The steep market declines over the past year have left many state and local governments struggling with severely underfunded pension plans.  The Wall Street Journal reported today that several states and municipalities are considering extreme measures to address pension shortfalls.  For example, New Jersey is considering a bill that will allow municipalities to defer payment of half of their annual pension bill for a full year.  Pennsylvania’s state employee and pubic teachers pension funds have warned that employer contribution rates could approach 28% of payroll starting in 2012.  Detroit’s police and fire pension plan may require contribution rates of 50% of payroll starting in 2011.

Roger Lowenstein wrote about the pension crisis in his recent book, While America Aged, which I reviewed in February.   Lowenstein discussed the New York City transit pension problems of the 1970s and the San Diego city pension debacle earlier this decade.  It appears that the same movie is playing again with the state and municipal governments discussed in the Journal’s article.  Since retirement benefits for most public employees are guaranteed by law, very little flexibility exists for politicians hamstrung by years of habitual under funding.  The best they can do is attempt to constrain benefits for future employees.  Current employees are grandfathered into pension plans based on already negotiated terms which are, for the most part, set in stone.

Even proposing very modest changes for future retirees can be political dynamite.  One would think that Gov. David Patterson and Mayor Michael Bloomberg’s proposal to establish a minimum retirement age of 50 for future New York City firefighters and police would be a common sense way to reduce the problem.  Currently, such workers must only work 20 years and have no minimum age requirement prior to taking full retirement benefits.

Implications for Municipal Bond Insurance

Historically, defaults for tax-exempt bonds have been very rare, and such securities are widely considered to be safe fixed income investments for individuals and institutions.  However, the stress faced by the pensions crisis poses a very real threat to the safety of many municipal bonds.

Warren Buffett recently made some very interesting observations regarding municipal bond insurance.  Berkshire entered the business of insuring tax exempt bonds issued by states and municipalities in early 2008 after many of the established players in the business ran into financial difficulties in 2007.  In Buffett’s letter to shareholders, he issues the following warning regarding how the existence of insurance on municipal bonds could alter the incentives of different stakeholders.  He uses the same example Lowenstein cited – New York City’s near bankruptcy in the mid 1970s:

A universe of tax-exempts fully covered by insurance would be certain to have a somewhat different loss experience from a group of uninsured, but otherwise similar bonds, the only question being how different. To understand why, let’s go back to 1975 when New York City was on the edge of bankruptcy. At the time its bonds – virtually all uninsured – were heavily held by the city’s wealthier residents as well as by New York banks and other institutions. These local bondholders deeply desired to solve the city’s fiscal problems. So before long, concessions and cooperation from a host of involved constituencies produced a solution. Without one, it was apparent to all that New York’s citizens and businesses would have experienced widespread and severe financial losses from their bond holdings.

Now, imagine that all of the city’s bonds had instead been insured by Berkshire. Would similar belt tightening, tax increases, labor concessions, etc. have been forthcoming? Of course not. At a minimum, Berkshire would have been asked to “share” in the required sacrifices. And, considering our deep pockets, the required contribution would most certainly have been substantial.

The prospect of local governments and the unions having fewer incentives to work together to solve funding problems is a distinct possibility.  As Buffett notes later in his discussion, governments are likely to face much more severe problems in the future.  Buffett notes that the ultimate profitability of the tax exempt insurance business that Berkshire has entered is “far from a sure thing” and compares it to insuring natural catastrophes.

With the underwriting discipline demonstrated by Berkshire’s insurance subsidiaries, I have confidence that adequate premium rates are being charged to compensate for this risk.  Berkshire shareholders should profit from the new mono-line business.  However, the prospect for taxpayers and pensioners is far less favorable given the current underfunding situation and the apparent inability of governments to negotiate common sense reforms with the unions that would still leave government pensioners with far richer benefits than their private sector counterparts.