American pensions are in trouble.
A Wilshire Consulting Report from 2017 shows that 97% of the 103 state pension funds that report actuarial values were underfunded. The "funded ratio" — that is, the percentage of liabilities (promised benefits) covered by current assets (funds available for benefit payments) — fell by 20% from 2006 to 2016.
Source: Wilshire Consulting
According to Pew Charitable Trusts, there isn't a single state pension that is 100% funded. Wisconsin's comes the closest with 99.1% of liabilities funded, while Kentucky and New Jersey are the worst-off states, each with a mere 31% of obligations funded. The Garden State is $168.2 billion short of the future benefit payments that it has promised, while the more lightly populated Kentucky is $43.4 billion short.
Public pension assets, on average, amounted to only 66% of liabilities in 2016, compared to 86% in 2007. Considering all U.S. pensions, the funding ratio sat at 72.5% in 2018, compared to 100% in 2001.
A handful of states have already dealt with this gap between promised benefits and available funds the hard way: by cutting benefit payouts to retirees. New York, Ohio, Michigan, Pennsylvania, Oregon, and other states have already resorted to this measure, according to former congressmen John Boehner and Joe Crowley, but it may prove to be only a temporary fix — a band-aid on an issue that will continue to deteriorate.
There are two reasons that pensions continue to run deficits: (1) demographics, and (2) shrinking investment returns.
The first point is simple. The Baby Boomer generation is huge, much bigger than the generations that came before or after it. Roughly 10,000 people enter retirement age every day (whether or not they actually stop working), and this is a significant reason why the unemployment rate has fallen as much as it has in recent years, despite a relatively low labor force participation rate. The number of people entering the workforce, on the other hand, is substantially lower than those exiting it.
More pensioners + fewer workers = pension funding shortfall.
But it isn't as if this demographic cliff appeared out of nowhere or that no one knew about it. We have all known it was coming for a long time, and one would expect pension fund managers to prepare accordingly.
That's where the second reason comes in. It starts with where pensions are investing their entrusted funds. In the 1950s and 1960s, pensions acted much like savings accounts, holding almost exclusively fixed income and cash assets. This worked quite well when interest rates were floating in a historically normal range.
Notice below that, from 1972 to 1982, when real interest rates were rising, pensions' allocation to equities and other alternative investments was falling. From the late-1970s to the mid-1980s, one could get a 5-6% real return from U.S. Treasury bills. Who needs equities in that scenario?
Source: Pew Charitable Trusts
But in the late 1980s, something changed. With few signs of trouble in the real economy, the stock market crashed in 1987. Fed chairman Alan Greenspan was quick to react, swooping in to cushion the market with interest rate cuts. The market liked this treatment. Greenspan repeated this treatment several times in the 1990s and early 2000s. His successor, Ben Bernanke, followed suit during the Great Recession. And, just like that, interest rates were pushed from a historically normal range in the 1980s to an ultra-low level in the 2010s.
As interest rates fell, so too did the achievable returns for pension funds. Hence the profound and rapid shift from majority allocations to fixed income to majority allocations to equities and alternatives (i.e. real estate, private equity, hedge funds, etc.).
Here is what the average pension asset allocation looks like today, according to the National Association of State Retirement Administrators (NASRA):
The Fed progressively starved pensions of safe yields, and thus those pensions were forced to chase yield in riskier assets in order to even come close to hitting their targets. In 1982, pension allocation to equities and alternatives was around 23%. Today, it's 75.3%.
This has exposed pension investment returns to significantly higher volatility. For instance, the median pension's return in 2016 was 1%, compared to the median target return (at the time) of 7.5%.
In 1992, though non-fixed-income made up almost half of pension assets, the 30-year Treasury bond yield alone provided nearly all the required return.
Today, the difference between pensions' median required return and the 30-year T-bill yield is about 5.25%, compared to 4.83% in 2012 and 0.33% in 1992.
Almost two-thirds (64%) of pension funds' revenue from 1993 to 2014 came from investment earnings, according to the Census Bureau. The rest came from taxpayers. The politicians who largely determine the tax rates to fund the pensions and the payouts that beneficiaries will receive tend to do what politicians do: promise more than they are willing to collect in taxes.
The way they get around this is by establishing overly rosy target investment returns. All the fund has to do is generate a return of 7% or 7.5% per year and there's no problem at all. Since the early-1990s, however, pensions have been regularly cutting their target returns to more reasonable levels.
