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Five Major Pension Problems and One Simple Solution

Economics / Pensions & Retirement Oct 11, 2009 - 06:02 PM GMT

By: Mike_Shedlock

Economics

Best Financial Markets Analysis ArticleEven with this huge rally in stocks and corporate bonds, pension plans are in incredibly poor shape. The Washington Post lists Two Bad Choices Cut Benefits Or Take Greater Risks to Rebuild Assets.



Please consider Steep Losses Pose Crisis for Pensions.

The financial crisis has blown a hole in the rosy forecasts of pension funds that cover teachers, police officers and other government employees, casting into doubt as never before whether these public systems will be able to keep their promises to future generations of retirees.

Within 15 years, public systems on average will have less half the money they need to pay pension benefits, according to an analysis by Pricewaterhouse Coopers. Other analysts say funding levels could hit that low within a decade.

After losing about $1 trillion in the markets, state and local governments are facing a devil's choice: Either slash retirement benefits or pursue high-return investments that come with high risk.

"The amount that needs to be made up is enormous," said Peter Austin, executive director of BNY Mellon Pension Services. "Frankly, they are forced to continue their allocation in these high-return asset classes because that's their only hope."

In New Mexico, lawmakers passed legislation this year requiring public employees to contribute about 1.5 percent of their salary to cover retirement benefits. Labor unions representing 57,000 of the workers sued the state in response.

Mish: The correct response would be to kill all unnecessary services, fire all the government workers and privatize everything remaining.

In Philadelphia, officials delivered an ultimatum to state lawmakers: Allow the city to take a two-year break from contributing to its pension system or Philadelphia would lay off 3,000 workers and cut sanitation and public safety services. Last month, the lawmakers not only granted the request, but extended the funding holiday to thousands of cities and counties, despite severe pension deficits in many of these places.

Mish: The correct response would be to kill all unnecessary services, fire all the government workers and privatize everything remaining.

In Montgomery County, officials last year committed to setting up an investment fund to finance about $3 billion in retiree health-care benefits promised to employees. But when it came time to put the first round of seed money into the fund this year, county officials balked, citing budget constraints.

Mish: The correct response would be to kill all unnecessary services, fire all the government workers and privatize everything remaining. I think you get the idea.

Just a few years ago, it seemed far-fetched that Virginia's pension system would hit hard times. In 2003, the state's primary pension funds either had more money than they needed or, at a minimum, were nearly fully funded. And like their counterparts across the country, state officials assumed they would earn around 8 percent a year from investing in financial markets for years to come given the outstanding performance of stocks in the 1980s and 1990s.

Then the crisis hit. Virginia lost 21 percent of the value of its portfolio, or about $11.5 billion. Maryland and the District, meantime, suffered drops of 20 percent.

But Virginia officials now estimate the funding level of its major pension funds will sink to about 60 percent by 2013.

From there, the deficit will grow even wider, according to Kim Nicholl, the national director of PricewaterhouseCoopers public sector retirement practice. Even if public pension funds were to hit their 8 percent investment targets every year, Nicholl calculated they would have less than half of what they need by 2025. This is because a greater share of the population will be retired and those who are will live longer, thus collecting benefits longer, she said.

Mish: Expecting 8 percent returns when 30 year treasury bonds are yielding 4%, the dividend yield of the S&P 500 is 2%, and the S&P 500 trailing PE is 138.97, is amazingly foolish.

Even if one uses "operating earnings" a euphemism for "blatant lie" in which all "one-time losses" that recur like clockwork are ignored (along with everything else the companies want to ignore), the PE based clocks in at 29.64 as of the end of the third quarter according to S&P Earnings Data.

To see an earnings spreadsheet, click on one of the XLS links that will pop up when you click on the above link.

Like many states, Maryland had begun moving money from stocks into hedge funds and private equity before the financial crisis. The goal was not only to earn a higher return but to diversify the investment portfolio. Should stocks sink, the thinking went, less traditional investments might hold up.

The financial crisis offered a shocking retort. Nearly all investments, save for government bonds, tumbled at the same time.

Yet Maryland is now continuing its shift away from stocks and into nontraditional investments. Pension officials argue they have little choice.

"How do I act in the new environment? There aren't any ready answers for that," said Mansco Perry, chief investment officer for Maryland's pensions. "But I have difficulty throwing away 30 to 40 years worth of knowledge and practice and say that doesn't work anymore."

Mish: I have a clue for pension managers: Understanding the paradigm of the last 30-40 years is indeed worthless. It is a serious mistake to assume the next 30 years will be anything like the last 30 years.

