This article first appeared at The McAlvany Intelligence Advisor on Friday, September 26, 2014:
Pension managers’ hopes that investment returns – i.e., pixie dust – would bail them out from their bad assumptions, and keep their plans solvent and fully funded so that they would be able to keep every promise made, have finally crashed on the rocks of reality. Just three months ago, the Center for Retirement Research at Boston College released a study showing that the shortfall between promises and assets to pay them for 25 of the largest public defined-benefit pension plans in the country amounted to more than $1 trillion. This, despite one of the more remarkable runs in the stock market with the S&P 500 Index (SPX) moving from a low of 676 in March 2009 to 1,966 on September 25, nearly a triple in 5½ years.
On September 18, Wilshire Consulting measured the funding gap at $1.4 trillion, while Moody’s recalculated the shortfall on Thursday at close to $2 trillion.
In other words, the investment chickens are coming home to roost. By violating or ignoring altogether basic investment rules, pension managers across the country have been hoping that sufficiently high investment returns would keep governments and workers from contributing their fair share to fund those promises. The report from Moody’s was politically correct, but clear nevertheless:
Despite the robust investment returns since 2004, annual growth in unfunded pension liabilities has outstripped these returns. This growth is due to inadequate pension contributions, stemming from a variety of actuarial and funding practices, as well as the sheer growth of pension liabilities….
According to Al Medioli, a Moody’s vice president, it was all political:
Accounting [rules] emphasize investment returns over annual contributions; the resulting funding disincentive is at the core of the public sector pension asset liability gap. (emphasis added)
Despite a run in stocks that few had seen in their lifetimes, the pension liabilities have been increasing even faster. Just 10 years ago those liabilities were estimated at $650 billion and now are closing in on $2 trillion.
The problem, according to Medioli, is that the pension managers have dug themselves a hole so deep that there’s no way they’ll be able to climb back out: “It is inherently difficult to recover an overall asset position after the double-digit losses seen during the [Great] recession.” He’s exactly right. Every amateur investor knows that if he loses half his money in the market he will have to double what’s left in order to get back to even. When it’s a pension plan that has lost half its assets, the liabilities don’t care: they keep continuing to grow exponentially.
So the first rule the managers broke was the triumph of hope over experience. They hoped that investment returns would so greatly make up for the lack of necessary funding by governments and workers that no one would notice. The second rule they violated they are about to enjoy to the fullest: reversion to the mean. Equities have grown at 20% a year over the last 5+ years, twice their historical average. At some point in the future, perhaps sooner than later, there will be a correction that will bring the market averages back to that mean. In the process, one can be certain that the correction will overshoot to the downside. The third rule these wizards have ignored is this one: nothing grows to the sky.
If these rules aren’t enough, then demographics ought to do the trick and expose the managers’ dreams for what they are. People are retiring in greater numbers than anticipated and earlier than anticipated, either because of the impact of the Great Recession or because of buyouts as firms try to downsize to maintain solvency.
Put all together then: with the combination of wishful thinking, ignorance of history, trusting in pixie dust instead of following sound investment rules and practices, along with demographics, it’s clear that these plans are in a death spiral. Every party to the crime, except the managers themselves of course, will feel the pain. It’s already begun. Workers are being asked to contribute more while working and waiting longer before retiring. Municipalities are being forced to increase their contributions, which come right out of the taxpayers’ wallets. Many of the plans are being shifted from defined benefit, where the risks are taken by the taxpayers, to defined contribution plans where the risks are being born by the workers. Those pension managers who dreamed big dreams decades ago that high investment returns would bail them out have long since vanished from the scene. What’s left is the inevitable reality that some laws can never be broken with impunity.