Pensions Fly Only If You Believe They Can

There’s a bank run happening in Dallas. The funny thing is, it’s not happening at a bank.

The city’s pension for firefighters and police is disastrously underfunded. Start with the normal problem that virtually all public pension plans are facing (overpromising benefits, underinvesting in the fund). Add in an attempt to make good on promises by investing in “non-traditional” assets like timber and real estate, which didn’t pan out as the investors had hoped. Add in a deferred retirement program which allows people to accumulate assets in the fund long after their retirement date — and to withdraw that money in a lump sum whenever they want. And what you get is a big mess.

Alarmed by the state of its pension fund, city officials have started talking about fixes. Folks with money in the fund have become justifiably suspicious that those fixes might include cuts. They are hastening to withdraw their money. At the moment, those withdrawals actually help the fund, because it’s required to pay out a fixed rate of interest that is below the current investment returns. But if the withdrawals continue, the fund will soon be in a parlous state. Naturally, this makes people want to withdraw their money, in order to get it out before the thing collapses.

As an example of what can happen to a pension fund, this is interesting, but not particularly representative. Pension funds do not have to allow lump-sum distributions, though many do. But it is nonetheless useful to look at what’s happening in Dallas, because it illustrates why bank runs happen, and why they’re so hard to stop once they’ve started.

The ultimate source of a bank run — the original sin of the financial system, if you will — is the conflict between what we want as borrowers and what we want as savers. As savers, we want a vehicle that will guarantee that we will not lose money and that we can get that money out before we need it. As borrowers, we want a predictable, fixed payment, preferably for a long time at a low interest rate. In economic terms, savers have a very high preference for liquidity (the ability to easily turn your investment back into cash), while borrowers have a very high preference for illiquidity.

That translates into the price of investments: the more illiquid it is, the more the investors are willing to pay for the privilege in the form of higher interest rates or other investment returns. This is why 30-year mortgages have higher interest rates than 15-year mortgages — and 30-year mortgages nonetheless dominate the market. The same sort of logic applies to assets, like stocks, that are generally relatively liquid, but are also volatile — meaning that their value can move around a lot over short periods, so that while you can usually liquidate, you might have to do so at a loss.