Illinois And The Tsunami

Apparently the standoff between Governor Rauner and Speaker Madigan continues. As it should. Madigan’s willingness to dispense unfunded largesse to his supporters is largely responsible for the state’s financial woes. Today also the state was ordered by a Federal court to pay its backlog of Medicaid bills, which will be interesting as the state is already cash flow negative.

However the biggest issue is the unfunded state employee pension obligations. This article from Bloomberg contains a nice graphic ostensibly showing the funding levels of most states (no data for California? Really? just check this blog)

These reported funding levels are a cruel joke. These funds continue to assume 7-8% returns, despite the fact that they have not achieved them for years. Just look at the column showing the decline in funding ratio from 2014 to 2015. Not only are the assumptions high, but they are for long-term averages, so that they adjust future return estimates higher to compensate for below-average realized returns. John Hussman’s work shows more or less zero returns for the next 12 years, with the high likelihood that there will be a major drawdown in that period. Drawdowns are lethal to pension funds because the payment of benefits continues, sapping the capital base and making recovery to previous levels nearly impossible.

Pension funds used to invest in bonds. The trustees would meet once a quarter, review the actuarial forecast of liabilities and approve adjustment of the laddered bond portfolio’s maturities to exactly meet the liability schedule. Then there would be lunch and golf. The future returns would be locked in and the contributions needed to fund the bond portfolio would be obtained from the sponsor. Everyone got to sleep at night.

Then Wall Street decided that pension funds had a lot of money, and not enough was being siphoned off into Wall Street pockets. So the sales force went out, armed with charts showing that stocks had historically offered higher returns than bonds. Higher returns mean that less contributions would be needed, so fund sponsors bought the pitch. Yes, stocks have offered higher returns but for a reason – much higher risk. Well, we’ll just assume a long-term average return and surely it will average out. GLWT.

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