we will look with fresh eyes at an old problem: US pension funds, both
public and private, are under-funded, and the situation is getting
worse. And the US taxpayer is going to get to fund the difference. The
recent slew of data on pension funds suggests that little is being done
to correct the huge and mounting problems I have written about for
years. Even the recent market upturns of the past few years have not
been as big a help as it should have been. I wrote this over two years
"...there is something north of $1 trillion dollars in equity assets in
the 123 state pension funds covered in this [Wilshire] study. My back of
the napkin analysis shows that pension fund estimates assume that the
equity portion of the pension fund assets will grow by 10% or around
$100 billion per year.
"That means in 7 years and at 10% compounding, they are assuming there
will be approximately $1 trillion dollars in growth from the equity
portion of their assets.
"If the stock market is flat, they will be short $1 trillion in only 7
years, from a "mere" $180 billion shortfall today. If the market grows
at 3%, the states will be down $750 billion from their estimates."
In the last few years since then, corporate earnings have grown well
above the long term trend and the broad stock market has grown over 10%
a year. Surely, then, things should better. Sadly, they have not
improved. Let's look at some recent data. First, let's look at corporate
America and then at Public (state, county and city) pension funds.
Companies with underfunded pension plans reported a record shortfall of
$353.7 billion in their latest filings with the Pension Benefit Guaranty
Corporation (PBGC), Executive Director Bradley Belt told the Senate
Finance Committee last week. That is up considerably from the $279
billion reported a year earlier, and over $300 billion from four years
ago. The total increase in underfunding last year was $75 billion, or
27%. Below is a chart showing underfunded pension plans.
Number of Plans
(Dollars in billions)
The 2004 reports, filed with the PBGC by April 15, 2005, were submitted
for 1,108 pension plans covering about 15 million workers and retirees.
The underfunded plans had $786.8 billion in assets to cover more than
$1.14 trillion in liabilities, for an average funded ratio of 69
But it is actually even worse. The reports are required only of
companies with more than $50 million in unfunded pension liabilities.
Smaller pension plans with smaller problems did not go into that figure.
Adding them, as of September 30, 2004, the PBGC estimated that the total
shortfall in all insured pension plans exceeded $450 billion.
Belt's testimony also contained a detailed analysis of the pension plans
of United Airlines. Although the plans have an aggregate funding
shortfall of almost $10 billion and an average funded ratio of 41
percent, the company was able to go for years without making any cash
contributions to the plans, without paying additional premiums to the
PBGC, and without sending underfunding notices to plan participants. All
within the rules, you understand. If you are a United employee, you are
not happy right now.
Hey, It's Only a Few Trillion Here and
OK, let's do a little back of the napkin math. These companies assume
about 8-9% forward earnings in their plans. The median plan got 10.8%
last year, according to Wilshire. That is quite troubling because if you
perform above plan and are in worse shape it means that you are not
funding your liabilities. It seems many companies are betting (hoping?
gambling?) that another new bull market will return and save their
collective pensions schemes. That puts tax-payers at risk, not to
mention those who expect to retire on their pensions.
Second, let's just look at the roughly $800 billion in assets. Let's
look at a typical 60% stock, 40% bond asset allocation mix. Let's
generously assume you can make 5% annualized on your 40% bond portfolio
allocation in the next ten years. That means to get your 8% (assuming a
lower average target) you must get 10% on your stock portfolio. Now,
about 2% of that can come from dividends. That means the rest must come
from capital appreciation.
Hello, Dow 22,000 in 2015. Care to make that bet with me? But pension
plan managers are doing precisely that.
Earnings over long periods (and ten years is a longer period) grow about
GDP plus inflation. Let's generously assume 6% earnings growth. A 22,000
Dow (or a 2500 S&P 500) means we will have to get back to bubble
valuations, or P/E ratios into the high 20s for the largest cap stocks.
Why? Because if earnings grow at only 6% and the market grows at 10%,
P/E multiples have to get much larger. It is Back to the Future.
6% is too low for earnings growth you say? Am I being too pessimistic?
That is Standard and Poor's spread sheet on S&P 500 earnings. Depending
in whether you use core, as reported or operating earnings, you get a
little more than 6% or a little less than 7% earnings growth over the
last ten years. That is a period of time encompassing the greatest bull
market in history, a very mild recession, and in which earnings in the
last few years have grown to all- time highs as a percentage of GDP. In
short, it is hard to find many better ten year earnings periods in the
last 100 years. It doesn't get much better, except in extreme cases
coming off of serious recessions.
Thus, all we can optimistically hope for is a lousy 6-7%, which is in
fact a very respectable number. I hope we can do that in the next ten
years. Bluntly, since we are at all-time highs in earnings as percentage
of GDP, it will be quite difficult to see earnings grow at 6-7%.
