We are hearing more about the status of underfunded pension and health care plans and the deficits are often unbelievably high. A recent headline in the Chicago Tribune was titled “Illinois Pension Nightmare”. Apparently Illinois state workers and teachers are short $45.8 billion in their pension plan alone. This scenario is far from an isolated incident and many states and local governments are in the same situation.
While pensions make up a large portion of these deficits health care plans are just as underfunded. The health care numbers were largely unknown until recently. As of December 15th new accounting rules require cities and states to report all non-pension retiree obligations. As these numbers become available it will show just how dire of a situation it is.
So how can all of this gloom and doom spell an investment opportunity? If you recall I had recently introduced the idea of municipal bonds, which as you know are not a very exciting investment vehicle. This is where the opportunity may lie, in simple bonds. What happens when a local government or city faces an underfunded pension or health care plan to their already or soon to be retirees? They have to raise more money. And as that previous post discusses, local municipalities raise money by issuing bonds and those bonds carry potentially tax-free interest.
As more baby boomers begin to retire and more benefits begin to be paid out it will clearly put even further strain on the already underfunded plans. Simple economics tells us that if these local agencies are in dire need of generating money to cover their deficit that they will pay a premium in order to receive the funds. What this means is interest rates on municipal bonds should go up and prices of the bonds should go down. This is great news for investors who are looking for a safe, tax-free and income-producing investment. Even at current muni rates with yields in the 4-5% range, depending on your state and tax rate that could easily mean a 6-8% tax-equivalent yield that is likely insured.
Again, these investments are for those of you who have maxed out your other available tax-favorable investments such as IRAs and 401(k)s. Once you have reached that point you may be able to safely tuck some money away into bonds such as these. If yields increase another 1-2% you may be able to obtain double-digit tax-equivalent yields that are on par with equity returns. Only time will tell how the pension and health care funding affects the municipal bond market, but it is worth keeping an eye on in 2007.
Reference: Capital Markets Column by Marylin Cohen in Forbes Magazine
Author: Jeremy Vohwinkle
My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.