Everyone seems to know the current path of federal fiscal policy is a deathtrap over the long term. What’s peculiar is the relative inattention to the balance sheets of state and local governments.
Hidden behind accounting fictions, the politically unspeakable reality is that public employee pension systems are under-funded by more than $2 trillion. Add more than $1 trillion in unfunded health care benefits for retired public employees, and state governments face protracted structural deficits ranging from challenging to insurmountable.
Unfunded promises are the equivalent of government debt. The burden of promises made by state governments to their employees – effectively an invisible wealth transfer from future taxpayers to current and prospective public sector employees – amounts to about one-quarter of U.S. gross domestic product. The strength and durability of the current economic recovery are unknowable. That state and local governments, which employ one in nine workers, will be a drag on that recovery is certain.
Ultimately, mathematically unsustainable trends must reverse. States cannot kick the can down the road ad infinitum.
The severity of the problem and the short-term focus of the interested parties create powerful incentives for elected officials and others to avoid doing the math.
In theory, exceptional investment returns could cover any funding gap. But beyond the improbability of sustained returns above historic norms, a skeptic might argue public pensions frequently tend toward an investment process heavily geared toward reputational risk control – which means averting political criticism – under the nominal guise of prudent investment management. Although it may be counterintuitive, systems geared toward perceived safety and political risk avoidance may in fact increase investment risk.
My impression is that too many fiduciaries think they can play it safe professionally by mimicking the investment decisions of their peers in other states. Consultants, in turn, tend to be too sensitive to the herding instincts of their clients, reinforcing the trend to invest in ways that are only perceived to be safe.
The herding effect is powerfully reinforced by how we interpret our legal responsibilities as fiduciaries. We are held to a prudent-man standard. At any point in time, many of us might differ as to what constitutes a prudently positioned portfolio.
But the law in effect creates a safe harbor for fiduciaries imitating the most common strategies of other fiduciaries. The fiduciary at legal risk is the one pursuing an unconventional strategy. So we have an anomaly. Investment success arises from purchasing assets that are cheap because they are undervalued by the crowd. But the only unassailable defense against legal exposure is pursuit of the crowd.
In looking at the pension problem, I would draw three broad inferences.
First, there is a correlation in government between the creation of long-term liabilities and the propensity to rely on fantasy math.
Second, the parties to the arrangement suffer to the extent they fail to understand the math.
Third, there is an inverse correlation between the magnitude of a shortfall and the visibility of the issue. Precisely because the size of the problem precludes easy answers, it lies beneath the surface of the public dialogue. •
Orin S. Kramer is chairman of New Jersey’s State Investment Council and manager of Boston Provident Partners.
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