Historically Low Interest Rates are a Double-Edged Sword for States

The federal government has a problem with debt and deficit spending, as well as a future funding crisis in Social Security and Medicare. And Bernie Sanders wants to give it to you for free. At a point in the not so distant future, the well will run dry for the feds, as baby boomers suck the last of their retirement benefits out of the system. Oh well, why worry today when it will be some other politicians problem tomorrow.

Our individual states will not get off the hook either without some financial changes. For states, the concern centers around interest rates and its dichotomy, in that municipalities are now paying no more than 2% interest to finance infrastructure and other capital needs. This is a good thing.

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The American Society of Civil Engineers estimates a lack of investment will cost almost $4 trillion in gross domestic product by 2025. Measured per household, that’s a loss of $3,400 a year thanks to congested roads, overworked electric grids, and other deficiencies. If U.S. Treasury yields drop to zero, as some economists expect, it stands to reason that rates for states will go down, too.

The debit side of the balance sheet shows the downside of very low interest rates. With $3 trillion in pension assets, states also face a cumulative unfunded liability of more than $1 trillion, even after the longest economic expansion in U.S. history. As the Federal Reserve cut rates for the first time since 2008 today, that pension liability number could be actually much higher.

Most plans assume annual returns of 7% to 8%. Were the U.S. to enter a recession, with bonds already yielding next to nothing, it would become virtually impossible to meet that target. A microcosm of this happened in California. The two largest U.S. pension funds, representing California’s public employees and teachers, respectively, each reported in July that they came up short in 2018 when the S&P 500 was down for the year.

Data from the Pew Charitable Trusts for fiscal year 2017 saw a combined $1.28 trillion in state pension plan funding deficits. That number keeps state comptrollers up at night. The following Wall Street Journal data shows the 10 best states, as far as pension funding goes.

I knew you would ask, so the following are the top 10 states with the lowest funded obligations:

The high yielding corporate debt that pension plans were buying in the ’90s will be maturing soon. Back then, the yields of roughly 7% covered their exposure perfectly. Present bonds will have a yield to maturity of half that number, thus compounding the ability to meet their targets. So what is one to do?

If you are a teacher or firefighter, the only two choices are to contribute more money now or take on additional risk. Unless the risk-asset rally lasts forever, loading up on equities and alternatives won’t be a long-term solution. More likely, states and cities will eventually divert a larger share of their budgets to supporting pensions. That means less funding for infrastructure. Hence the double-edged sword.

About John Thomas

John Patrick Thomas is a four-time cancer survivor who lives with his family in South Florida. John attended Gettysburg College and The American University before embarking on an entrepreneurial career on Wall Street. He turned to the teaching profession after his life-threatening bout with bone cancer. John has recently written a #1 Amazon Cancer Bestselling book entitled, “A Call to Faith, the Journey of a Cancer Survivor.” He has appeared in publications such as The New York Times, The Wall St. Journal, The Washington Post, Memorial Sloan-Kettering Cancer Center publications, and was featured in new DayStar network series, “Impact with Pastor Dave.” He has traveled as a missionary and may be one of the few people that tell you cancer was the best thing to ever happen to him. You’ll have to ask him why.

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