March 7, 2014 6:27 p.m. ET
The Detroit bankruptcy is offering a hard education in the risks of lending to deadbeat governments, which are increasing as state and local pension obligations swell. Investors who have enabled these unsustainable promises may be in for a lot more pain.
Public pension funds have posted double-digit gains four of the last five years, and asset levels have never been higher. Yet government pension costs are soaring as the bills that politicians postponed during the hard economic times come due. No less than Warren Buffettwarned this week that “local and state financial problems are accelerating, in large part because public entities promised pensions they couldn’t afford.” Moody’s MCO +0.14% last month advised investors that “contribution requirements for pensions will remain high and trending upward in most cases.”
Perhaps the biggest pension landmine outside of Detroit is Chicago. The Windy City next year must make a $1.07 billion balloon payment—equal to a third of the city’s operating budget—on $19.4 billion of pension debt. The pension payment could cover salaries for 4,300 police officers or the resurfacing of 16,000 blocks of road, and Mayor Rahm Emanuel has warned that property taxes may have to double to pay the bill.
Railroad ties and track are stacked along the CTA’s Red Line reconstruction route on Chicago’s South Side. Associated Press
Meantime, the required pension contribution for Chicago schools this year is tripling to $613 million. Chicago unions are pressing the state government to raise property, sales, income and corporate taxes to bail out worker pensions. Chicago’s pension funds are only half as well-funded as even Detroit’s, if you can believe it, and could run dry by 2020. With state politicians up for re-election this November and Chicago’s mayoral race next February, it’s more likely that investors will foot the bill.
Last month, Chicago’s city council approved the issuance of $500 million in commercial paper and $900 million in general-obligation bonds purportedly to refinance existing debt and improve public works. There’s little to stop politicians from pouring the proceeds into pensions—or later reneging on this unsecured debt if it were to file for bankruptcy.
Detroit plans to repay its general-obligation bondholders a mere 20 cents on the dollar and has sued to invalidate $1.4 billion in certificates of participation, which were used to backfill the pension funds in 2005. Banks that helped the city hedge this pension bet with an interest-rate swap will be lucky to recover 30%. Unions refuse to support a readjustment plan that repays banks even a penny since this would be a “gift” to investors.
Retirees’ pensions will be cut between 4% and 34%, but unlike investors they could recoup their losses if pension investments perform well. Workers will also get to keep their defined-benefit plans with modest adjustments going forward.
Back in Stockton, California, which declared bankruptcy in 2012 due partly to soaring retirement obligations, Franklin Templeton Investments is recovering only $94,000 of the $35 million it furnished the city to modernize public works. Investors who lent the city $125 million for pensions will get 50 cents on the dollar. Worker pensions will remain intact.
Moody’s last month warned that California municipalities “will likely continue to pay a steep price if bankruptcies remain venues for restructuring debt obligations but pension liabilities remain untouched” and that Stockton’s fiscal challenges could resurface. The Bay area suburb of Vallejo, which didn’t modify pensions in its recent bankruptcy, faces a structural deficit of “$8.9 million without corrective measures” and “the risk of a second bankruptcy.”
Pension costs are increasing across California. In the last year, the California Public Employees’ Retirement System (Calpers) has raised pension bills of municipal employers by up to 50% to amortize its unfunded liability and compensate for its erroneous mortality assumptions. Local governments won’t feel the full brunt until 2020 since the pension behemoth softened the blow by phasing the increase in over several years.
Calpers also voted last month to dun state taxpayers for an additional $1.2 billion a year. And lo, the state Legislative Analyst’s Office says that California State Teachers’ Retirement System (Calstrs) says it needs $5.3 billion to $5.7 billion more annually by 2020 to pay down its $71 billion shortfall. That’s more than California spends on the University of California and Cal State colleges.
Not worried enough? Governor Chris Christie in New Jersey has declared that modest pension reforms in 2011, which suspended retirees’ cost-of-living adjustments and raised the retirement age to 65 from 55 for new workers, were too little, too late. The state’s pension bill has gone from zero to $2.4 billion in the last four years and will increase to $4.8 billion by 2018, which will crimp public services.
As Mr. Christie has explained, politicians goosed benefits during good times to curry favor with public unions, knowing that the bills wouldn’t come due for many years. Unions now argue that retirement promises are de facto contracts that the U.S. and state constitutions protect from impairment, and they’re going to court in states like Illinois to try to prove it.
Governments have sought to reduce their pension bills by tweaking benefits for new workers, but this won’t save much cash for decades. So taxpayers are now footing the bills in reduced services and higher taxes. Yet as Detroit shows, there’s only so much pain the public can endure. Investors shouldn’t be surprised if they’re asked for more “gifts” to bail out union pensions.
Wall Street Journal Op-Ed. “Red Alert for Public Pensions.” Wall Street Journal, Wall Street Journal. 7 March 2014. www.wsj.com. 7 March 2014.