The Pension Cartoon

Nowhere is the cartoonification of politics and investing more prominent than in PensionWorld.

The Wall Street Journal published a story last week detailing Chicago’s plans to issue pension obligation bonds to help close their rather robust funding gap – $10 billion worth. The head of municipal strategies at Citi is quoted, calling it “…a big test for sure. But if it works it’ll set a good precedent for the other cities and states that have pension problems.”

This is “big test” in the way jumping out of an airplane without a parachute is a “big test” of the ability of our bones to withstand the force of a collision with the earth at terminal velocity. It’s a really, really bad idea.

Not because pensions running with leverage is inherently bad. There’s a place, maybe a big place, for a liquid and levered bond portfolio (err, I mean futures-based risk parity implementations) and an illiquid and levered equity portfolio (err, I mean private equity) in most pension plans. And not because issuing pension obligation bonds can’t be part of the solution for many plans – it can.

It’s a bad idea because in this case, the cost of this debt (these are taxable bonds, so Chicago will have to offer higher rates than other muni offerings) will require the assets bought with the proceeds to be riskier than the usual allocation, just to justify issuing the debt in the first place. In other words, they’re going to have to buy a lot of stocks. It’s absolutely possible that positive returns in some periods could exceed the cost of debt and the assumed rate of return. It’s also absolutely possible that in one of those years, the negative returns on an equity portfolio could be enough when levered up to 2x that they would, for all practical purposes, wipe out the plan’s assets. Not impair. Not reduce fundedness. Take to zero.

How did we get here? How is it even possible that smart, well-meaning people – which, in my experience, describes the vast majority of pension fund trustees and managers – could even contemplate this action?

Because public defined-benefit plans depend on narrative cartoons and common knowledge.

Every public pension narrative is built around a sentence that starts with, “We can always…”

In left-leaning states, the faith-supporting narrative for pension plans is usually some variant of, “We can always raise taxes,” by which they mean that they can always squeeze homeowners and really put the screws to “the rich”. In right-leaning states, the narrative is usually, “We can always restructure benefits,” by which they mean that they can always squeeze current beneficiaries and really put the screws to new hires. These are usually strong narratives, and they keep the shockingly low funding levels – themselves typically built on very aggressive long-term return assumptions – outside the public eye.

You do not choose to run the real risk of ruin unless you know or have discovered that you can’t actually do the things everyone thought “we can always do.”

So if we all know that the emperor has no clothes, why are we all still watching the procession as if we didn’t know? Because the alternative (raising taxes AND reducing benefits, by a lot) is something our narrative attachments in a twin-peaked political environment won’t let us even consider, and because the cartoons created by long-term return assumptions, actuarial smoothing, benefits projections and arithmetic (vs. geometric) math take time to unwind.

But unwind they will.

For more on the cartoonification of politics and investing, read “The Icarus Moment“.

For more on the role of time in the unwinding of narrative abstractions, read “The Fundamentals are Sound“.

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