For an excellent analysis of the ever-changing investment paradigm, please read Marc Faber's excellent book Tomorrow's Gold. It is number one on my reading list for a reason. It is not about "gold", it is about investment opportunities and how they change over time. Every pension manager in the country needs to read it.

When Treasury and corporate bond yields are high and falling as they were for 30 years, it is easy to get very high returns safely. Not only could one lock in high yields, one also was rewarded with capital gains as the yields compressed. Now with yields low and dividends low there is no magic formula that can possibly help.

Compounding the problem is the fact that all asset classes save government bonds, something no one wants, at least right now, have been correlated on the upside and downside. This should have been easy to spot. Yet somehow it wasn't.

Pension funds thought they were a genius in their diversification strategies between 2002-2007 when everything rose. They failed to appreciate what would happen when things went into reverse.

Some pension funds are also continuing to engage in other investment practices that got them in trouble during the crisis.

One such trading technique is called securities lending. In this transaction, a pension fund lends a stock it holds to a hedge fund and receives cash in return as collateral. The deal is meant to provide a twofold benefit: The pension fund can make money by investing the cash collateral and can continue to benefit from the stock through its dividends and any appreciation in its value.

Before the crisis, states committed billions of dollars to this practice. But when the credit markets seized up last year, pension funds got stuck. They could not access the investments they made with the cash collateral. Some had to sell off other investments at a loss to pay retiree benefits.

California's pension fund lost $634 million from securities lending as of March 31, but the total could reach $1 billion after a full accounting is done, according to a report from the system's consultant, Wilshire Associates. Still, the pension fund says it remains committed to the practice because it boosted returns in the two decades before the financial meltdown.

Mish: Notice the obvious problem? CalPERS, the California pension fund is assuming what worked before the crisis, will continue to work after the crisis.

Pray tell what good does it do to "boost returns" when you give it all back and more when the strategy blows up in your face. Moreover, note how progressively little they get for their lending. The yield on the S&P 500 is a mere 2%.

As for "appreciation in value", the hedge funds the pension plan lent the securities to shorted them, betting that they would drop in value. Meanwhile the pension plan locked in meager dividends. Who gained from that?

If a hedge fund wants to borrow your securities to short them, it's a reasonable bet they know more about what they are doing than you do.

In Ohio, for instance, the teachers pension system reported that it would take 41 years for its investments to catch up with the costs of meeting its obligations to retirees. That was before the worst of the financial crisis.

During the last fiscal year, Ohio's fund lost 31 percent. Its most recent annual report detailed how long it would now take for its investments to put the fund back on track. Officials simply said: "Infinity."

Unsolvable Problems

  • Expecting 8% returns in a 4% world. When 30 year treasury bonds are yielding 4%, the dividend yield of the S&P 500 is 2%, and the S&P 500 PE is 140 (26 if you use operating earnings), 8% returns are from Fantasyland.
  • Pension benefits start too early. People are living longer.
  • Private employees do not receive these kind of benefits. Public employees should not either, especially at taxpayer expense.
  • Indeed, continuing to chase high-yield in a low-yield world is a guarantee those plans will blow up again down the road.
  • Pension plans are so underfunded that it is virtually impossible to catch up, no matter what risks the plan managers undertake. When asked how long it would now take for its investments to put the fund back on track, Ohio officials simply said: "Infinity."

There is a solution of course, it's just not one that anyone wants to here: The correct plan is to kill all unnecessary services, fire all the government workers and privatize everything remaining.

That is a choice the Washington Post failed to mention. Moreover, it's the only thing that reasonably works.

By Mike "Mish" Shedlock

http://globaleconomicanalysis.blogspot.com

Click Here To Scroll Thru My Recent Post List

Mike Shedlock / Mish is a registered investment advisor representative for SitkaPacific Capital Management . Sitka Pacific is an asset management firm whose goal is strong performance and low volatility, regardless of market direction.

Visit Sitka Pacific's Account Management Page to learn more about wealth management and capital preservation strategies of Sitka Pacific.

I do weekly podcasts every Thursday on HoweStreet and a brief 7 minute segment on Saturday on CKNW AM 980 in Vancouver.

When not writing about stocks or the economy I spends a great deal of time on photography and in the garden. I have over 80 magazine and book cover credits. Some of my Wisconsin and gardening images can be seen at MichaelShedlock.com .

© 2009 Mike Shedlock, All Rights Reserved

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