Start the conversation
It's been 25 years since state and local governments across the United States were in such bad shape – and the budgetary pain is far from over.
The state-funding gap is growing, local governments lost 76,000 jobs last month, and property tax receipts are slated to fall for years.
"While the recession might have officially ended on the national level, cities are in the eye of the storm and the problems are intensifying," Christopher Hoene, a director at the National League of Cities, told The Financial Times.
A study released last week showed that big U.S. cities could face a painful financial squeeze: Their pension plans are under-funded to the tune of $547 billion.
And that's only part of a very ugly public-pension picture. State-run pensions are believed to have unfounded liabilities of $3 trillion, according to research by Kellogg School of Management at Northwestern University and the University of Rochester.
Of the 50 cities and counties studied, Philadelphia is in the worst shape, with only enough assets to pay benefits in current pension plans through 2015. Boston and Chicago would run out of money by 2019.
Another recent study by the Citizens Budget Commission of New York measured states' financial obligations against their economic resources. The study gave New Jersey the worst ranking, although the fiscal outlooks for New York, California, Illinois and Rhode Island are nearly as dismal.
Because states and cities didn't keep their financial houses in order, taxpayers can look forward to years of tax increases, service cuts and other slick tricks to foot the bill for unfounded pension obligations. And that bleak outlook could actually exacerbate the situation and accelerate urban flight by pushing many current urban residents to head for "greener" (read that to mean suburban) pastures – further eroding city tax bases.
"The fact that there is such a large burden of public employee pensions concentrated in urban metropolitan areas threatens the long-run economic viability of these cites, as residents can potentially move elsewhere to escape the situation," Joshua Rauh of the Kellogg School told The FT.
The truly frightening state of local government finances is sparking heightened concern for municipal bond investors.
Investors are scrutinizing "munis" more than ever – and with good reason: Some governments have masked their budgetary woes with such creative accounting methods as borrowing money for operational needs, moving money from task-dedicated funds to general funds, and pushing vendor payments into future fiscal years.
And those employed tactics aren't presented to bond investors.
"The long-running use of gimmicks is part of the reason most state budgets are in crisis today," George Mason University's Eileen Norcross wrote in a recent study cited by The Wall Street Journal.
Take Illinois, which presented a $10 billion bond offering in 2003 and used extensive borrowing to make its pensions appear well funded. Then the state skipped contributions for years, and now a Northwestern University study projected that Illinois's pension system could run out of money in the next decade.
Money Morning Contributing Editor Martin Hutchinson warned investors in July to avoid the muni sector, citing the exorbitant state budget shortfalls.
"[I]t seems hopelessly unlikely that all the vulnerable states – and there are perhaps a dozen with considerable degrees of vulnerability – will be able to save themselves this time around," said Hutchinson. "And this will all come back to bite investors."
While bondholders often think they get first dibs on government funds, getting paid in a fiscal crisis will not be as easy as they hope.
As Kellogg's Rauh noted: "The bondholders would be competing with the pension beneficiaries for scarce government resources."
This prompted last week's installment of the Money Morning "Question of the Week": Are you vulnerable to this state-and-local government budgetary squeeze? Have you seen – or are you expecting – spending and service cuts and big tax increases? Is your retirement tied to this public-sector-finance disaster? Would you consider switching jobs, or perhaps even moving to escape this public-budgetary fallout? Finally, as an investor, do you trust municipal bonds, or are you now avoiding them?
Following are responses we've received from readers concerned about their local governments and questioning the argument that munis might not really be a safe investment.
States Pulled in Two Directions
Am I vulnerable? You bet. I work for the state of New Jersey. We've been cutting services for years, and with reason (though not a good one) – we don't want to raise taxes, yet we can't afford to offer services at the discounted prices politicians are willing to charge. Who ever said that quality services were supposed to be cheap? Governor Chris Christie is trying to rein in the horses, but the monster (federal government) is breathing down his neck ever harder to spend even more money that the government still doesn't have.
Unless governors take matters into their own hands and inject some discipline into the budget process by charging users what their services really cost, and refusing to spend the funny money Congress continues to print in an ever increasing bid to buy votes and power, we're done. I have no faith in legislators' ability to grow up any other way.
