The biggest scam going in American financial life may be the collusive effort by Wall Street, the political class, and public sector unions to use union retirement money to prop up Wall Street speculation.
Step One: state politicians promise big pension and health care benefits to their unionized work forces, but don’t set aside enough money to fund those benefits when the bill comes due. This makes union leaders and unions look good, because they can point to the shiny new benefits they have negotiated with the politicians. Meanwhile, it makes the politicians happy because the unions support them with contributions and volunteers at election time, but because the unions don’t insist on full funding for the benefits, the politicians don’t have to raise costs or otherwise disturb the big majority of voters who don’t work for the government.
Step Two: Make aggressive assumptions about the rate of return on pension investment funds. This has two consequences: it covers the gap between promise and reality (for a while), thereby postponing the day when the politicians have to face the voters and the union leaders have to tell their members that those beautiful benefits were bogus from the start. But the other purpose, equally important, is that it forces America’s public sector pension funds into the deep end of the financial markets, leading pension funds to be major investors in hedge funds, derivatives and various other not-for-the-widows-and-orphans investments. If these work out, great — the funds hit their investment targets and the benefits, or at least some of them, get paid. If they go awry — as many did in the last few years — then the pension problem turns into a crisis.
The scandal is that the structural assumptions of these funds require them to have a 7 or 8% nominal rate of return. In a period, like now, in which real interest rates are negative, in order to accomplish a 7 or 8% nominal rate of return you’ve got to go up the risk ladder. When large domestic companies are sitting on big wads of cash for whatever reason rather than investing them in expanding their operations, developing new products, or making capital investments to reduce their costs of operations, it gets so you aren’t talking about blue chips any more. You start talking about Greek and Spanish bonds. Have a nice day.
The real scandal here is that politicians were allowed to talk about 7 and 8% rates of return without being held accountable for the fraud.