Quantum Pranx


Pensions: Even worse than they seem

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by John Rubino
Posted originally September 18, 2010

AN ARTICLE IN TODAY’S WALL STREET JOURNAL ILLUSTRATES YET ANOTHER LIE we’re being told. It seems that pension funds, despite plunging interest rates and negative returns in the stock market over the past decade, are still assuming an 8% annual return on their assets. This allows them to pretend to be more fully funded than they are. Here’s an excerpt:

Pension Gaps Loom Larger
Funds Stick to ‘Unrealistic’ Return Assumptions, Threatening Bigger Shortfalls

Many of America’s largest pension funds are sticking to expectations of fat returns on their investments even after a decade of paltry gains, which could leave U.S. retirement plans facing an even deeper funding hole and taxpayers on the hook for huge additional contributions. The median expected investment return for more than 100 U.S. public pension plans surveyed by the National Association of State Retirement Administrators remains 8%, the same level as in 2001, the association says.

The country’s 15 biggest public pension systems have an average expected return of 7.8%, and only a handful recently have changed or are reconsidering those return assumptions, according to a survey of those funds by The Wall Street Journal.

Corporate pension plans in many cases have been cutting expectations more quickly than public plans, but often they were starting from more-optimistic assumptions. Pension plans at companies in the Standard & Poor’s 500 stock index have trimmed expected returns by one-half of a percentage point over the past five years, but their average return assumption is also 8%, according to the Analyst’s Accounting Observer, a research firm.

The rosy expectations persist despite the fact that the Dow Jones Industrial Average is back near the 10000 level it first breached in 1999. The 10-year Treasury note is yielding less than 3%, and inflation is running at only about 1%, making it tougher for plans to hit their return targets.

Return assumptions can affect the size of so-called funding gaps—the amounts by which future liabilities to retirees exceed current pension assets. That’s because government plans use the return rates to calculate how much money they need to meet their future obligations to retirees. When there are funding gaps, plans have to get more contributions from either employers or employees. The concern is that the reluctance to plan for smaller gains will understate the scale of the potential time bomb facing America’s government and corporate pension plans.

Pension funds at companies in the S&P 500 faced a $260 billion shortfall at the end of 2009, according to Standard & Poor’s. Estimates of the fund deficits faced by state and local governments range from $500 billion to $1 trillion. Another article in today’s WSJ illustrates one possible future for underfunded pensions:

Japan Weighs More Risk in Pension
TOKYO—Japan’s public pension fund, the largest in the world with assets totaling 123 trillion yen ($1.433 trillion), is weighing the idea of investing in emerging-market economies in order to gain higher returns as it faces a wave of payout obligations over the next four to five years, the fund president said in an interview.

The Government Pension Investment Fund, which has roughly 67.5% of its assets tied up in low-yielding domestic bonds, is selling a record four trillion yen of assets by the end of March 2011 to free up funds for payouts to Japan’s aging population. By the year 2055, 40% of all Japanese are expected to be over 65.

Some U.S. public pension funds face similar issues. Burned by the financial crisis, some are rethinking their commitments to assets that tie up cash, such as real estate, while others are on the hunt for higher returns to make up lost ground and support swelling obligations to their pensioners.

Japan’s situation has its own distinguishing factors. Japan now has a record proportion of older people, with 21% over 65 years old, according to the Ministry of Internal Affairs and Communications. Within Japan, debate has been brewing over how the pension fund, also known by the acronym GPIF, allocates its assets in the near term, given the shrinking number of workers who pay pension contributions.

In addition to the roughly 67.5% of the fund’s assets in domestic bonds, including government and corporate bonds, 12% are in Japanese stocks, 10.8% in overseas shares, and 8.3% in foreign bonds.

Takahiro Mitani, president of the pension fund, said in an interview the fund could face a few years in which its payouts exceed its incoming contributions.

We “may face difficulty in the next four to five years…we currently have a hard time catching up with payouts since wages have been on a downtrend recently,” he said.

Mr. Mitani said the fund won’t sell just domestic bonds. “It could be [Japanese] stocks or foreign-currency-denominated securities or stocks,” depending on market conditions, he said.

Some thoughts:
▪ Because pensions are seen as politically untouchable, pension managers have no choice but to lie about their future returns and then try to make the lie a reality by investing in assets that are wildly unsuitable for this kind of institution.

▪ Both strategies will fail. The lies can’t continue for much longer in the face of low-single-digit returns — which are all but guaranteed by the rate on high-grade bonds which dominate most pension fund portfolios. And shifting to riskier assets will cause actual losses during the next bear market (coming soon), which will put underfunded pensions in an even deeper hole.

▪ Assuming we don’t slide directly in to a deflationary depression, interest rates in the US and Japan will rise as the major pension funds shift out of Treasuries and investment grade corporates and into emerging market securities and real estate. This will produce losses in the remaining “low-risk” part of pension fund portfolios, more than offsetting the returns (if there are any) from the riskier assets.

▪ Japanese stocks, the yen, and US long-term treasuries will be, for those who time it right, the short of a lifetime.


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