Pension Problems

What’s wrong with our retirement system?

State pension funding ratios. Source:

It used to be that firms offered pensions as an employment benefit. They were structured to reward employee loyalty—the longer you stayed at a company, the higher the payout ratio when you retired. Then came the ‘70s and ‘80s, with massive restructuring and layoffs. What good was loyalty when the firm wasn’t loyal to you? Workers lost a good deal of their benefits, through no fault of their own.

So pensions and retirement savings became mobile, through IRAs and 401(k)s. Now retirement savings follows the workers, and the only penalty comes if you withdraw the funds early. The main source of pensions is now the government—an employer not subject to leveraged buyouts or a hostile takeover—we hope.

But there’s a problem with public pensions. The States haven’t set aside enough money to fund them. Different states vary by how responsible they’ve been—Illinois is the worst, and Wisconsin and Washington the best, as can be seen above. New Hampshire’s funding level is pretty bad. Why is this?

Source: Conversable Economist

All pensions are local, but the States now find themselves in the position they were in the early ‘50s. The unfunded liabilities, in aggregate, are equal to about 80% of annual revenue. That’s a lot. And the pensions are fixed obligations—similar to debt in terms of payment priority.

Pension funding worsened dramatically after the 2008 financial crisis partially because the stock market went down, but also because interest rates fell. When rates fall, the future obligation goes up. After the dot-com boom, States should have re-allocated their investments into a lot of 30-year government bonds. Instead, we saw everyone jumping on the alternative investment—hedge fund—private equity—venture capital train. Bonds were boring. But if they had gone with boring bonds, we’d all be a lot better off.

S&P 500 and Gov’t bond returns since 12/31/99. Source: Bloomberg

What’s to be done, now? Different States will approach the problem in different ways. Some folks have floated pension obligation bonds, borrowing from the bond market to invest in the stock market. That may work, long-term, since rates are so low now, but it’s risky. And it doesn’t’ satisfy any immediate revenue needs. One approach would be to apply a “pension surtax” to other revenue sources—to recognize that unfunded obligations are obligations, and you can’t borrow your way to prosperity. But there’s not much political consensus around new taxes. Or, the States could try to privatize their pensions—paying the present value into retirement savings accounts. But that would be another political nightmare.

We’ve got a problem: stormy markets ahead, low interest rates inflating future benefit obligations, and limited prospects for more revenue. We have to remember, though: we—through our leaders—made these pension promises. We have to keep them.

Douglas R. Tengdin, CFA

Chief Investment Officer

By | 2017-07-17T12:22:07+00:00 March 4th, 2016|Global Market Update|0 Comments

About the Author:

Mr. Tengdin is the Chief Investment Officer at Charter Trust Company and author of “The Global Market Update”. The audio version of each post can be heard on radio stations throughout New England every weekday. Mr. Tengdin graduated from Dartmouth College, Magna Cum Laude. He received his Master of Arts from Trinity Divinity School, Magna Cum Laude and received his Chartered Financial Analyst (CFA) designation in 1992. Mr. Tengdin has been managing investment portfolios for over 30 years, working for Bank of Boston, State Street Global Advisors, Citibank – Tunisia, and Banknorth Group. Throughout his career, Mr. Tengdin has emphasized helping clients manage their financial risks in difficult environments where they can profit from investing in diverse assets in diverse settings. - Leave a comment if you have any questions—I read them all! - And Follow me on Twitter @GlobalMarketUpd

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