– Jim K.
Taking Matters Into My Own Hands
Yes, I am subject to local government budgets. I am a local government employee with 20 years in the fire service. I was demoted a pay grade during the last budget cuts and I'm lucky I still have a job, so they tell me. They're looking at another 12% cut across all departments; they're anti-business and pro-fees and taxes. It is nuts. As a union we get a lot of bad press but we have been working with the city and have given back quite a bit of what we gained during the boom times.
Unfortunately, the pension issue is untouchable on both sides. Over 20 years I went from the 2%-at-55 compensation formula to the 3%-at-50 formula. That benefit is nuts in itself and only sustainable in boom times. No one thought that we'd be where we are today. The city could have said no but they bought the union line that employees would leave for greener pastures if they didn't give us the benefit. I swear, local government politicians are every bit as bad at making decisions, and worse, than our national politicians.
So, I'm taking matters into my own hands here, minding my investments better, starting a couple of internet businesses, and basically looking for new cheese since my current cheese is looking moldy and starting to smell bad.
No More Pension Plans
This is going to be a very unpopular point of view, but stop publicly funded pension plans. Work while you can, save your own money, and manage your own retirement plan. Do not rely on the government to care about your future. Also, when you are no longer working and serving the public, the public should no longer be obligated to pay you.
– Brecken L.
Still in Favor of Munis
I strongly disagree with the assumption that munis may not be the place to be right now. Actually I believe just the opposite. First of all, there is the supply issue. This was mainly created because of the Build America Bonds, which were technically munis but were not tax free, because they were subsidized by federal money. As a result, tax-free munis soon became short in supply.
A higher tax environment under the current administration is only going to exacerbate this issue, as there will be more and more people seeking relief from Uncle Sam, especially retirees and those in higher tax brackets. It is very difficult in this environment to find AAA-rated munis near 5% (federal-tax-free yield) without paying a large premium. These are the same bonds that I was able to get at substantial discounts just a year ago.
Then there is the default risk. Only I see it a little differently. When compared to corporate bonds the default rates (according to Moody's report on defaults back in February) are not even close. Investment grade munis 10-year cumulative default rates (of which four of those years the country experienced severe recessions) is a paltry .06%. Corporates were 2.5%.
Non-investment grade munis during this tough 10-year period did reach 4.55%, but corporate bonds reached 34.01%. I strongly agree that rating research is now more important than ever, but when compared, historically, to the alternatives, munis are still a very high quality investment class.
Finally, last year, California wasn't the big problem, it was actually Florida. More than half of the defaults experienced last year were connected to Florida real estate.
I think it's time to position ourselves for higher taxes of which munis are an important part.
Obviously, as an advisor, I have to study, in depth, the bond market. Not many people realize that the bond market is about three times larger than the stock market They are an important part of most portfolios and as an investment strategy the odds are in your favor.
I'll take those odds any day.
– Dion M.
[Editor's Note: Thanks to all who responded to last week's "Question of the Week" feature regarding state and local governments' budgetary concerns. Be sure to answer next week's question: How will Mortgagegate affect you and your investments and financial assets? Has a fatal flaw been exposed in the foreclosure process that will spark a "financial tsunami"? How can the foreclosure process be changed to ensure less negligence and more fairness and efficiency?
Send your answers to email@example.com.!
Is there a topic you want to see covered as a "Question of the Week" feature? Then let us know by e-mailing Money Morning at firstname.lastname@example.org. Make sure to reference "question of the week suggestion" in the subject line. We reserve the right to edit responses for length, grammar and clarity.
Thanks to everyone who took the time to participate – via e-mail or by posting their comments directly on the Money Morning Web site.]
News and Related Story Links:
- Money Morning:
Defensive Investing: Beware of Municipal Bonds
- Financial Times:
US cities face big public pension deficits
- Financial Times:
US cities feel tax hit on real estate bust
- The Wall Street Journal:
How States Hide Their Budget Deficits
- Money Morning News Archive:
Question of the Week Feature