If you think the problems confronting Social Security are daunting, brace yourself. The problems of some private-sector retirement programs may be worse. That's because the rosy expectations of strong equity returns have been undercut over the past two years, according to pension industry observers.

And institutional investors' expectations may be almost as unrealistic as retail investors. Take IBM, the mainframe computer giant. For the current year, IBM's financial officers assumed they would earn 9.5% on their equity pension assets. General Motors, known to its pensioners as Generous Motors, is assuming 10%. These assumptions may not have sounded so unreasonable in January when equities were rallying after two bleak years. But with the Standard & Poor's 500 Index down 21.3% though August 12, the projections now looks out of reach.

The problem could ripple through the large-cap sector of the stock market, since includes those companies that are most likely to have significant pension plans. This is a group that derived as much as 15% of its earnings in the late 1990s from overfunded pension plans, whose assets were ballooning with the bull market. But now the combination of low interest rates and negative equity returns is wreaking havoc on the pension business. If companies now are forced to come up with additional contributions over and above their normal outlays to meet future pension obligations, it could serve to depress large-cap companies' earnings going forward, hamstringing market returns for several years to come.

"We're going to have a pension crisis in America soon." That is the analysis of Ronald Ryan, a former brokerage official who is now president of his own registered investment advisory firm, Ryan Labs. The services of the firm, based in New York City, include research and analysis for pension funds. On average, returns on pension fund assets caused a shortfall of about 37% on pension liabilities during the last 24-month period, the firm says. More important, the number of underfunded plans recently has begun to rise.

That means, Ryan says, many problems will soon overtake defined benefit programs. Pension fund officials often don't take the proper measurements, he argues. They are ignoring the warning signals of plans that can't keep up with their exploding obligations, he says. Many plans, he adds, were in trouble even before the recent bear market.

"With the possible exception of immigration, there's nothing more of a hot button globally these days than pension plans," says Laszlo Birinyi, a strategist with Deutsche Bank.

One warning signal, says Ryan, is the relatively poor performance of defined benefit plans over the course of the recently concluded bull market. Ryan Labs' asset liability watch measures the performance of these pension plans. The cumulative performance of pension assets vs. liabilities in these plans over the last 13 years, a period of mostly outsized stock market returns, has not been good, he says. During seven out of 13 years, the funds have been in the red. That means liabilities grew faster than assets, according to an index compiled by Ryan.

The collective return of these funds has been negative at -7.32%. What is alarming is that 13-year span was during the greatest bull market in history, Ryan notes. What happens to these funds if the current bear market is protracted?

Even those who disagree with the alarmist nature of Ryan's thesis agree that plans are going through difficult times. "It's obvious many plans that had surpluses are seeing them disappear, and we are going to see more underfunded plans," says Jeffrey Saef, director of institutional strategy and research for Putnam Investments. However, Saef believes Ryan is exaggerating the extent of the problem. Still, there's no doubt that the private retirement systems are going to be challenged over the next few years.

According to government figures, about a third of the approximate 33,000 single employer defined benefit plans in the United States are underfunded. Those that are underfunded are required to pay a higher premium, one that is variable, than plans that are properly funded, according to officials of the Pension Benefit Guaranty Corp. (PBGC). The rest pay a fixed premium as long as they are fully funded. This is a reversal of a trend that was fueled by the bull market of the last decade. Indeed, in the late 1990s, the number of underfunded plans was rapidly on the decline, dropping from 37% in 1997 to 28% in 2000, according to the PBGC. But during 2001, that number has dramatically increased by 5% to some 33%. Since January the situation is unlikely to have improved. "We have been seeing a slight rise in the number of plans that are underfunded, especially in the areas of airlines and steel companies," says Jeffrey Speicher, a spokeman for the PBGC.

Ryan warns this is just the beginning of an ominous trend that will continue for several years. How serious will it be? Ryan said the trend will be a drag on earnings for stronger companies, which didn't have to worry about contributing to fat plans in the 1990s when market appreciation was covering the cost of their obligations. Now, they will have to ante up again.

