The state pension crisis and Obamacare as the two biggest problems for the US economy moving forward. CALPERS, the California Public Employee retirement system, was only able to earn a 1% return over the past year. That compares to their 7.5% actuarial assumption. There’s no way for the big public employee pension funds to earn 7.5% annualized returns consistently without taking outsized risks, when 10-yr treasury bonds are paying out 1.75% yields.
Even the positive FY 2011 returns for CALPERS are misleading. Much of California’s huge gain on bonds is coming from falling bond yields, as some investors (particularly financial institutions) are willing to take ridiculously weak yields since they have no better alternatives for investment. This situation is unlikely to continue, which means the pension funds will either take very low yields, as well (a worst-case scenario), or yields start to recover, but the pension funds’ get hit by falling bond prices. They lose either way, but at least in the latter scenario, they might be able to find some alternatives (e.g. real estate).
But the bottom line is that the pension funds are going to have difficulty earning 7.5% on an annual basis for the next 5-10 years, without taking huge risks by expanding their investments in alternative investment vehicles, such as hedge funds and private equity. Even that might not be enough, because remember, the “7.5%” assumes that they are adequately funded to begin with; and most of these pension funds are not.
In reality, these funds have to earn more than 7.5% to avoid insolvency; which is going to eventually end up triggering a political crisis in California, as well as other majorly underfunded states, such as Illinois. The end result will either be major cuts, or significantly higher taxes, and the latter solution is not sustainable.
For these reasons, I view the state pension issues as being one (if not “the“) of the biggest macroeconomic risks in the US over the next decade.