All this simply means is that unless we get a return to a stock market
bubble, it is highly unlikely we get to Dow 22,000 or S&P 2500. That
means that those pension plan woes are going to get worse. How much
If you buy my case that we are in a secular bear market and that
valuations are going to go lower, then it can get a lot worse. Stock
market valuations are easily within the highest 20% in terms of the last
100 years or so. When valuations are at today's level, the stock market
on average has returned 0% in real (inflation-adjusted) terms. Not 3 or
2 or 1, but a big zero. Assuming 2-3% inflation and a 2% dividend, you
get at most 4-5% nominal returns from the stock market over the next ten
years, much less than the 8% growth and 2% dividends projected by the
When combined with lower bonds returns, total portfolio returns are
likely to be in the 5% range, significantly less than the 8-9% projected
by most funds.
And don't forget, we will have at least one recession and perhaps two in
the next ten years. With all the other headwinds, it is hard to see the
next ten years as an ideal one for outsize earnings growth.
Given the above numbers, the pension plans which are the most
under-funded could see a shortfall of between $500 billion and $750
billion. Of course, the rest of the plans will have to make up their
losses as well. The latest data I could find suggest that there is about
$1.5 trillion in defined benefit corporate plans (looking at a graph and
not numbers). The PBGC problem funds have about $800 billion, so there
is another $700 billion or so. The actual number is irrelevant for the
sake of the argument (and it is getting toward my deadline).
All total, corporate pension plans may have to make up an almost $ 1.2
trillion shortfall if the market gives only the 5% which history suggest
it will at current valuations and earnings levels. That number comes
from the current $400 billion dollar shortfall and a 4% earnings
shortfall on the portfolios. It could be a few hundred billion here or
there, as no one knows exactly what the future will bring. But whatever
the number, it is huge. It is especially huge when you think of it in
terms of the potential profits of the companies which offer defined
Someone is going to have to make up that difference. Most of it will be
through reduced corporate profits. This of course makes it harder for
the stocks to grow in valuations, which makes the problem of the
projected market growth even more problematical.
United We Stand Means Tax-payers Will Pay
And some of it will be through you and me as we pay taxes to fund the
PBGC. We just bought $10 billion of United Airlines pension debt. But
United was allowed to survive. Now they can compete without that debt
burden against the rest of the old-line carriers who have not yet gone
into chapter 11 so they can shed their pension burdens. And you know
they are all thinking about it.
The tax-payer in me says let United die so we can see the rest of the
airlines possibly survive. With less capacity, the airlines will be able
to raise prices and maybe even make a profit. Require them to fully fund
their pensions so you and I don't have to pay for their pensions.
The free market economist in me says let them die so better run
companies can take their place. The government should not be in the
business of meddling with the markets. Why should tax-payers pick up the
tab and then the shareholders and especially the bond-holders get their
money? They knew the risks. Let the market sort out the winners and the
Of course, the consumer and frequent flyer in me says let them live so
my travel costs will stay low. And the kinder, gentler soul in me says
let them live so all the employees will have jobs. And the conflicted
tax-payer worries about the unemployment benefits and costs. Ah, the
internal conflicts of the modern world. There is no free lunch.
Someone's ox will be gored, no matter what the decision.
Given the reality of future market returns which project to be below
trend, it seems that underfunding problems are only going to become
worse. And without new rules protecting tax-payers, it seems likely that
we tax-payers are going to pick up several hundred billion or far more
in PBGC debt. And the bet is that we will not see new rules until the
horse is already out of the barn. Business (and political donors) will
scream if faster make-up payments are required of pension funds which
are in the hole. Employees (and local voters) will scream about the loss
of their jobs. The easy thing for politicians to do is hold committee
meetings and actually do nothing. There is no easy solution, so Congress
will do nothing.
Whether or not you like Bush's Social Security plan, you have to give
him kudos for at least bringing the subject up. And with SS a relatively
easy fix, it is sad we can make no progress. What will we do when the
hard questions of Medicare comes up next decade?
It is like the old Fram oil filter commercial: "Pay me now or pay me
later." Congress is opting for later.
Public Pensions, Public Disasters
Wilshire associates report that the problem is worse for public pension
plans than for corporate plans. The average underfunded plan has a ratio
of assets-to- liabilities equal to 78% (averaging across several
categories). 84% of state retirement plans are underfunded.
Let's go to the US Census Bureau for some details. (http://www.census.gov/govs/www/retire03.html)
The latest data is from 2003. There is roughly $2.2 trillion in state,
county and city public pension plans. In 2003, there was a net
contribution (or funding) of only $13 million over expenses. The cities,
counties and states are clearly hoping the market will bail them out,
and data suggest that in 2004 the market did indeed help. But not enough
to do more than drop a few percent of the public pensions off the
Texas pension plans, which I assume are typical of all US plans, assume
they will get a return of 8.3% (on average) from their investments. They
note they have made 9.8% over the last ten years, so if past performance
is indicative of future results, projecting 8.3% is safe and
Except that much of that return was from increased multiples on stock
market valuations which are unlikely to repeat in the next ten years,
and bonds paid a great deal more then they do today.
