The Pension Time Bomb

In recent years, there have been intense political battles regarding pension systems, and these arguments will persist and only worsen.  Many readers of this website will have sharply divergent views from one another on this topic, so I will do my best to present this in a rational economic construct.

Governments on the federal, state, and municipal levels have completely and systematically overpromised pension benefits to current and retired employees.  The mid-to-late 1990s witnessed significant economic growth and stock market appreciation, which is unquestionably a good thing, but unfortunately this outperformance set unrealistically high expectations for future investment growth rates.  Many politicians, who receive significant campaign contributions and electoral support from public sector unions, were incentivized to make pension plans more and more generous.

Unfortunately, investment returns over the past 13 years have been quite paltry.  Crucially, for the past four years and going forward for at least the next couple, we have been in a protracted low interest rate environment.  This drives bond yields lower, thereby making it exceedingly difficult for pension funds to achieve investment targets without taking undue risks.

Source:  http://www.freeworldmaps.net/printable/us/us_political2.gif

Nearly every state now finds itself having promised way more in benefits than it can possibly deliver.  As we have witnessed in California and other high-tax states, trying to tax your way out of this problem ends up being largely counterproductive, as businesses and higher-income earners end up relocating to states like Texas and Florida which are relative tax havens.  In this still-depressed economic environment, states may be able to raise some revenue without suffering a significant exodus, but not nearly enough to make up for the pension shortfall.

This leaves us with an uncomfortable realization, but a realization nonetheless.  Pension reform isn’t a choice, it’s a necessity.  And the sooner states adopt pension reforms, mathematics proves that comparatively small short-term sacrifices will be far preferable than having a bankrupted system that cannot afford to make any payments to retirees.

The next article below provides the math to back up this statement.