The Next Catastrophe

Think Fannie Mae and Freddie Mac were a politicized financial disaster? Just wait until pension funds implode.

Funds worth trillions of dollars start to plummet in value. Political pressure to be “socially responsible” distorts the market decisions of government-related enterprises, leading to risky investments. Investors who once considered their retirements safely protectedwake up to a sinking feeling of uncertainty and gloom.

Sound like the great mortgage-fueled financial crisis of 2008? Sure. But it also describes a calamity likely to hit as soon as 2009. State, local, and private pension plans covering millions of government employees and union workers with “defined benefit” accounts are teetering on the brink of implosion, victims of both a sinking stock market and investment strategies influenced by political considerations.

From January to October 2008, defined benefit funds—those promising a predetermined amount of retirement money to the payee—averaged losses of 26 percent, according to Northern Trust Investment Risk and Analytical Services, making it the worst year on record for corporate and public pension funds. The largest public pension fund in the United States, the California Public Employees Retirement Security System (CalPERS), lost a staggering 20 percent of its value in just three months last year. In May 2008, Vallejo, California, became the largest city in the state ever to file for Chapter 9 bankruptcy, thanks largely to unmanageable pension obligations. The situation in San Diego looks worryingly similar. And corporations with defined benefit plans are seeking relief in Washington as part of a bailout season that shows no sign of slowing down.

If the stock market remains in a funk for even a few more months, corporations that oversee union pension funds and state and municipal leaders responsible for public retirement pools may be faced with difficult choices. First on the docket might be postponing cost-of-living increases and reducing health care coverage for retirees. Over the longer term, benefits for new employees will have to be shaved and everyone is likely to see an increase in personal payroll contributions. Corporations will have to resort to more cost cutting and layoffs of their own just to guarantee the solvency of their pension funds. And things could go from bad to terrible if the managers of those funds do not quickly revise their investment practices.

During melting markets, all pension funds come under siege. If you’re covered by a “defined contribution” plan, contributions are invested, usually by your employer and usually in the stock market, and the returns are credited to the employee’s account. Your retirement savings grow if the market rises or, as is the case now, bleed when it crashes. You carry the risk on your shoulders.

The risk shifts to the employer under “defined benefit” plans, in which future outlays are guaranteed. That seemed like a great idea for business as recently as 2007, when the market was rising and the pension funds of America’s 500 largest companies held a surplus of $60 billion. Now they’re at a deficit of $200 billion, with fund assets dropping like a lodestone.

The Pension Protection Act of 2006 requires that companies keep the accounts fully funded over time, meaning that they have to have enough money to pay all of their retirees should they decide to withdraw their funds. Yet more than 200 of the 500 big-company plans are nowhere close to meeting that standard, and those dire numbers are increasing.

Companies with defined-benefit pensions may soon find themselves choosing between making payroll or pumping money into their pension plans. If companies are forced to make up the shortfall out of their assets, which seems likely, that would send profits tumbling even more, further destabilizing the stock market. And even with a cash infusion, many businesses might still have to freeze or even cut benefits.

Both the corporations and the pensioners are victims of a market meltdown whose depth and duration almost no one predicted. Yet the investment performances of their corporate pension funds, while dismal, are holding up better than the returns of many public and union defined benefit plans. Those funds are facing their own reckoning, but in this case a lot of the pain is self-created and exacerbated by politics.

Social Investing Shenanigans

There is about $3.5 trillion sloshing through the U.S. retirement system, scattered across more than 2,600 public pension funds and federal retirement accounts. Another $1 trillion or so covers union workers at corporate jobs in which the union has key management control of the fund. These public and union-based defined benefit plans cover 27 million people and represent more than 30 percent of the $15 trillion dollars held in U.S. retirement accounts.

Traditionally, public investments and union-based corporate pension funds were managed according to strict fiduciary principles designed to protect workers and taxpayers. For the most part they invested in safe government securities, such as bonds or U.S. Treasury bills. Professional managers oversaw the funds with little political interference.

But during the last 30 years, state pension funds began playing the market, putting their money into riskier and riskier securities—first stocks, corporate bonds, and foreign investments, then real estate, private equity firms, and hedge funds. Concurrently, baby boomers whose politics were forged in the 1960s and ’70s began using those pension funds to advance their social visions. Investments designed for the long-term welfare of retirees began to evolve into a political hammer. Some good occasionally came from the effort, as when companies were pushed to become more accountable in their practices. But advocacy groups often used their clout to direct money into pet social projects with dubious fiduciary prospects. Sometimes the money went to the very companies and financial instruments that, in the wake of the market meltdown, are now widely derided.

