Pension Apprehension

I have a bunch of pieces “ganged up” to go on real estate, international economics, government policies, market risks, and a book review on “Think Twice,” but tonight the topic is pensions, with a side order of Bill Miller. Hopefully I will get to the other topics next week.

Defined benefit [DB] pension plans have run into the perfect storm: lousy equity returns and low high-grade bond yields. It makes the last great pension crisis in the late ’70s look good — at least they had higher yields back then. Thus this article from the Washington Post. Many pension plans face almost impossible odds of catching up, raising the odds significantly of more plan terminations, where the two main losers are healthy defined benefit plans, who will have to pay higher amounts for PBGC coverage, and pensioners with high benefits, because those benefits will be cut.

That places pension plan sponsors in a bind. What to do? Take more risk, contribute more assets to bridge the funding gap, terminate the plan, or declare bankruptcy? It is worse for US states, who can’t declare bankruptcy. And municipalities don’t have the PBGC behind them; the pension liabilities are difficult to shake.

Why are there these problems? Three reasons:

• Actuarial funding methods were too optimistic for sponsors, and led them to underfund.
• Investment assumptions were too generous, which also led to underfunding.
• We have a cultural problem where we hide deficits/profit shortfalls through adjusting pension assumptions, or trading lower salary increases for pension benefit increases, which don’t hit the bottom line immediately, but increase funding needs for years to come.

With life insurance reserving, we use assumptions that are conservative for reserves and capital. Pension reserving is best estimate. If a life insurance reserve is inadequate, it must be raised to adequacy. Pensions have a lot more flexibility, even with the recent legal changes. It should not have been that way — pension reserving should have required pre-funding and conservative reserving.

We had boom years in the ’90s, and most DB pension plans were overfunded for a while, but the boom gave the illusion that returns would be stupendous for a long time, and companies stopped contributing as much or at all to their DB plans. Some of that was IRS policy; the IRS did not want companies hiding income by contributing to the employees’ DB plans. Thus the IRS capped the degree of overfunding at the time when overfunding was needed.

The states have their own issues in that it was always easier to defer making payments to the DB plans, because no one wanted to raise taxes, or defer spending plans. Now the true costs have come home to roost because of the financial crisis. Not only are interest rates and asset values lower, but tax revenues are down significantly, and unlike the US government, the states can’t print their way out of it; there are no foreign buyers that think they have to buy the states’ debts.

I have said before that it is foolish to take more risk in order to try to get ahead of the pension promises. Periods of debt deflation are not kind to those taking risks.

That applies to defined contribution [DC] plans as well. This article in Time suggests that 401(k) plans be scrapped, which are a type of DC plan. A few notes:

• 401(k) plans were an accident that got shoved into a piece of legislation for providing supplemental savings benefits. It was probably design for a special interest, but was discovered by an then-obscure Ted Benna, who started a practice around it.
• Whoulda thunk that it would get bigger than DB plans? Few thought it possible until the early ’90s.
• During the boom years, few questioned the abilities of plan participants to direct their own investing. The bust years have made that inadequacy plain. Average people don’t know how to allocate assets. They are either too conservative or aggressive. Few choose the middle ground of a Ben Graham 50/50, or a DB plan 60/40 (stocks/bonds).
• Participants are also not well equipped for receiving and managing a lump sum of assets at retirement. Few will buy an immediate annuity for part of their funding needs, smart as that is. They also will not limit themselves to withdrawing only 4% of assets per year at most.

As for the Time article, I take issue with this phrase: “This isn’t how retirement was supposed to be.”

Oh please, retirement is a modern innovation that only the developed world achieved, and only because they had more than enough children (with technological development) to fund the economic growth of the entire system. Now that developed countries are down to replacement rate or less, the only way these systems hold together is through tax subsidies or optimistic assumptions.

The world is not so bountiful that everyone can have an easy time after age 62, without taxing others to make it happen.

Now, the 401(k) was not a bad idea, but there were limitations:

• People did not contribute enough. They should have contributed to the max, but many only did it to the degree of the match, and and some did little to nothing.
• They were too aggressive or too conservative, which led to greed, panic, and underperformance. A middling allocation would have served most well, and could have been maintained through good times and bad.
• Perhaps it would have been better to have had trustee-directed plans, where participants could have chosen the amount to save, but trustees would have invested for them. One can’t easily tell when bad markets will come, thus it pays to have dispassionate advisors do he investoing for those that will give in to fear and panic.
• People were poor at choosing how to distribute their 401(k) assets — few chose immediate annuities, for two reasons: it means the forfeiture of assets for a stream of cash for life, and insurance agents don’t want the money locked up; they want to earn multiple commissions.

