Pension funding, whether in the public or private sector, can be a complex issue, but it affects nearly everyone. The fallout from underfunded pension plans impacts you directly if you are a beneficiary, and affects everyone else indirectly through falling stock prices and increasing taxpayer liability.
Many companies and governments (from the local to the federal level) still have defined benefit (DB) pension plans, meaning that they have promised to pay retirees $X annually, usually based on a complex formula that includes years of service and recent salary levels among other things. Future and current retirees from these plans don’t have to worry about 401(k) performance -- they are guaranteed a certain payout. But problems arise when there isn’t enough cash to meet these obligations.
Let’s start by defining what it means to be underfunded.
DB Pensions have long term obligations to their beneficiaries, which have to be funded now. The whole amount due over time does not need to be put up right away because the asset base used for the funding is expected to grow. Using a simple present value example, if you have a $1 billion dollar pension obligation due in five years, and you assume that your assets will grow at 8% per year (compounded annually), you will need roughly $680 million in assets today to reach that goal.
Now you may complain that expecting an 8% return on assets is a little unreasonable given the market action over the last few years, but this is the average assumption made by corporate pension funds.
To the credit of corporate America, plan assets have grown an average of 9.2% annually over the last 20 years. However the last decade has not been quite as kind, yielding only 6.2% per annum on average. In other words, returns from the 1990s are inflating the long term number. Remember, however, that this is an average, so some companies are likely meeting their targets.
On the other hand, if we return to our present value example, lowering the expected growth rate from 8% to 6.2% increases the assets needed today to $740 million. Keep in mind that in this simple example we are assuming that the principal is consumed as well as interest; the overall situation becomes worse if entities start eating into the funding base because they cannot fulfill their obligation through asset growth.
Of course companies don’t fund their plans in one fell swoop; they make contributions along the way to augment short falls and to fund current retiree benefits. These can be voluntary or planned or sometimes forced, which may occur in the next 5 years. What is important to realize is that, although plans are frequently well diversified between stocks, bonds, and alternative assets, there is still a heavy dependence on fixed income.
This makes sense because, if you need a certain amount of money at a given date in the future, you should choose a more conservative investment. It’s like saving for your child’s college education -- as that date nears, you should become more conservative in your investments. Stocks don’t offer the certainty of return that can be found in fixed income.
Simply put, if I buy $100,000 of a debt security, I will receive interest along the way and receive the principal ($100K) back at maturity. Stock could do anything over the same period. The problem here is that investment grade debt, which pension funds are frequently limited to, is yielding nowhere near 8% or even 6.2%. In fact, average high quality corporate yields are closer to 4%, forget Treasuries which recently yielded around 2.6% on the 10 year.
That means that plans need to earn substantially more than that on their other assets to meet their expectations of 8%. That is no mean feat in this market, so there is certainly a valid argument for lowering expected returns.
The point here is that the assumption regarding asset growth is a little out of whack with reality. This is compounded by the fact that many assets are not worth as much as they were a few years ago, further eroding a pension fund’s base.
In 2007 Goldman Sachs put the funding of DB plans for S&P 500 companies at 108%, and most plans were in very good shape. Fast forward to the middle of this year and Credit Suisse Group AG estimates the current funding status of S&P 500 DB plans at 75%, a shortfall of $402 billion. A volatile stock market and a declining discount rate have had a major impact on the pension universe.
So companies need to up their funding, which means diverting cash that would normally be part of earnings. And that means earnings shortfalls in the coming years. The Credit Suisse report, according to Bloomberg, suggests as many as 95 of the 500 companies in the S&P could take an earnings hit of $.05-.12 over the next year. The report named a number of firms that might need to adjust earnings downward by 10% or more, including Boeing and John Deere.
This is particularly important because the Pension Protection Act of 2006 requires private DB pension funds to achieve full funding by 2015. If the stock market remains range bound and interest rates low, there could be a drag on S&P 500 earnings for the next 5 years. At that point, not only will companies be scrambling to fund their pensions, but failing to reach full funding means that they will also incur fines that can run as high as 100% of the underfunding, creating a further drag on earnings.
While the market hardly needs more bad news hanging over its head, corporations do have the ability to earn their way out, albeit to the detriment of share holders. But the problems are not limited to the private sector – the public sector is in worse shape.
New Jersey – 40% underfunded.
Illinois – more than 60% underfunded.
Connecticut – 38% underfunded.
South Carolina – 45% underfunded
CalPERS – underfunded by as much $237 billion.
The list goes on. The New York Times estimated the total underfunding of state and local pension funds at around $1 Trillion (yes the T is correct, and it could be as much as twice that). Unlike corporate America, they may, over the long haul, be able to earn their way out of the hole; state and local governments generate revenue in one primary way – taxes.
Yes, you, the American taxpayer, have another huge liability on your hands, and it isn’t going away.
With shortfalls this great, state and local governments are eating into the principal just to meet current payments, so the spiral will continue without resolution.
“Solutions” have been bandied about and some put into practice, including raising the retirement age, capping payouts, cutting benefits, etc. There are a number of other shady practices that states are using to create the illusion of more stable funding. One of my favorite, which was used by Texas among others, was to reduce the benefits to employees that it has yet to hire.
Pension calculations are so complex that administrators must incorporate long term expected changes in employees, including the yet-to-be hired. Obviously, this is just a bit of accounting gimmickry that does not really address the problem.
Although market conditions put pressure on public pensions similarly to that of their private brethren, in recent years many public pensions received no contributions from the state or municipality responsible for the funding. States have been struggling for a while now and the easiest way to avoid revenue short falls was to not put cash in the pension funds.
Essentially, many public pension funds are headed the way of Social Security, in which payments come from current Social Security taxes, a system referred to as PAYGO (pay as you go). This deterioration will likely require new state and local taxes to fund current and future retirees going forward.
Bottom line: From the corporate perspective, funding requirements for DB pensions is yet another reason not to make new investments that would help the economy. Regardless of what the market does on any given day, this will be an overhang on corporate earnings and potential recovery. From the state and local perspective, some may be able to kick the can a little further down the road through borrowing, but that is likely to come at a significantly higher cost. Moody’s has saddled both Illinois and New Jersey with a negative outlook on their debt. So eventually your taxes must increase or state and local governments will face insolvency and at that point it may be too little too late.
I have only scratched the surface with this very basic discussion because the complexities of DB pensions are beyond many of us who are not actuaries, but it does not make the issue any less real or the concerns any less frightening.
Price Shock Trader