"About 85% of 129 U.S. public pensions have cut return assumptions since 2014," according to a Bloomberg article by Alexandra Stratton and John Gittelsohn.
But even that median return target is probably too high for most pensions. For instance, the chief investment officer of the California Public Employees Retirement System (CalPERS) recently told the board of directors that, despite their target rate of return of 7%, their expected rate of return is only 6.1%.
Why don't pension managers just face the facts and lower their target rates of return, then? Because of the implications for taxpayers. A study conducted by J.P. Morgan concluded that if pensions assumed a more achievable 6% return, half of states would need to devote more than 10% of tax revenue to fill the gap. Instead, that gap is being filled with debt, thus preventing the need for tax hikes.
But in this new era of ultra-low interest rates, 7+% assumed rates of return make less and less sense. Pew estimates that the median long-term return for the average pension fund will be 6.4% going forward, and there is a decent chance that they turn out even lower than that.
Importantly, the primary catalyst for falling pension investment returns has been plunging interest rates, led by Fed policy. “Each month and each quarter that goes by with low inflation and interest rates remaining low provides more ammunition to justify lower investment returns,” says Keith Brainard, research director at NASRA.
What About Corporate Pensions?
Corporate pensions are only slightly better off. For instance, the yearly Milliman Corporate Pension Funding Study, which surveys the one hundred largest single-employer defined benefit plans, shows an average funding ratio of 87.1% as of the end of 2018. But that ratio would have been lower if not for a higher discount (target return) rate. With a slightly higher target return percentage (4.01%, compared to 3.49% in 2017), the $100 billion YoY fall in the market value of assets is more than mitigated and financial strength appears greater.
But that small uptick in the assumed long-term rate of return masked a -2.8% actual return for the year. "By one industry estimate," writes pension consultant Mark Johnson, "each 1 point reduction in the discount rate means 10 percent more in current contributions." Conversely, then, raising the discount rate by a percentage point should result in a 10% better funding ratio. Hiking it by 0.52% should result in a 5.2% better ratio, meaning that 2018's funding ratio with the discount rate held constant would have been a mere 81.9%.
If not for the boosted discount rate (which is unmerited at this point in the market cycle and perhaps intentionally deceptive), the funded ratio would have fallen below the 85.8% of 2017.
Since 2000, the 100 corporate largest corporate pensions have run surpluses in only three years.
Roughly 50% of corporate pension fund assets are fixed income, which helps to explain their deteriorating balance sheets.
As recently as 2007, the 100 largest private pensions were 105.7% funded, according to Milliman. This despite having run deficits for years in a row in the early 2000s.
Total corporate pension funding (including smaller companies) rose to almost 90% by the end of 2018, when the Fed hiked rates in December, but fell back down to 87.9% at the end of May 2019 after interest rates plummeted.
Back in the Spring of 2018, when rates were still rising, it was estimated by Tom Lee of FundStrat Global Advisors that if the 10-year Treasury yield rose to 4% and remained there, corporate pensions would be sustainably 95% funded. Around that time, Lee found that there were at least 29 companies in the S&P 500 whose pension liabilities exceeded 10% of their market value. At the present date, that number is almost certainly higher.
In 2018, much focus was placed on General Electric's (GE) $28.7 billion underfunded pension, but its pension wasn't the only one with a scary balance sheet. Delta Air Lines (DAL) and International Paper (IP) are two corporations that have had to issue debt in order to cover pension obligations.
But single-employer plans aren't the only ones struggling in the corporate space. Several multiemployer pensions, such as Central States, are projected to collapse by the mid-2020s. The federally chartered Pension Benefit Guaranty Corporation (somewhat like the FDIC of pensions) is likewise set for insolvency by 2025. According to the 2018 PBGC annual report, the agency took over 58 failed single-employer pensions and paid over $150 million in financial assistance to 81 different multiemployer sponsors.
A collapse of the PBGC would be something like a collapse of the FDIC during a banking crisis. Promised benefits that pensioners expect (like savings that depositors have entrusted to banks) would simply disappear. The money wouldn't be there, so it wouldn't be paid. At least, not all of it. Some fraction of benefits could still be paid out to pensioners, but much less than what they are counting on.
In sum, defined-benefit retirement plans of all kinds (state, local, corporate) are suffering from deteriorating balance sheets, even after a record-breaking bull market. "Pension liabilities and debt have never been so large relative to taxpayers' capacity to pay," writes Josh McGee in National Affairs, "and pension investments have never been so uncertain."