Many union funds and larger state pension plans screen stocks and investment opportunities based on what are known as “socially responsible investing,” or SRI, principles. Instead of focusing solely on maximizing value, fund managers have used the economic clout of concentrated stock holdings to make a statement by divesting from companies that don’t make it through certain “sin screens.” These included companies involved with weapons, nuclear energy, tobacco, alcohol, natural resources, and genetic modifications on agriculture, many of which did well over the past decade. Stocks of public companies deemed to have poor records on labor, environmental issues, women’s rights, and gay rights are also frequently screened out, as are corporations that do business with regimes that activists consider unsavory. In some cases, investments have been withheld altogether from some of the markets expected to best weather the current financial storm, including China and India, because of perceived transgressions.

Socially responsible investing now claims a market of more than $2 trillion, according to the Social Investment Forum, the trade group for social investors. There are dozens of mutual funds and investment advisory companies that incorporate ideological screens. Most of them are liberal, although there are now a few conservative funds and some based on religious principles, such as Islamic law. Activist treasurers and pension fund managers in numerous states and municipalities, most notably in California, New York, and Connecticut, have incorporated social screens into their investment strategies.

Editor's Note: We invite comments and request that they be civil and on-topic. We do not moderate or assume any responsibility for comments, which are owned by the readers who post them. Comments do not represent the views of Reason.com or Reason Foundation. We reserve the right to delete any comment for any reason at any time. Report abuses.

  • joesixpack||

    What does Joe the Plumber think about this?

  • ||

    No surprise. Houston TX pensions will now be paid for with PENSION BONDS. Just like San Diego our kleptocrats screwed the pooch and the fool taxpayers are on the hook again. Unfortunately none of our crooks went, or will go, to jail.

  • LurkerBold||

    More evidence of your collapsing Capitalist system. When Obama begins converting the US to Progressivism then things will change for the better.

  • Reinmoose||

    One of the problems with funds that only invest in what they see as socially responsible firms is that these investments will atificially support a stock's price. Of course there are ways to be socially responsible without necessariliy hurting the bottom line (a dedication to promoting women to executive positions, for example), but deliberatly picking stocks based on the fact that you think they won't seek as much profit is a really stupid way to invest money that you need.
    Sure - if you have some extra money laying around, throw it at firms that incur extra costs to be environmentally friendly or be uberphilanthropic and all that - but don't do that with money you expect to grow at a certain rate and ultimately lead to your ability to retire with a house on the beach.

  • xyz||

    I supose if we all had invested with Nazi Germany in 1930 we will all be VERY RICH Nazis. The free world will not exist and Germany's Arian race will be ruling Washington and the rest of the world. Where will you the author find a place on the internet to voice your oppinion and not get your face broken afterwards in a prison cell?

  • Reinmoose||

    impressive - godwinned in the 5th comment.

  • ||

    Actually, lurkertroll, I would say that it's more evidence that "progressivism" is a pie-in-the-sky, dreamy vision that doesn't work. This has zero to do with capitalism and everything to do with social engineering. Had the investors stuck with the Make Money system of investing, rather than their warm-fuzzy dream of "making a difference", things probably would have worked out better for them.

    I know...don't bait the troll...I just couldn't resist.

  • ||

    Of course there are ways to be socially responsible without necessariliy hurting the bottom line (a dedication to promoting women to executive positions, for example)

    FAIL
    Promoting people with ovaries to executive positions over people with greater merit, can not help but have a detrimental effect on the bottom line.

  • Reinmoose||

    Warren -
    Fail yoself
    I didn't make any distinction over qualification. My statement was made assuming equal qualification between candidates.

  • ||

    So if a man and a woman have equal qualifications, the woman should automatically be the one chosen? Fail there too. That's discrimination.

  • Reinmoose||

    Ok, maybe someone should try reading what I wrote.

  • ||

    Don't worry about a thing- our retirement funds are safe as houses, mate!

  • ||

    Cool. Barack Obama will just help bankrupt the country like he helped bankrupt Illinois' pension systems. Obama voted to increase pension obligations and benefits for government union employees while also voting to decrease payments to fund those pension systems. As a result of Barack Obama's fiscal policy votes in Illinois, they now have this.

    "In the time it takes you to read this sentence, Illinois taxpayers will be $200 deeper in debt. The state's pension debt will exceed $44 billion this summer(08), increasing at a rate of about $120 per second, according to Gov. Rod Blagojevich's administration.

    The debt already tops $42 billion - enough to give every one of Illinois' 12.8 million residents a check for $3,300 or buy 937,000 Cadillacs at $45,000 a pop." - Springfield State Journal-Register 5/25/08

  • ||

    Reinmoose | January 12, 2009, 1:26pm | #
    Ok, maybe someone should try reading what I wrote.


    I read what you wrote. If what you wrote doesn't mean favoring women over men for promotion, then it doesn't mean anything.

