcome for future retirees will be even more challenging. Ultimately, knowing how pensions are funded will force investors large and small to educate themselves. They will also need to focus more on lowering risk and expenses to better achieve their retirement goals. No matter what the political or economic climate, that's a sound practice.
Theory and Reality of 401K Plans
Back in March of 2005 the Washington Post wrote about the Theory and Reality of 401K plans. In theory, 401(k) plans and other tax-preferred savings programs can provide a good retirement fund -- if the worker joins up, contributes a substantial chunk of his or her pay, makes the right investment choices and doesn't drop out or tap the account for non-retirement expenses. That's the theory.

The reality so far isn't pretty. Today, the median account balance - median means the midpoint, that half are larger and half are smaller -- of 401(k) and individual retirement accounts combined, for households headed by someone 55 to 59 years old, "on the verge of retirement," is about $10,000, the Brookings Institution's Peter Orszag noted last week. How far is $10,000 going to go in retirement? How about nowhere? Bob Chapman writing for Goldseek.Com had this to say about the pension crisis: Almost all public pension plans are underfunded, some by 80%.

They are not covered by the PBGC. It will be interesting to see how these pensions are handled. Some employees after 30-years will get 90% of their final salary. For a commander in a police department that is $100,000 a year. In faltering San Diego six board members are accused of making a deal to let City Hall underfund the pension system in return to agreeing to higher benefits for themselves. Explicitly or otherwise, this is what unions and legislators have been doing all over the country. That is conflict of interest and it's a felony. Forty-four million are covered by private-sector plans and half are already retired and are collecting benefits. Only 50% of active employees support the entire system, which means in 30 years the system will die a natural death because it was actuarially unsound in the first place. Solutions?

To fix the problems multiple things can happen and none of them will be particularly good for boomers:
· Retirement age has to go up
· Tax rates have to go up
· Benefits have to decline
· Services have to suffer
· Defaults
None of those options will be welcome, especially raising taxes. States might look for the easy way out by floating more bonds. If allowed, that will only postpone the problem and make it worse.

The Cockroach Theory

Is that the full extent to this mess? Of course not. There is the seen and there is the unseen. The cockroach theory says that for every problem you see there are at least two more hiding somewhere. In fact there are a couple more roaches that we have not even talked about yet. What happens if just as boomers are about to retire and need cash the stock market goes into a protracted slide? Certainly the market is vulnerable and overly dependent on a housing boom that seems to have stalled. What happens to the stock market as boomers retire and no longer contribute to it but start pulling cash out? How far away is that? Are other savings sufficient? I think not. Too many people expect the value of their house to rise forever and bail them out.

Just who will the boomers be selling to anyway? If taxes rise to pay retirees will active workers be able to bear the load? What about pension plan assumptions at GM and IBM and other places that are close to 10% while bonds are yielding 4%? Has a demand for yield forced money into junk bonds and other risky investments to meet those expected returns? I think so, so what happens when that unwinds? Questions, Questions, Questions. Unfortunately there seems to be a lot of questions but few good answers. Ready or not the Baby Boomer Bombs are about ready to go off. Are you prepared?

Mike Shedlock ~ "Mish" How to Ensure a Lifetime of Fiscal Independence for Your Young Loved Ones: http://www.isecureonline.com/Reports/400SSEEDS/E400G116/
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