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How to Get Rich Investing in Stocks by Riding the Electron Wave

The Multi-Trillion Dollar Black Hole That Could Undermine the U.S. Economy

Economics / US Economy Jul 30, 2012 - 05:11 AM GMT

By: Money_Morning

Economics

Best Financial Markets Analysis ArticleShah Gilani writes: The difficulties facing retirees aren't just their problems. Underfunded pensions weigh down everyone's retirement expectations and America's future growth prospects.

Kicking the can down the road on this one has involved everything from outright lying to misrepresentation, bordering on fraud in the way pension plans calculate their liabilities.


If long- term solutions aren't implemented, the U.S. economy will experience a secular decline, equities will plummet, and millions of Americans of all ages will suffer.

While huge problems exist in private pension plans, public-sector plans -- those slated to provide retirement benefits to public-service employees of state and local governments -face exponentially larger problems.

Here's a look at what the problems are, who's responsible for the mess we're in, who's going to have to fill in the deep holes, what the bad news is when it comes to fixing pensions and what the worse news is if they aren't fixed.

A Multi-Trillion Dollar Hole
A recent S&P Dow Jones Indices study highlighted record levels of pension underfunding at publically traded companies in the U.S.

At the end of fiscal year 2011, according to S&P, corporate pension plans were collectively $354.7 billion underfunded based on obligations totaling $1.676 trillion and assets of $1.322 trillion.

In addition, S&P noted that OPEB promises (Other Post Employment Benefits) such as health related benefits and life insurance were $233.4 billion underfunded.

To some extent the private sector's pension woes are ostensibly offset by the more than one trillion dollars of cash sitting on corporations' balance sheets.

But the problem with that cash is that it's not being earmarked for pensions.

Managers are stashing cash for any potential global rainy days ahead, for strategic acquisitions and as a cushion against an expected peak in the earnings cycle. But none of the officers or executives of any corporations sitting on mounds of cash have indicated any intention to fill pension holes with their coveted cash hoards.

On the public sector side of the pension plan dilemma, things are exponentially worse.

Actuaries, the professionals who calculate the life expectancy and needs of pension beneficiaries and the level of assets and expected returns on plan assets necessary to meet promised obligations, estimate the shortfall at more than $1 trillion.

But that's a far cry from the $4.6 trillion shortfall figure that some economists and analysts have levied as the true liability picture.

The difference isn't a guess. It's based on real math, which makes it frighteningly clear that even the $4.6 trillion liability figure woefully underestimates the depth of the hole.

Pension Fund Pressures
There are two components that determine a pension plan's assets.

Annual required contributions (ARC), the expected cash investments made by employees and employers, and the return-on-investment on those assets together determine the health of pension plans.

Annual contributions are a problem for both private and public sector plans.

Corporate woes and cash- flow issues may result in underfunded employer contributions.
Additionally, employee contributions are a function of the size of workforces, which decrease usually at the worst time in an economic cycle, causing fewer contributors to bear the burden of increasing obligations.

It's even worse now in the public sector.

Deficit reduction pressures are sinking federal, state and local employment rolls at the same time that tax bases are narrowing.

In effect, fewer government employees, at all levels of government -- federal, state and municipal -- are contributing to pension assets as retiring and laid-off workers add to budget woes and pension liabilities.

To make matters infinitely worse, government leaders and legislators have raided pension plans to pay for spending projects. They've also tapped pension funds in many backroom deals to show balanced budgets and offer more tax cuts and services to the voting public.

But the ailing contribution side of the two-pronged asset equation pales in comparison to the willful and almost criminal misrepresentation of expected returns on plan assets.

Expected Returns Meet Reality
Most pension plans use an expected 8% (blended) return on assets under management to determine future asset streams sufficient to meet obligations.

The 8% figure used to be the historical annual average return that was expected to continue into infinity.

Then reality intervened. Markets sank, crisis after crisis decimated equities as well as the economy, and the Federal Reserve began an articulated policy prescription of the decades-long depression of interest rates.

The reality may be that, on a good day, based on an acceptable risk profile given the absolute requirement for positive returns to meet retiree living expenses, a 4% return is the best pension plans can assume under current circumstances.

Actuaries, as a matter of shorthand, call the expected return they apply to plan assets the "discount" figure. In other words, though in strict finance theory terms this is not how it's calculated, a discount of 8% implies an 8% return on investments.

As this excerpt from the "Report of the State Budget Crisis Task Force" explains:

"One of the actuary's critical jobs is estimating the liability that a pension system has to its beneficiaries. This requires projecting benefits that will be paid in the future and "discounting" those benefits to the present. The choice of discount rate is critical.

For example, the estimated liability today for a single-year's pension benefit of $31,700, payable 15 years hence, is approximately $10,000 using an 8% discount rate, but more than $15,000 using a 5 % rate.Put differently, using a 5% rate increases the estimated liability by about 50% relative to an 8% rate.The impact on unfunded liabilities can be dramatic.

In the example above, if a pension plan had $8,000 in assets set aside for the future benefit it would have unfunded liabilities of $2,000 at an 8% discount rate (given the liability of $10,000). But with a 5% rate the plan would have $7,000 in unfunded liabilities (given the liability of $15,000) - the unfunded liability would be more than three times as large."

As for an 8% return, plans aren't close to achieving it and haven't been for more than a decade now.

Experts calculate that a 1% drop in the discount rate can lead to a 10-20% increase in the present value of pension plan liabilities.

A Crisis in the Making?
As all this is coming to light, the Government Accounting Standards Board (GASB), responsible for government accounting of pension plans, is changing the rules.

It's going to require pensions with less than 80% funded plans to discount short-funded balances at 3-4% rather than 7-8% as they are calculating now.

Moody's, citing accounting changes and the impact that will have on pension plan liabilities, states and localities, has issued warnings that credit downgrades are sure to follow.

C orporations can escape some of the burdens of pension obligations through bankruptcy, selling off divisions, restructuring and other tactics, and hand off future obligations and their financing to the Pension Benefits Guarantee Corporation (the 1974- enacted pension bailout fund that's financed by premium payments from beneficiaries whose plans collapsed and were taken over by the PBCG). But public sector pension plans don't have it so easy.

Deficit reduction demands, increasingly volatile and narrowing tax bases , an uncertain economic future, and the dreaded fiscal cliff are wreaking havoc with pension funds and Americans' retirement prospects.

In the short run, if long-term fixes are put in place, there will be pain. Retiree benefits in general will have to be cut. Contributions from employers and employees will have to increase and payout amounts may in the future have to fluctuate with real returns.

But we'll get through, and knowing that a good, honest and realistic fix is in place will set the stage for greater employee confidence and productivity.

On the other hand, if there is no fix in our foreseeable future, markets will start discounting the prospect of less well-heeled retirees and slowing consumer demand.

A market crash based on the fiscal cliff crumbling on top of underfunded pension plans would compound future return prospects for both pension plans and America's future.

Something has to be done now.

Source :http://moneymorning.com/2012/07/30/underfunded-pensions-undermine-the-entire-economy/

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