Again, we could see a 3-5% shortfall under the assumptions. At 4%, this
would mean a $1 trillion dollar shortfall on total plan assets. But it
gets worse. Since Wilshire suggests that plans are underfunded by
slightly over 20%, this means that total underfunding is now over $400
billion (with a B) on a $2.2 trillion dollar portfolio.
Every year that $400 billion is not funded means that the fund loses the
potential gains from that amount. If plan assets are SUPPOSED to be $2.7
trillion to be fully funded, then an 8% average annual shortfall (the
assumed rate of return) due to lower stock and bond market returns
suggests that the real shortfall in ten years could be well over $1.5
trillion. (That is their future projections are based on assets of $2.7
trillion with 8% annualized returns, but they are starting now with only
$2.2 trillion in assets, so not only are their return assumption to
high, but they are starting with 20% less assets to compound over that
10 years. They not only have to make up the 20% shortfall but also the
8% return they projected to make from that 20% that is not there now.)
But what if the shortfall is more than $400 billion? From a Business
week article entitled "Sinkhole" of last week:
"As much as states are throwing into pensions, they may owe even more.
Despite a 2004 stock market rise that should narrow some of the gap,
pension experts at Barclays Global Investors say that if public plans
calculated their obligations using the more conservative math that
private funds do, they would not be $278 billion under, but more than
$700 billion in the red. 'It's just ruining the financial picture for
states and municipalities,' says Matthew H. Scanlan, managing director
of Barclays, one of the largest managers of pension-fund investments.
'You're looking at a taxpayer bailout of this pension crisis at some
Crisis is the correct word. If the guys at Barclays are close to right
on their pension projections, the shortfall in ten years could easily be
$2 trillion! Run that number into your local taxes. And each year the
underfunding situation remains, the problem gets worse because of
compounding of the losses. It is like a negative amortization loan on a
depreciating asset. Each year you owe more but have less to pay with.
Back to the article:
"There's more bad news. One major category of cost isn't disclosed at
all: how much retiree health care has been promised to public retirees.
No one can estimate how much these promises will add up to, but they're
sure to be in the tens of billions, and only some states seem to have
put aside reserves for them, according to bond analysts. That's
chilling, given how quickly medical costs are rising. After a pitched
battle, the Governmental Accounting Standards Board (GASB), the
independent accounting standards-setter for state and local governments,
has finally begun to require states to disclose these liabilities.
Numerous unions and state government representatives objected to the
change, says GASB member Cynthia B. Green, 'not because [unions and
states] didn't think these were important, but because they thought once
the governments did their studies and found what the price tag was, they
would be concerned or, if not concerned, staggered.' The requirement
will be phased in beginning in late 2006."
Figure that into your local and state taxes. Courts have consistently
upheld the obligations of municipalities to fund the promised retirement
programs. Unlike private pensions which can be cut or simply abandoned,
public pensions will have to meet their commitments. Only four states
allow for public pension funds to be cut retroactively. That means taxes
will have to be raised or services cut to fund increased contributions.
There is a local tax and/or service crunch coming to a city near you in
the next decade. If French entrepreneurs are voting with their feet to
leave France (which is a beautiful place and one of my favorite
countries to visit), you think US tax-payers won't move to cities and
counties a little farther out with lower taxes and fewer commitments?
The attraction of lower tax communities with fewer pension commitments
is going to rise. This will drive down property values in high cost
cities. Cities will need to raise taxes collected and this will start
In that same Business Week article last week, they cited a Michigan
school district which has revenues which are capped, but pension
contributions are expected to grow from 13% of payroll to over 20% in
three years. No new revenues mean that services will have to be cut.
Cutting education expenditures is not always popular in local
communities. Few school board members get elected on a promise to cut
education expenses, teacher salaries and increase classroom size.
Major public pension plans paid out "just" $78.5 billion in the year
ended September, 2003. By 2004, that had grown to $118 billion. The
growth trajectory is only going to increase as the baby boomer
generation reaches retirement age.
Of course, you can always do what the Democratic led Illinois
legislature is trying to do. You can ignore the $80 million dollar
contribution needed for this year, spend it on other items and use
accounting tricks to say there is no shortfall. In fairness, you can
find many Republican groups who do the same thing. Ignoring pension
obligations is one area where there is true bi-partisan cooperation.
We could go on, and if you want more gruesome details, I suggest you go
to the Business Week article at:
Note: John Mauldin is president of Millennium Wave Advisors, LLC,
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