Pension Funds: Rock, or Hard Place?
Board: Macro Economics
I have posted several times about the challenges that municipalities face in meeting their pension commitments to retirees. You can debate whether the pension promises were overly generous or not. You can also debate how the situation will be resolved:
a) Pay pensions as promised, substantially increase taxes
b) Taxpayers unwilling and/or unable to pay pensions as promised
c) Some combination of pension cuts and tax increases.
This is one of the largest Macroeconomic unknowns that we have to ponder IMO. That said, we are not going to resolve it on METAR. I do think it is vitally important to our financial future, I just don’t believe we can influence the ultimate path that municipalities choose.
So far, none of this is news. I trust that all METARites are well versed that a day of reckoning will arrive when the question WILL be answered.
One major factor that has gotten less attention has been mentioned on METAR. That is the subpar equity returns during the oughts (2000 through 2010). Pension’s funds have an assumed rate of return they use to calculate “underfunding” or “overfunding.” The standard number used is about 8% per year. This is the overall blended portfolio return with stocks, bonds and “other asset” categories all inclusive. Traditionally pension funds followed something close to a 60% stocks/ 40% bonds mix. Factor in 10 years of ~ 0% equity returns and you can see why pensions are actuarially underfunded. The largest public pension fund in the US, CALPERS, recently lowered their assumed return. It was 7.75%. The chief actuary wanted to reduce it to 7.25%, but the investment committee settled on 7.5%.
Link to CALPERS announcement:
The reduction in assumed return has an almost immediate impact. It means that the municipalities need to pay in several hundred million dollars each year, in addition to their current contributions. Failure to pay in the additional funds will worsen the underfunding. How would you like to to be a California Mayor/City Manager that is already running budget deficits, only to be forced into raising your annual CALPERS contribution?
There is another major factor in underfunded pensions that I have not seen discussed. It is the very low interest rates on medium to long term US government bonds. Over the last ~ 30 years, falling long term interest rates helped pension funds. Funds would love to go back 30 years to 1982 and load up on 14.5% coupon UST’s. Pretty easy to hit your 8% annual goal when 30 year UST’s are yielding 14.5%.
Fast forward to today. 30 Year UST’s are yielding 3.32%. If you assume a 60/40 mix, the equity portfolio must average 11.1% to have the overall portfolio return 8.0%. The fed has taken a lot of actions to lower not only short term rates, but medium and long term rates as well. By driving down long term interest rates, they are making pension fund management that much harder.
What prompted this post was a recent story that corporate pension funds have recently RAISED their allocation to bonds. It rose to 41% in 2011. Equity fell to 38%. This means that 21% is in other investments, like hedge funds, commodity funds, REIT’s etc.
Link to Reuters story on pension allocation:
How would you like to be the pension fund manager striving for an 8% annual return with a 41% current allocation to fixed income? The pension funds are between a rock and a hard place. Their traditional refuse from equity volatility was the fixed income side of the portfolio. So they increase their allocation to fixed income at the end of a secular bull market in UST’s. My assumption and belief is that the next 30 years will NOT see a similar bull market in UST’s. Pretty tough to do when your starting point for 30 year UST’s is 3.32%.
1) Under funding of public pension funds is going to worsen due to poor fixed income returns.
2) Pensioners are going to suffer; taxpayers are going to suffer or a combination of both.
3) Corporate pension funds are also going to find it difficult to hit their assumed returns.
4) Corporate pressure to dump the pension and turn it over to the PBGC will increase. (Ask American Airline pilots how that option is looking. In round numbers, their pensions will be reduced by about 66% when it is turned over to the PBGC.)
5) If the corporation keeps the pension plan, profits will suffer as an increased percentage of earnings will flow into the pension fund to keep it close to “fully funded.”
There is NO actionable investment theme in this post. I post it because many of us are taxpayers, pensioners and/or hold corporate equities which will be impacted by the pension shortfall.