Other people's pensions can threaten your retirement
Although public pension funding sounds like an obscure issue, it directly affects how we are investing client portfolios today. Historically, we have invested a portion of clients' taxable portfolios in municipal bonds. These bonds generally offer federal (and sometimes state) tax-free income, and as an investment class were considered quite secure. Thus, municipal bonds have been a conservative way to generate meaningful tax-free income for investors.
But over the last few years, we have been reducing our investments in municipal bonds primarily because of the issues related to public pension funding. You may have heard the news reports lately that many public pension plans are underfunded. What this means is that based on the amount of promised retirement plan benefits to public employees, the plans don't have enough money to pay them. This funding gap is estimated to reach into the trillion dollar plus range. When your liabilities start with a "t" … that's a lot of money.
The reason these liabilities impact our investment decisions is that when investors buy municipal bonds, they are basically lending money to a state or local government in exchange for the tax-free interest payments and the return of their principal when the bond matures. But, if states and cities have huge unfunded pension liabilities, there is a risk that when money gets tight, politicians will favor making pension contributions over making bond interest or principal payments.
We say there is a risk because the law is unsettled in this area. It's not clear how bankruptcy issues may apply to public entities; plus pension benefits can hold a different legal status depending on the locality. But the bottom line is when times get tough and states or cities run out of money (as some have and others are projected to do), who do you think they are likely to favor with the few dollars they have left? Will they favor the pensioners who likely live in their districts and vote? Or, will they work hard to pay the bond holders who most likely don't live in their district and can't vote?
Our sense is that if politicians have been irresponsible enough to promise benefits and fail to fund them, then it's not a far stretch to assume they'd be irresponsible with borrowing money and failing to pay it all back. (This is the same reason why we are not interested in European government debt, as we watch the financial comedy in Greece unfold).
Now, to be clear, not all public entities are the same. Many have been very responsible and have adequately funded their pensions. These municipalities still offer investors opportunities for safe, tax-free income. But the pressures are mounting in many state and local entities because of public pension obligations. These issues may take many years to surface because states and local governments aren't subject to strict accounting rules. But, some of the writing is on the wall.
Metrics like deteriorating credit ratings, high unfunded post-employment obligations and a struggling taxpayer base are red flags. If you're wondering what entities might exhibit some of these characteristics, the state of Illinois, the city of Chicago, New Jersey and Puerto Rico serve as examples.
As a result, we have been reducing our general municipal bond exposure and staying focused on those municipalities that are being careful with their finances. When it comes to bond investing, it's the return "of" the money that's more important than the return "on" the money.