For weaker companies, which had underfunded plans even in part of the bull market, it will likely start the process of pushing some of them into bankruptcy, Ryan predicts. Several observers of the pension plan business say that, at the very least, pension funds are not going to be bailed out by Wall Street in the short term.

"We all agree that returns are going to be lower than they have been in the immediate past," says John R. Serhant, vice chairman with State Street Global Advisors in Boston. That's because in recent years equities have had "above trend returns," so now it is logical to assume that the market is likely to produce below trend returns, he adds.

And that will mean hard times for traditional pension plans, Ryan says. Ryan warns that the return-on-assets assumption by most actuaries "is not in line with reality."

Nevertheless, Serhant says that he doesn't foresee "a crisis" in the pension fund industry, but he does believe that more companies are going to be forced to put more money into their plans. "There's a problem," adds Putnam's Saef, "especially in the public pension funds where it is almost impossible to raise contributions or reduce benefits once the latter have been increased. But there will be no crisis." In the private sector, companies can always eliminate or scale back their pension plans or convert to a defined contribution plan. Indeed, many have.

"Funds are already looking at alternative investments and at ways to obtain better returns in bad markets," Saef adds.

He says it's inevitable that more pension funds will be underfunded. "It's going to happen in every bear market, but it is a situation that pension fund officials understand and can, in most cases, handle."

But both Saef and Serhant agree with Ryan that many more pension funds should have improved ways of measuring their obligations. However, Saef says that many funds already are working with consultants to improve the quality of liability indexes.

The basic problem of most pension funds, according to Ryan, is they lack proper yardsticks. They need to calculate and monitor the present-value growth of liabilities. This measure can be very sensitive to interest rates. Because interest rates have recently sported some of their lowest yields in modern history, the increase has been great in the present value of liabilities. They also need to analyze what percentages of liabilities are short, intermediate and long term.

Ryan contends that although pension fund officials need to have a customized liability index, very few do. "Most of these funds are flying blind," he says.

The other problem: The fat stock market returns of the 1990s have distorted the expectations of pension fund officials. "They are using return-on-asset assumptions that are just beyond belief," he complains. "That's because too many pension fund officials are projecting an average annual return of 9.2% on equities."

Their asset allocation also is unreasonable. Ryan says that in the last 13 years, too much was invested in the S&P 500. The typical allocation in the period was 60% in the S&P 500, 30% in the Lehman Brothers Bond aggregate, 5% in cash and 5% in the EAFE index.

"Look at EAFE. We should go to church and pray when we use that. Can you believe that after 10 years, EAFE underperformed a Treasury zero [coupon bond] by over 400 basis points a year and we still use it. Asset allocation failed because liabilities are missing in action," Ryan maintains. Besides zeros, Ryan claims that many plan officials are generally ignoring the benefits of bonds.

He cites a section of the Financial Accounting Standards Board (FASB) guidelines. Section 88, Paragraph 44 states that, in making estimates of pension fund returns, "employers may also look to rates of return on high-quality fixed-income investments currently available and expected to be available during the period of maturity of the pension benefits."

What should advisors do to avoid potential problems for their clients? Clients need to know that the formulas used to calculate pension benefits can be altered. Indeed, entire plans can be terminated, though that is a complicated process that requires companies to inform employees.

Ryan and others say advisors should insist on high measurement standards, and they should critically examine the investment assumptions of plans. Are they realistic? Are they overly dependent on the S&P 500 stocks? Are their alternative investments to reduce risks? Are there hard assets and alternative investments other than the garden-variety stocks, bonds and cash?

Most important, adds Ryan, is there a risk index that accurately measures assets against liabilities? Here is a point in which both Serhant and Ryan agree. "There is certainly a need for a spread product for pension fund officials. We need something that would do more than measure the raw value of returns and value of assets," Serhant says.

Ryan, who has an interest in marketing this kind of service, contends that a customized product is a basic fundamental that every well-run plan should have. "Without this kind of chart, no matter what returns a plan is getting, there is no doubt that it is flying blind and that there is no accurate way to keep score," Ryan said.