  • Reinmoose||

    It didn't suggest favoring women over men. It brought it up as an example of one thing that could be described as "socially responsible" that would not necessarily have a detrimental effect on the bottom line of the company, leaving all other variables alone.
    Just because I admit that such a thing exists does not mean I'm in support of it. Although frankly, a company can do whatever they like - if they want to favor women, go ahead and do so. I imagine some companies that do this will end up more profitable than companies that don't, but not by virtue necessarily of the sex of their employees.

  • ||

    Excellent article. The point about SRI favoring companies who make symbolic gestures is an excellent one too.

  • LurkerBold||

    Companies should employ more women as part of social good. Women should be bosses for great justice.

  • Sam Grove||

    We've had progressive government in the U.S. for over a century.

    This is where it has brought us.

  • LurkerBold||

    HA! You call this corrupt Corporatist system Progressive? HA! FAIL

  • ||

    One thing that goes unacknowledged in assessing the Federal Government's balance sheet is the fact their pension scheme is completely empty. Congress robs it every year and stuffs it with IOU's of a similar legal structure to the "special securities" they ply into the Social Security system every year when they skim it.

    I don't know the exact numbers, but it is an onerous debt that the government perversely owes itself. Talk about an Enron scheme for hiding debt, they just do it right in front of our faces. At least the other public pension schemes actually invest the proceeds of the worker's payments (albeit poorly, it seems).

  • ||

    Progressivism as ideological vanity is not a sound investment for the future of anything .

    You see this stupid bullshit social awareness crap!?!?! This is why whatever horrible bullshit conservative rhetoric is out there, liberals will always be able to piss me off more.

  • Damn it all||

    "When Obama begins converting the US to Progressivism then things will change for the better."-
    But of course, Jesus dressed as a half Kenyan- half white American man has come to save us all.
    Sure if you like cradle to grave socialism.

    Progressivism is the back handed way of saying…baby sit.

  • ||

    I'm 50, never been in a union, or worked for the government, and have no pension at all. Please tax me more. Thankyou.

  • spike||

    Hey, I've got a great idea. Let's privatize Social Security!

  • Dan||

    I don't think the author really makes his case.

    The story is filled with specific anecdotes about investments that turned out badly, and decisions that cost potential gains, but the article does not tie these to overall performance of the funds, except by insinuation. To be convincing, I think the article would have to show that social investments were a major part of the overall investments, and that these specific investments performed significantly worse over a period of time.

    The story does not disentangle public pension fund underfunding from investment problems. Politicians have a well-known bias for believing extravagant promises of investment returns, because it allows them to promise great pension benefits to public employees while leaving plenty of money left over for other purposes. As I understand it, at least until recently, public pension funds were not subject to the same federal requirements as private plans. Even without investment problems, I believe that public pension plans in the United States are underfunded by trillions of dollars. To be more convincing, the story would have to distinguish poor investment performance from underfunding. For example, a 20% loss by Calpers is less than the average decline in the stock market.

    The story mixes different kinds of investment influences. Investing to promote specific causes, activist investing, and investing to provide jobs all have different effects. Investing to promote specific causes clearly reduces investment performance for social causes, which is potentially a problem. Activist investing (as famously practised by Calpers) is a way to increase returns. On average, I understand that management at large companies manages to squander about half of profits on ill-conceived expansion and excessive pay, with ill-conceived investments by far the larger of the two. Simply forcing a rubber-stamp Board of Directors to actually function can greatly increase returns, and this is what Calpers attempted. Investing to provide local jobs and housing is clearly counterproductive, because the investment will show losses precisely when the pension fund recipients most need the money. Regardless of the reasons this kind of investing is done, it is a mistake.

    Suspiciously absent is any discussion of pension fund management fees, which are an obvious source of problems.

    I think the article would be more convincing if it stated a hypothesis, such as that social investing is a problem, and showed the total effect as a lower long-term investment return compared to other types of investments. I think the article is less convincing when it mixes different issues, lists specific anecdotes without relating this to overall performance, and does not separate out other problems such as underfunding and excessive fees.

  • ||

    Eventually the taxpayers will rebel and refuse to vote for tax increases to cover these plans. The local governments will file for the chapter 9 and that will be that. The plans will be reduced from the impossible to the barely possible and that is as good as it will get. The states that have the highest burden are losing population, specifically from the productive segment. Eventually when the goose can't be plucked any further is when the proverbial spaghetti will hit the fan. Already there are rumblings in Congress about the bailouts, and this is occurring at the best possible moment for the statist. When the public pension bomb goes off, the fight between the states will be rather ugly, but in the end the more lefty states will take the hit as the rest of the country will be in no mood to subsidize them.

