The Problem With Pensions

If only it were as simple as a single "problem."  The issue of who makes up the difference when pensions are underfunded is a tricky one, and will certainly depend on the readers philosophical beliefs.  I prefer to start with what I consider the bigger problem - the reason pensions end up being underfunded is because their return assumptions are, well, to put it bluntly:  wrong.

Thus, even though pensions are being reformed so that workers contribute more to their pensions, perhaps work for more years, and may have capped benefits, the damage done by overstating long term compounded annual returns by even a little bit is catastrophic, and still results in massive underfunding. Of course, if we're lucky, we won't actually have to recognize this reality for another 10, 20, or 35 years.  Extend and pretend, bayyyy-beee!

From the Wall Street Journal:

"The median expected investment return for more than 100 U.S. public pension plans surveyed by the National Association of State Retirement Administrators remains 8%, the same level as in 2001, the association says.

The country's 15 biggest public pension systems have an average expected return of 7.8%, and only a handful recently have changed or are reconsidering those return assumptions, according to a survey of those funds by The Wall Street Journal.

Corporate pension plans in many cases have been cutting expectations more quickly than public plans, but often they were starting from more-optimistic assumptions. Pension plans at companies in the Standard & Poor's 500 stock index have trimmed expected returns by one-half of a percentage point over the past five years, but their average return assumption is also 8%, according to the Analyst's Accounting Observer, a research firm.

The rosy expectations persist despite the fact that the Dow Jones Industrial Average is back near the 10000 level it first breached in 1999. The 10-year Treasury note is yielding less than 3%, and inflation is running at only about 1%, making it tougher for plans to hit their return targets.

Return assumptions can affect the size of so-called funding gaps—the amounts by which future liabilities to retirees exceed current pension assets. That's because government plans use the return rates to calculate how much money they need to meet their future obligations to retirees. When there are funding gaps, plans have to get more contributions from either employers or employees.

The concern is that the reluctance to plan for smaller gains will understate the scale of the potential time bomb facing America's government and corporate pension plans."

Of course, they might do better than their benchmark assumptions:

"The Oregon Public Employees Retirement System has had an 8% assumption since 1989. Its actual return averaged 10.7% annually from 1970 through 2009. The Teachers Retirement System of Texas has had a similar expectation since 1986, with an annual return of 9% return since then. 

A spokeswoman for the Texas system said it doesn't change assumptions "in response to short-term situations," and currently "sees no reason to change our investment-return assumption." A spokesman for the Oregon system said there are no special plans to review its return expectation."

I guess, for me, the point is that managers are failing to recognize the economic paradigm shift we've undergone.  The last thirty years of leverage and debt expansion are finally coming home to roost, and since we don't want to recognize the reality of that, preferring instead to try to delay taking the losses that are inevitable, growth will be impaired for as far as my eyes can see.

But obviously, there's a reason why they don't want to lower return assumptions - it creates more pain!

"The Colorado Public Employees Retirement Association showed in its 2009 financial report the impact of reducing the rate. Using a 8% expected return rate, the plan faced a $23.4 billion deficit, based on market values, at the end of 2009. If the rate was cut to 6.5%, the shortfall would jump to $34 billion.

Meredith Williams, the Colorado plan's chief executive, says cutting the rate "creates pain." Nevertheless, Colorado at year-end of 2009 cut its return assumption to 8%, from 8.5%. Mr. Williams says the rate may be lowered again later this year.

Others have been more hesitant. In 2009, Matt Smith, state actuary for Washington state, recommended that its retirement system cut its return expectation to 7.5%, from 8%. That advice was rejected by the state's pension-funding council.

Mr. Smith says he thinks Washington and other states eventually will lower expected returns, but that it will be a slow process because reduced assumptions "will increase the cost of pension benefits, and right now the budgetary environment is a big obstacle to that.""

One thing that still makes no sense to me, and perhaps a reader can help me out with this, is how pension funds can be buying long term corporate bonds (I mean REALLY long term, I'll get to that in a second) with returns below their annualized bogey.  Last month Norfolk Southern issued "century bonds," due in 100 years.  Their yield was around 6%.  Last week, Rabobank did the same thing, issuing 100 year bonds with a yield of around 5.8%.  The WSJ says "Life insurers and pension funds tend to be the main buyers for such lengthy bonds because they need to match their long-term liabilities with assets of a similar duration."

Now, correct me if I'm wrong, but if you're making a super long term investment with a 6% return, your long term return assumptions probably shouldn't be in the vicinity of 8%, right?  What do you do to recoup the difference  - make up for it in volume?   wink wink...

-KD