Thursday, January 20, 2011
What clients told me is important
Each year in January I try to meet with as many of my clients in person as I can. We talk about the previous years performance, what my expectations are for the coming year and what changes I might want to make in their portfolios. I also spend time asking them what are they concerned about for the next 12 months and longer.
I have to say that I was very surprised by the comments I heard this year especially after the mid term election results. I found two themes were repeated more than any others in these discussions; the level of government spending and the amount of debt at both the Federal and state level.
Clients who owned municipal bonds were worried about the interest payments and if they would receive their money back when the bonds were due. A look at the chart below -- it shows why they are and you should be concerned. Look at what has happened to the total return on the national index line of tax-free bonds and California and New York long-term bonds. What the picture shows is that there is very little confidence in the muni marketplace.
In a recent article in the New York Times covering the problems in the State of Illinois, it reported that the state was over $13 billion in the red. The article went on further to say that the State needed to borrow $3.7 billion to make the retirement fund payments so there was sufficient money to make payments to the beneficiaries. In the deep recesses of my mind I remembered that Illinois had come to the bond market twice before with pension bonds to shore up the shortfall.
I did some research on my own and found that with the most recent $3.7 billion in pension bonds the state had issued over $30 billion in pension bonds to help fix the fund in the last 10 years. The Times article went on to say that Illinois had the lowest pension-funding ratio in the nation. It suggested that the state had only funded about 65% of its liabilities.
Many states have serious funding issues and growing deficits because expenses are exceeding income and have for some time. S&P just reported that they believe that the amount of unfunded post employment liabilities at the state and local level is in excess of 2 trillion dollars. We found out through our new governor in New Jersey that a number of local governments had not been making payments on behalf of their employees to the state retirement fund. They were living off the assumption that the state pension funds would earn 8% and cover their shortfall and unfunded liabilities.
The big problem with using an 8% assumed return for pension assets is that the S&P 500 has had an average rate of return over the last 10 years of negative returns. So how valid is the 8% assumption?
If the plan sponsor, the state, were to adjust downward the assumed return on the pension assets reflecting as PIMCO says is the new normal, then the contributions from the governments to fund the pension liabilities would have to rise significantly. The reason is that the lower rate of return the greater the amount of money that has to be invested to produce enough to make the pension payment to the beneficiaries. The states don’t have the money to make the current payments let alone increasing the amount of the contribution driven by a reduction in the assumed rate of return.
In my first blog of the year I suggested some of the things that could adversely affect the markets this year, one was the problem in the municipal bond market. I think the chart above shows why I have concerns. I truly believe that with unemployment at just under 10% and the housing market going nowhere we are sitting on a time bomb. Illinois answer was to hold spending at the 2010 level which was already at a deficit, increase personal income taxes by 65% and raise taxes on corporations. I truly believe that the public sector retirement system and other state budgets have to change. I realize that many people will be hurt, but unless we bite the bullet now millions of Americans besides state employees will be adversely affected.
If you think that muni bonds looks attractive then take another look at the chart and see what the capital markets are saying about the desirability of owning tax-free bonds.