Some of the large insurance companies are offering deferred income benefits, i.e., pay so much today, and we will give you an income of such and so at age 65, if you are still alive then. They are not yet common, and will say that it is a tough benefit for insurers to fund. Not many fixed income assets are not long enough to fund such a risk.

Regarding the termination of DB plans, and their replacement with DC plans, I predicted that 15+ years ago. Why? As the Baby Boomers got older, there would be no way that a corporation could afford the huge benefits, because the pension funding methods were back-end loaded, as I said before. Corporations had to pony up a lot more to fund the retirement of a 60-year old than a 25-year old. Corporations that did not terminate their DB plans would lose investors to those that did terminate, becausetheir profits would be a lot lower.

And, If the IRS had not made it tough to overfund DB plans, perhaps we would have more of them today. Alas, it is not so.

So, what can I say? Don’t blame 401(k) plans for broader societal trends. Corporations would have had to terminate their DB plans simply due to demographics. Also, understand that the economy is limited, and stocks are not magic. Stock don’t guarantee a good return or even a positive return. Also, don’t blame 401(k)s and other DC plans for people not investing enough.

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Okay, time for the side dish. So Bill Miller has had a comeback over the year to date. Big whoop. He is still behind the S&P 500 over the last 10 years, though over the last 19 years, he is still ahead by 1-2%/year. This is not as impressive as John Neff, by any means.

What has fueled the returns of Mr. Miller? Low quality companies bouncing back from a crisis that the Government/Fed bailed them out of. What Bill Miller does not do is value investing. Value investing is not “buying them cheap,” but buying with a margin of safety. Financials have not had a margin of safety for a long while.

Given that I think that companies with a lot of debt will underperform in the future, so do I think the Bill Miller will underperform as well. That is an area where he he been sloppy in the past; given the weakness in the current economy, it will bite him again.

Comments

[Living4Divi...:]

Good article.Many companies face overwhelming pension obligations because of their severely underfunded DB Plans that could depress their profits for years.

Most traditional pensions (DB plans) have been eliminated to increase the profits of American corporations at the expense of the workers. The great shift from DB Plans to DC Plans has shifted the risk of investing for retirement squarely on the shoulders of the worker. The 401K plan was intended to be a superior replacement, but has a myriad of problems. Great in theory, bad in implementation.

Oct 13 07:43 AM

[george archers:]

Companies did not fund enough?
If they did(as in bad stock investment or Made-off's club),no differance, same results!

Oct 13 08:28 AM

[Mike from NYC:]

One of the giant shoes that will fall in the not too distant future is the sound of public pension plans falling as a result of the wildly optimistic calculations by actuarians about how much it will cost to fund the pensions. I started reading about this issue in 2001 but most everybody ignored the issue until Congress passed legislation requiring states and local municipalities to actualize their obligations in 2006 or thereabouts. Some funds are so unfunded that there is no possible way to fund them without raising taxes so high that people would have to turn their paychecks over in their entirety to government.

This is a smoking gun that has been ignored by far too too many. Ultimately many states and municipalities will either have to greatly reduce pension benefits or go bankrupt.

To me 401Ks and IRAs were conceived as another way to channel money to Wall Street to play with and lose. Sort of gambling money for the gambling junkies who work on Wall Street and other places. The difference is they win no matter what and the rest of us lose. The problem is that there are far too few great investment advisers/analysts and far far too many mediocre ones.

Oct 13 09:18 AM

[Jimbo:]

Very good article. Agree with you about Bill Miller. Financials are toxic because they are tied into the Wall Street/Washington corruption.

Oct 13 10:48 AM

[Midas1:]

Two weeks before giving dismal guidance for the next year, WellPoint gave very positive guidance. Employees who were in the 401K and shareholders saw their accounts tanked when the real results were announced. WellPoint knew what was going to happen by lying in the weeks prior to the ACTUAL numbers coming out. We have so many greedy bums running everything, they are succeeding at ruining everything. Lying, cheating, stealing seem to be the top qualifications for any executive nowdays. It is so sad to see our once-great country turn into the corrupt vessel it is today.

Oct 13 11:34 AM

[axelrod608:]

What you have described here is the chicken. The egg was ZIRP - a federal zero interest rate policy. While ZIRP is manna from heaven to the few giant companies that can receive the free money, it drops the rate of return on every class of return-producing investments. The result has been reduced returns - usually less than taxes and inflation - on a wide variety of investments.

It also has pushed investors out onto the increased risk continuum, especially those nonprofessional investors who don't know or understand the risks. Bernie Madoff's scam was made possible by Alan Greenspan. He pushed us all out onto the risk continuum.

