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Underfunded Pensions and a Devil’s Bargain

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By Elisanth @ Shutterstock.com

In Pontiac, Michigan, pensions for public employees have been underfunded for years, and the city is going to raise taxes to help fund pension payments.

This same predicament is playing out across America, with pensions in many states and cities woefully underfunded, and with pension boards who overestimate returns to paper over the problem.

Like many pensions, those in Pontiac are restricted on the proportion of assets that may be invested in equities compared to fixed income and other securities. The current limit is 40% of assets may be invested in equities. These limits are in place to prevent pension fund managers from taking on too much risk. This is a prudent policy that aligns retirees’ investments with the level of risk normally suggested for people their age.

Despite raising taxes, Pontiac’s pensions are still in trouble. The city wants to be able to invest more of its elderly retirees’ money in riskier equity assets to attempt to make up its shortfall with higher expected returns. The problem with that plan is that higher expected returns don’t always materialize. Adding risk to the portfolio could work, but it could also open up the fund to massive losses that wouldn’t have been as likely with a greater portion of the portfolio in fixed income. Taking on more risk in an attempt to gamble for better returns is a devil’s bargain.

Paul Westermeyer reports on Pontiac’s pension situation in the Pontiac Daily Leader:

Having been put in an unenviable position, the Pontiac City Council took a step at its Dec. 3 meeting that it was unwilling to take the year prior — the body voted to increase its annual levy beyond the 2.1 percent rate of inflation in order to combat the growing costs of local pensions. Despite some dissent in 2017, the more palatable choice then was to not raise taxes.

Avoiding the ire of taxpayers did not allow the city to cut into its ballooning pension deficit for public jobs, which have hurt municipalities as much as they’ve hurt the state government. But a recently released study suggests that there’s a way to help curtail the pension crisis without risking an incensed public.

Part of the trouble, City Administrator Bob Karls has noted, is the tight restrictions on how pension boards, such as the local fire and police pension boards, are allowed to invest.

Pension boards are allowed to put 40 percent of its allocations in the stock market, which makes hitting the 6 percent rate of return factored into the state’s actuarial calculations difficult. The success of this measure has been mixed, predicated on a pension board’s chosen investment firm’s ability to accurately forecast the stock market. Some pension boards of smaller municipalities might not have the same talent pool of those with market acuity that larger cities might.

Yet the pension problem remains significant enough locally to require a property tax hike, albeit a small one. The increased levy, which would tack on about $37,000 from the new equalized assessed valuation, amounted to about an extra $7 a homeowner would have to pay — provided they possessed a $100,000 property.

Beating the pension problem will require more than very modest tax increases. A study commissioned by the Illinois Public Pension Fund Association argues that there’s merit in easing a pension fund investment restriction.

You can see on my display of the arithmetic of portfolio losses below that losing money on risky bets can be debilitating for a retirement portfolio. Protect your wealth.

Arithmetic of Portfolio Losses
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E.J. Smith - Your Survival Guy

E.J. Smith is Founder of YourSurvivalGuy.com, Managing Director at Richard C. Young & Co., Ltd., a Managing Editor of Richardcyoung.com, and Editor-in-Chief of Youngresearch.com. E.J. graduated from Babson College in Wellesley, Massachusetts, with a B.S. in finance and investments. In 1995, E.J. began his investment career at Fidelity Investments in Boston before joining Richard C. Young & Co., Ltd. in 1998. E.J. has trained at Sig Sauer Academy in Epping, NH. His first drum set was a 5-piece Slingerland with Zilldjians. He grew-up worshiping Neil Peart of the band Rush, and loves the song Tom Sawyer—the name of his family’s boat, a Grady-White Canyon 306. He grew up in Mattapoisett, MA, an idyllic small town on the water near Cape Cod. He spends time in Newport, RI and Bartlett, NH—both as far away from Wall Street as one could mentally get. The Newport office is on a quiet, tree lined street not far from the harbor and the log cabin in Bartlett, NH, the “Live Free or Die” state, sits on the edge of the White Mountain National Forest. He enjoys spending time in Key West and Paris. Please get in touch with E.J. at ejsmith@yoursurvivalguy.com