When half of the plans' assets are in fixed income, interest rates play a critical role in determining the financial health of pensions. This explains why median target returns for corporate pensions fell from 7.5% in 2000 to 5.42% in 2010 and finally to 4% in 2018. Compare this to 20-year Treasury bill yields of ~6.8% in 2000, ~4.5% in 2010, and ~3% in 2018.
The Fed's interest rate policy plays just as large a role in corporate pension underfunding as it does in public pension underfunding. It has forced an increasing number of Fortune 500 companies to divert cash to pension funding rather than business operations or investment.
Listen To The Experts
Not convinced by the above line of reasoning? Don't take it from me.
Take it from banking policy expert, Karen Petrou: "Historically, pension funds and insurance companies have invested only in the safest assets. These are now in scarce supply due in large part to QE and comparable programs by central banks around the world. Pension plans and life-insurance companies increasingly have two terrible choices: to play it safe and become increasingly unable to honor benefit obligations or to make big bets and hope for the best. Under-funded pension plans are so great a concern in the U.S. that the agency established to protect pensioners from this risk, the Pension Benefit Guaranty Corporation, faces its own financial challenges. Yield-chasing life insurers are also a prime source of potential systemic risk."
Take it from the Pensions & Investments publication: "...the belief that lower long-term rates leads to more investment has led the Federal Reserve, and now the European Central Bank, to depress long-term interest rates... In a perverse way, lowering long-term rates has dramatically increased the liabilities of DB [defined benefit a.k.a. pension] funds in the U.S., U.K., Canada and Europe... and has lowered funded status dramatically."
"We believe it is imperative for central banks and academia to examine this perspective immediately and develop a new monetary policy toolkit..."
Take it from the Wall Street Journal, with a headline from March 2018 that reads: "Britain's Monetary 'Stimulus' Has Fed The Pension Crisis."
Take it from the Financial Times, which reported in the same month as the WSJ article that "Bank of England measures to boost the economy in the wake of the 2007 financial crisis harmed investment in the UK as companies diverted cash to deal with ballooning pension deficits." These deficits were caused by the lowering of rates and implementation of quantitative easing.
Take it from this economics paper published in the Journal of Banking and Finance in 2017, arguing that "monetary policy shocks, as identified by changes in Treasury yields following changes in the central bank’s target interest rates, lead to a substantial increase in pension funds’ allocation to equity assets. Notably, the shift from bonds to equity securities is greater during the period where the US Federal Reserve conducted unconventional monetary policy measures."
I will note here that longer term interest rates were falling during the bull market from 2003 to 2007, which led to increased equity allocation among pensions. This exposed many pensions to negative returns during the recession and aggravated funding issues. Remember that -2.8% average return corporate pensions suffered in 2016?
Not to mention what average annual returns for stocks and bonds will be going forward, as we approach another recession. Earlier in 2019, Morningstar put out a collection of estimates from various asset managers, ranging from -4.1% real returns to 7% nominal returns for stocks, and -0.2% real returns to 4% nominal returns for bonds. Assuming mid-single digit nominal returns for a mixed portfolio, pensions are still in trouble.
“Pension funds can’t match their liabilities with where rates are today so they have to hope that equity markets will continue to rally,” says Rick Rieder of BlackRock.
Raoul Pal's Thesis: The "Doom Loop"
Raoul Pal is a former hedge fund manager who retired at age 36 but remains actively involved in the world of macroeconomics and finance. In recent years, he started a finance news and content service called Real Vision.
In a video posted on YouTube on August 14th, Pal discusses his case for a recession in the next year or so as well as a very alarming scenario he calls the "doom loop." It's a fascinating and frightening thesis, and I find it persuasive. Here's the line of reasoning:
(1) The Fed lowers interest rates to stimulate the economy through increased lending. How else are lower interest rates supposed to stimulate anything besides through more lending, i.e. more debt?
(2) As a result, all sorts of market and government actors increase their debt loads. Corporations, especially, took advantage of falling rates to refinance and take on more debt.
(3) Some of this debt buildup has been for acquisitions or mega-mergers, but much of it was taken on simply for share buybacks. See, for instance, this chart showing the way in which debt issuance and share buybacks became tightly correlated right around the time that the Fed Funds rate bottomed near zero. (See my article addressing this subject here.)
