Pension Crisis And 'The Pain Ahead'

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Includes: SPY
by: Shock Exchange

In June I was featured on a panel held by my business school to discuss the current state of the U.S. economy. Given the fact that I have been teaching inner-city kids from Brooklyn about the stock market and U.S. economy since 2006, the panel expected me to bring a fresh perspective to the discussion. My message to the crowd was that "My generation has failed this country and frankly, I am embarrassed - influence peddling, Wall Street profligacy, betrayal of the public trust, and overall greed have brought the country to the brink of disaster." I actually received a standing ovation. However, after the panel discussion, a member from the audience alerted me to another crisis not addressed by the panel - the looming pension crisis. Her exact words were, "There is a lot of wealth in areas where I live (Connecticut). However, people are scared. Many have had to dip into their pensions just to stay afloat. It's a subject that is not discussed publicly ... only behind closed doors. There is a serious pension gap that needs to be addressed and no one is talking about it." Apparently she knew what she was talking about. The Wall Street Journal's Pension Crisis Looms Despite Cuts puts the nation's funding gap for public-employee pensions at approximately $1 trillion.

The pension gap partly stems from soured investments made by pension plans in private equity and real estate at the height of the financial crisis. While investment banks and companies deemed "too big to fail" have received bailouts from the government, pension funds have not been as fortunate. CalPERS reportedly lost over $10 billion on busted real estate deals during the crisis, and has in a sense culled the number of private equity and real estate funds it does business with. That said, according to the Journal, states have reacted to the crisis by rolling back pension benefits:

Since 2009, 45 states have rolled back pension benefits for teachers, police, firefighters and other public workers, including cuts by Michigan and California this month. Next week, Republican Ohio Gov. John Kasich is expected to sign legislation requiring, for example, that certain teachers work longer and pay more toward their pensions ... But the new laws have trimmed just $100 billion out of the $900 billion gap between what the states and their workers put into their retirement plans and what the states owe in retirement benefits, according to estimates prepared for The Wall Street Journal by researchers at Boston College.

States are attempting to trim pension benefit expenses in the following ways:

Cut Benefits for New Hires

Many states have applied changes in pension benefits to newly hired workers. Though this may be the most politically expedient route, cost savings from this tact will not be realized until decades into the future. By reducing pension benefits for newly hired workers, pension benefits can be reduced by about 25% over 35 years according to a Boston College study.

Increase Pension Contributions

States have passed through double-digit increases in the contributions toward retirement plans, for both newly hired and existing workers. Though the increases will gradually reduce states' unfunded pension liabilities, they are a drop in the bucket compared with the $1 trillion liability currently outstanding.

Suspend Cost-of-Living Adjustments for Retirees

Reducing cost-of-living adjustments for retirees will also reduce benefit expenses, if not the overall unfunded pension liability. This method is a political football in that seniors have a lot of voting power, and lawmakers who sign off on such bills may soon find themselves out office.

The Pain Ahead

While Fed Chairman Ben Bernanke's series of quantitative easings have driven interest rates to record lows in order to spur the economy, they have also created another dilemma - lowering the expected rate of return on trillions of pension assets. When the expected return on such assets are lowered, unfunded pension liabilities grow, creating a vicious cycle of having to further cut pension benefits, raise pension contribution levels or raise taxes in order to mute the growth in unfunded liabilities. Moreover, while the reduction in the rate of return on pension assets is real, the pain ahead suggests the benefits of quantitative easing may be in doubt:

Big ticket items like housing and autos drive the economy. The Fed initiated its Quantitative Easing program in the fourth quarter of 2008. Yet housing starts have been flat since that period; starts were 906 thousand in 2008 and ranged from 554 thousand to 609 thousand from 2009 to 2011. Auto sales were 13.5 million in 2008, reached a trough of 10.6 million in 2009 and rebounded to 13 million in 2011. But they still pale in comparison to the roughly 17 million just prior to the financial crisis.

For the avoidance of doubt, I am bearish on the U.S. economy and the stock market as a whole. I would avoid the market until the economy's vital signs improve or the market declines to levels where the economy's anemic growth is priced in.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.