(Bloomberg) — Public pension plans threaten the financial health of U.S. cities and states more than taxpayers realize, billionaire investor Warren Buffett said.
“Citizens and public officials typically under-appreciated the gigantic financial tapeworm that was born when promises were made,” Buffett wrote in his annual report to shareholders of Berkshire Hathaway Inc. released on March 1. “During the next decade, you will read a lot of news –- bad news -– about public pension plans.”
Obligations to retirees have weighed on governments from Puerto Rico to the bankrupt city of Detroit. Illinois lawmakers passed a bill last year to bolster the worst-funded U.S. state pension system. New Jersey Governor Chris Christie said last week that Detroit shows what could happen if his state doesn’t limit obligations to workers.
“Local and state financial problems are accelerating, in large part because public entities promised pensions they couldn’t afford,” Buffett said. “Unfortunately, pension mathematics today remain a mystery to most Americans.”
The municipal bond market has defied prior warnings of disaster. Meredith Whitney, a former Wall Street bank analyst, in 2010 incorrectly predicted defaults totaling hundreds of billions of dollars. Buffett said that year that cities and states battered by the recession faced a “terrible problem” and might require a federal rescue.
Berkshire cut holdings of state and local obligations by half in a five-year period to about $2.3 billion as of Dec. 31. The company also scaled back insuring municipal bonds, after setting up a firm to back the debt in late 2007.
“I don’t know how I would rate them myself,” Buffett said at a June 2010 Financial Crisis Inquiry Commission hearing. “It’s a bet on how the federal government will act over time.”
Apart from Detroit, communities including Stockton, Calif., and Jefferson County, Ala., have sought the protection of bankruptcy court to sort out their debts.
Moody’s Investors Service said a measure of retirement obligations for U.S. states deteriorated in the 2012 fiscal year. The median ratio of pension liabilities to revenue was 64 percent, compared with 45 percent a year earlier, Moody’s said in a Jan. 30 statement. The net liability for all U.S. states stood at $1.2 trillion, though investment gains have probably helped since then, the ratings firm said.
“Warren Buffett is a reasonable man, and he’s pointing out there are still some very visible pension issues among states and cities,” said Richard Ciccarone, chief executive officer of Hiawatha, Iowa-based Merritt Research Services, which analyzes municipal finance. “But the message shouldn’t be distorted into a panic about municipal bonds. The vast majority of credits in the muni market have manageable debt loads.”
There are signs that the fiscal health of municipalities is gaining strength almost five years after the recession. State tax collections have probably grown for 16 straight quarters, according to the Nelson A. Rockefeller Institute of Government in Albany, New York. Meanwhile, 60 issuers defaulted for the first time last year, down from 107 in 2012, data from research firm Municipal Market Advisors show.
The $3.7 trillion municipal bond market has been rallying, pushing benchmark 10-year yields to the lowest since June. State and local bonds returned 3.6 percent in the first two months of this year, compared with 2.9 percent for U.S. corporate debt, Bank of America Merrill Lynch data show.
Buffett isn’t the first to compare pension obligations to an unsavory creature. Illinois Governor Pat Quinn’s office likened the liabilities to a python strangling state finances. Lawmakers in his state voted last year to raise the retirement age for some workers and limited annual cost-of-living adjustments as part of a bill that’s expected to save the state $145 billion over 30 years.
As Berkshire’s chairman and CEO for more than four decades, Buffett has used his annual letter to shareholders to opine on matters of public policy, corporate governance and investing. In media appearances and op-eds, he’s argued for increased taxes on the wealthy and an end to political brinkmanship over the U.S.’s borrowing authority.
Buffett may have called attention to public pensions because they will influence the business climate in which his company operates, said Tom Russo, a partner at Gardner Russo & Gardner. The U.S. is the largest market for Berkshire subsidiaries from utility owner MidAmerican Energy to auto insurer Geico. The cost to meet retiree benefits could cause governments to raise taxes, said Russo, whose firm invests in Buffett’s company.
The Berkshire report this year also included a memo about pensions that Buffett wrote to his friend and former Washington Post publisher Katharine Graham in 1975. In it, he advised her to first understand the promises that are being made.
“Rule number one regarding pension costs has to be to know what you are getting into,” Buffett wrote to Graham. “As will become so expensively clear to citizens in future decades, there has been even greater electorate ignorance of governmental pension costs.”
Investment policies also bear responsibility for shortfalls, Buffett said. He advised Graham to abandon Morgan Guaranty as the company’s pension asset manager and switch to investors that shared his approach of treating money management like acquisitions. Graham took the advice, helping give the pension plans at the former Washington Post Co. more assets than liabilities.
Buffett has been following a similar strategy at Omaha, Nebraska-based Berkshire by drawing on his deputy investment managers to oversee assets backing pensions at several subsidiaries. The deputies’ picks and a rising market helped narrow Berkshire’s pension shortfall by about $3 billion last year, the report showed.