Source: Hussman Funds
Debt-funded buybacks have served as a convenient way for corporate executives to lift earnings per share, thus meeting guidance more regularly and reaching the targets for their performance bonuses more often. (I wrote about this subject here.) What's more, an SEC study found that insider selling tended to coincide with the announcements or implementation of buybacks.
(4) Indeed, if you look at the performance of U.S. stocks versus any other country or world region's stocks, you'll notice a stark difference. U.S. stocks have soared ahead of the competition. It turns out that this is largely because of buybacks, as corporations themselves have been the biggest net buyers of corporate stock since the Great Recession:
Source: Avondale Partners
Notice that institutions (including pension funds) have been net sellers of U.S. equities since the recession. This likely means that pensions have been forced to sell many of their assets to fund benefit payouts but have sold other assets such as Treasuries at a faster rate than equities.
(5) Who is buying all this debt being issued to fund buybacks? The answer, in large part, is pensions. Mainly corporate pensions:
Writes Mark Johnson: "This uptick in bond buying has caused corporate pension funds to play a more influential role in the bond market, since pension managers tend to hold bonds for the long term. As more and more companies adopt the strategy of buying more bonds, pension demand could total $150 billion a year. It is estimated that corporate pension funds buy more than 50 percent of new long-term bonds, up from an estimated 25 percent a few years ago."
So corporate pensions are buying more and more bonds. Which bonds? Specifically, corporate bonds: "Pension plans... like to use corporate bonds to hedge liabilities." Corporate bonds offer the highest yields. Of course, pensions are only allowed to own investment grade corporate debt, but if they opt for longer duration or lower rated bonds they can get a higher yield. In the previous twelve months, BBB-rated corporate bonds have yielded as high as 4.83%, certainly better than the highest yield offered by the 20-year Treasury bill in the last twelve months — 3.27%.
BBB-rated corporate debt has grown to be roughly half of all corporate debt outstanding. That's one (small, for some companies) step above junk status.
(6) During a recession, much of this investment grade debt (Pal guesstimates 10-20%) will be downgraded. But remember: pensions cannot own junk bonds. If BBB-rated debt on their books gets downgraded, they will be forced to sell it, even at a loss. If multiple downgrades happen quickly in succession, the supply of newly labeled junk bonds will overwhelm demand from other market buyers of those debt instruments. This could lead to a fire sale scenario, in which the prices of junk bonds plunge as pensions dump huge supplies into an unsuspecting market.
(7) Not only would pensions have to accept a fraction of their cost basis for these former investment grade bonds, they would also see their primary revenue stream — tax revenue — slacken during a recession. Tax receipts, after all, are as cyclical as the business cycle. When individuals and businesses aren't making as much money, there is less available to be taxed. This would diminish demand for corporate bonds, which would cause corporate bond yields to spike.
(8) All of this chaos in the credit markets will make it very difficult for corporations to issue debt at anything other than high rates. This will cause the costs of new debt to soar high enough for buybacks to become prohibitively expensive. Moreover, cash flows will dry up, as they do in every recession, and thus every potential source of funds to use for buybacks will disappear.
(9) If the previous points play out, the biggest net buyer of U.S. equities over the last ten years will no longer be a buyer. "The largest buyer will have left the room," as Pal says. In fact, publicly traded corporations may actually be net issuers of shares during the next recession as they were in 2008-2009.
In the words of Jesse Colombo, "If the stock market performed as poorly as it did in 2018 with record amounts of buybacks to prop it up, just imagine how much worse it would be if buybacks were to slow down significantly or grind to a halt?"
I don't see how the preceding chain of events playing out as described would not ultimately result in a very nasty stock market crash. Whether it's a relatively quick crash like in 2008-2009 or a bit more drawn out like from 2001-2003 is unknown. Either way, I see the above scenario as plausible. Disturbingly so.
Since I'm an income-oriented investor, my preferred method of hedging against this possible crash scenario is to hold ample cash and ultra-short term bond funds. That way, if this scenario does play out, I will be prepared to buy assets at fire sale prices with yields higher than I might ever see again in my lifetime.
Raoul Pal's thesis is fascinating, but it could be wrong. What I'm much more certain of is that the Fed bears the majority of the blame for the underfunding of pensions and thus for putting us into a situation in which Pal's thesis would even be possible.
Disclosure: I am/we are long EDV, NEAR, SHV. 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.