Pensions plans are in trouble (and it's going to get worse)

November 15, 2017

We all dream of retirement. A twilight of life where the daily grind is replaced by meaningful experiences, adventure and quality time with loved ones.

Yet for many, a nightmare is coming. Some is self-inflicted: Baby Boomers in the US have less than half the savings they need for retirement, according to a Legg Mason report. And only a third of Americans that have access to a 401(k) plan contribute to it, per US Census Bureau research. (Social Security, as an aside, isn't looking so great either.)

But much is out of their hands—especially for those relying on others to secure their retirement via defined benefit pensions. The problem: Many public and corporate pension plans are underfunded, with obligations outpacing assets, despite recently enjoying one of the greatest, most persistent equity bull markets in history.

And now, we're all going to pay the price.

With asset valuations stretched—the S&P 500 has only been more expensive relative to earnings in 1929 and 1999—the underfunding is likely to get worse. Why? Because return assumptions and actual investing results are likely to decline over the next few years.

Average public pension asset allocation


In response to these pressures, many pension managers are increasing their allocation to alternative investments, such as private equity and infrastructure; at the same time, in some cases, they are shying away from equities on possible valuation concerns, according to a study by the OECD. Other "reach for yield" behavior they found included shifts within their fixed-income allocation to riskier high-yield and alternative credit strategies.

The Pew Charitable Trust also recently highlighted the increasing use of complex alternative investments by state pensions funds (more than doubling since 2006, as shown above), which is not only increasing the year-to-year volatility of returns but also increasing investment-related costs (which they estimate have risen 30% over the past decade).

Yet the shifts haven't been enough.

Milliman's 2017 Public Pension Funding Study finds that, through the end of the second quarter, the aggregate funded ratio for the industry stands at 70.7%, for a total underfunded liability of $1.43 trillion. For the 100 largest corporate pensions, Milliman estimates an 81.2% underfunding for a total of $323 billion in unmet promises to retirees, as of the end of 2016.

Kentucky pension system underfunding under alternative discount rates


The chart above (of the Kentucky state pension plan) shows even a modest change to pension interest rate assumptions—the rate used to discount future pension benefit payments—has a large impact on underfunding levels. Currently, Milliman believes the median public pension discount rate (7.5%) is slightly too high (versus their 6.71% assumption) making reductions likely.

Also noteworthy is the investment return assumption pensions use to calculate asset growth. Focusing on Kentucky as an example, state budget director John Chilton warned local governments that pensions costs could jump upward of 60% next year after reducing the assumed rate of return to 6.25% from 7.5%, as well as cutting the assumed annual payroll growth rate to 2% from 4%. 

Kentucky's state plan is just 37% funded. And these numbers, for Kentucky and everyone else, are all but surely headed lower.

McKinsey, in a report from last year, warned of a future of diminished investment returns where "investors may need to lower their expectations" as we exit a "golden era" for financial assets associated largely with the three-decade-plus bull market in bonds. This period was associated with an average annual real total equity return of 7.9% and a real bond return of 5% in the US—1.4% and 3.3% above the 100-year averages, respectively—driven by tailwinds such as lower inflation, strong global GDP growth, positive demographics and productivity gains that are now subsiding.

As a result, they are looking for US equity returns to average 4% to 5% over the next 20 years with fixed-income returns around 0% to 1%.

Deutsche Bank paints an even darker picture, considering what the future looks like under a "mean reversion" scenario where financial asset valuations revert back to long-term trends and averages: An annual real equity decline of -1.3% to -4.3% in the US over the next 10 years and a 10-year US Treasury bond real decline of -1%.

Overall, McKinsey estimates that a decline in investment returns would increase state and local pension plan underfunding by upward of $2 trillion while corporate pension plan underfunding would rise by the hundreds of billions.

This dim outlook is fueling interest in pension risk transfer strategies as plan sponsors look to move the underfunding liability to insurance companies and other acquirers. These are known as "pension lift-outs" and can also include lump-sum payouts to plan participants. It has also fueled a recent increase in pension plan allocations to alternative asset classes like private equity in a desperate attempt to boost investment returns.

Another option, a national pastime at this point, is the specter of a taxpayer-funded bailout: US Senator Sherrod Brown (D-OH) plans to introduce legislation allowing troubled pension funds to borrow from the US Treasury to remain solvent, creating a new office within the Treasury Department dubbed the "Pension Rehabilitation Administration."

As a prime-age working millennial, I've gotta ask: Who's going to rehabilitate my wallet when the tax bill comes?
 

Related read: 'Reach for yield' dynamic driving private capital deluge

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