I remember reading 3 - 4 years ago about the "looming pension crisis". Then, Fortune 500 pension plans were underfunded by well over a $Trillion. But the financial assumptions were so insanely rosy that those in power just ASSumed we'd grow our way out of the problem. Duh.

With a jobless recovery well under way, I expect US economy to be very similar to the Japanese economy of the past decade or two. So the ultimate question is, if ZIRP is such a brilliant policy why does it result in ZEGR - zero economic growth rate? And yes, I realize it was extremely effective at inflating the bubble. But now that the bubble has popped, what will ZIRP do ? For a few megacompanies it will provide opportunities for obscenely high earnings. For the middle class, especially retirees, it will suck the life out of every class of retirement vehicle.

Oct 13 12:40 PM

[hooligan:]

To me this article has all the hallmarks of manic depression. But then perhaps, that's where we are headed. Pensions represent an attainable outcome that continues to be thwarted by poor legislation. There is only a small amount of return required to deliver a pension pot that is sufficient to provide a comfortable retirement for all. Self funded also. It is grossly unfair ro charge consumers with the label of stupidity in allocating assets. To accuse consumers in this way reflects a callous assumption that consumers choose to lose money in the long term. This is patently false. What we are dealing with is the hiding place provided by "the long term" and a system that seeks to chip away at a sensible 3% real return with taxes, management fees, advisory fees and all the little costs hidden by the corruption we have seen in stock exchange charges, brokerage fees etc etc. I think it is offensive to posit that individuals do not deserve an economy that provides a 3% real return on a 5% savings rate. Think of this number. You cointribute the 40 year average savings rate of 5% of salary, to provide for 20 years of retirement. The numbers without any return or inflation adjustment, mean that an individual can save a pot of 200% of current salary. That pot can buy 200x5 = 10% of current salary per annum for 10 years. The economic system should be able to increase that number by 3% real, to quadruple that pot with investment returns (around that..rule of 72 says that 3% will compound todouble in 24 years, so poetic license here). This means that the pension will be 40% of salary. Starting salaries are small, but nonetheless, play with the savings rate, the investment return and then consider this. The system has delivered a massive fraud to all savers into 401k's and companies with defined benefit schemes equal to the shortfall in a "common sense" expectation of a reasonable pension with reasonable assumptions. The Fed has instituted a collosal political view by penalising those in age cohorts who have recently retired and who will retire in the next five years by adopting a zero interest rate policy. It is representing (without due democratic process) either by accident or design, a borrowing community of people who have demonstrated profligate behaviour and is punishing all those who have exhibited prudent behavior. The average consumer is not a masochist or stupid, the average consumer has been cheated and is being visited a collosal fraud by blinkered, ivory towered regulators and government officals.To

Oct 13 03:49 PM

[hooligan:]

my apologies, please read 20 years in this sentence "pot can buy 200x5 = 10% of current salary per annum for 10 years"

Oct 13 03:52 PM

[User 46526:]

maybe someone in Congress will finally get wise to the fact that every federal retiree will continue to prosper in pension bennies out of all proportion to the rest of the country---they all have cpi increases for the entire amount of their retired lives---inflation is their friend while the rest of us starve slowly in retirement. And the bottomless well of the US Treasury continuously supports the syste. In the 1980's US News pointed this out to no avail

Oct 13 04:21 PM

[Vaun:]

The article from the Times is horribly misinformed and playing on people's irrational fear and ignorance.

Oct 13 06:16 PM

[jimmy46:]

DB plans are frauds.
Very few ordinary workers will get enough time with the company to get a reasonable pension.

DB plans exist only because the tax code says that if the executives
of a company get a DB plan then others must too.

BUT, A LOOPHOLE EXISTS,
SO A NEW BIG SHOT CAN BE GIVEN 20 YEARS OR MORE CREDIT TOWARDS THE TIME NEEDED TO GET A PENSION.

HE ONLY NEEDS TO WORK 5 YEARS OR SO FOR THE COMPANY AND IS THEN A PIG AT THE TROUGH.

IF THIS LOOPHOLE WAS CLOSED,
ALL DB PLANS WOULD FOLD TOMORROW.

Oct 13 09:19 PM

[John Lounsbury:]

David - - -

Thanks for a thorough discussion of this topic. I wrote a short Instablog a few days ago that asked the question: "Whose Pension Will You be Paying"? The overcommitted and underfunded public sector pension plan mess will likely be a taxpayer burden. How the PBGC and other private pension shortfalls will impact the taxpayer has yet to be determined.

Oct 14 01:18 PM

[TinyTim:]

1- How many corporate DB plans are left?

2-What happens with the government employees DB plans in the future?

3-What about the biggest DB plan of them all - Social Security?

Oct 14 04:49 PM