  • ||

    In NY, both the State and Municipal employees' pensions are guaranteed by the State Constitution. If the penion funds went bust, the taxpayer would have to come-up with additional funding. Even if the state filed bankruptcy, pensions would be paid first. In order for NYC to keep it's head above water, a new pension tier would have to be created. It is a difficult task to lure future employees, expecting them to do the same job for less moneys and a lesser of a pension. Middle class prospective employees will eventually leave (when a robust economy returns) for warmer weather and, hopefully, better opportunities. This is when a City starts to really decay... as did Detroit, et al.

  • ||

    States Lose 867 Billion in Pension Funds-

    Governors:
    Please give us a bailout because of our stupid social investments!

    http://www.bloomberg.com/apps/news?pid=20601087&sid=aw9HrY21Ynno&refer=worldwide

    I think we should give Citi Bank and Citi Group Credit card hijackers even more-

  • ||

    spike | January 12, 2009, 11:12pm | #
    Hey, I've got a great idea. Let's privatize Social Security!



    Great Idea!

    Then the FEDS can say- We so sorry! Our Bad! We lost all your retirement monies in a scam hedge fund.

    Hey! Don't laugh-
    It could save trillions in paper work.

  • Brian Cartmell||

    The United States hasn't ever really been a capitalist state, so blaming capitalism like some of the commenters on here is fairly naive, it's never been much of a free market either.

    Right now the biggest threat is the divide between the politicians and the rest of us, those states who funds should reign in the federal government which is out of control with power and spending.

    Also this just popped up on Bloomberg.

    (State Pensions' $865 Billion Loss Affects New Hires)

    http://www.bloomberg.com/apps/news?pid=20601109&sid=aV0VZMxdImVQ&refer=home

  • Keith Brainard||

    The author attributes the bankruptcy of the City of Vallejo "largely to unmanageable pension obligations." This is not true; Mr. Entine should correct this misrepresentation. Vallejo's bankruptcy was caused by declining tax receipts (mostly due to lower property tax collections) and exacerbated by high employee salaries. Vallejo city workers do not participate in Social Security, meaning that the employer (taxpayers) do not pay the 6.2 percent to Social Security most private sector workers pay. Vallejo's employer (taxpayer) pension contributions are consistent with most other public employers in California.

    Moreover, Mr. Entine does not put into proper context the value of the socially-responsible investments of public pension funds. Public pension funds hold assets of more than $2 trillion. Some funds have engaged in socially-responsible investing initiatives, but as a percentage of total assets, the sums are quite small and SRI cannot be held responsible for pension fund investment returns. In fact, for the 10-year period ended June 30, 2008, public pension fund investment returns outperformed their corporate pension fund counterparts as well as the universe of endowments and foundations. The idea that these funds are substandard performers is not supported by the facts.

    The author's contention that the Alaska public pension funds loaned one-third of the value of their assets to mortgages, is simply false. These funds had several billion in assets at that time; $165 million was nowhere near one-third of their value.

    Numerous studies by academics and professional economists recently have documented the positive economic benefits that emanate from public pension funds. Read some of those studies here:

    http://www.nasra.org/resources/economic.htm

    Do public pensions face problems? Yes. However, compared to any other facet of this nation's retirement benefit structure, including 401k plans, Social Security, pension benefits for federal employees, etc., pension benefits for employees of state and local government are in better condition and far more cost-effective.

    This is not the first attack by Reason on public pensions that relies on misrepresentations and distortions; read my response to a similar Reason attack several years ago, here:

    http://www.nasra.org/resources/NASRA%20Reason%20Response.pdf.

    Keith Brainard

  • ||

    LurkerBold you meant to say socialism not progressivism ...

    'Obama begins converting the US to socialism then things will change for the better'

    And of course because you are a socialist, you support using private tax payer's money to replenish government pension funds because the managers of these funds blew it. Isn't socialism great? We all get to pay for somebody elses mistakes and problems. That seems to be a major tenant of socialism.

    We will see about socialism changing things for the better. Socialism hasn't worked anywhere else and it will not work here. Calling it progressivism won't change that.

    If you want socialism, move to Europe and have 50% of your income stolen from you by the government in exchange for a nanny state and sub par services you probably don't even want.

    And remember lurker, progressivism is socialism. don't try to dress it up with a fancy word. Call it what it is. You are not fooling anyone. Troll.

  • ||

    "The plans will be reduced from the impossible to the barely possible and that is as good as it will get."

    I wish that was true. Unfortunately I think the federal government will make this its next big bailout and cover it with more federal debt. The old coots will get their SSI and their pensions, enjoy 30-year retirements, and the younger generations will work until they die in the traces, trying to pay for it all. Unless they move to another country.

  • ||

    "Unless they move to another country."

    It's not just a safe bet, it's already happening.

    Economist.com

    America's Berlin Wall

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