Defined Failure

Employer-based retirement plans come in two flavors: defined benefit and defined contribution. A defined-benefit plan is what we usually think of as a pension. You work for employer X, who promises to let you retire at age 60 or 65 with a defined monthly pension payment – so many dollars per month, based on your salary, years of service, etc. You and your employer pay for this plan by contributing cash to it during your working years. (Unless you work for a government entity like a police force or fire department and can retire in your early 40s with full benefits after 20 years, then go to work for another government entity and retire with a second and sometimes even a third defined-benefit retirement plan. Yes, there are numerous instances of this. Not a bad gig if you can get it.)

But will the amount you and your employer contributed be enough to pay that defined benefit for all the years you survive after retirement? The answer necessarily involves guesswork and assumptions about events 20 or 30 years in the future. It also means someone has to be on the hook in case the guesswork is wrong. That’s usually the employer … or taxpayers.

Private-sector employers realized decades ago that carrying pension liabilities on their balance sheets left them at a competitive disadvantage. They removed those liabilities by switching newer workers to defined-contribution plans – the now-familiar 401(k) and similar programs. You and (if you’re lucky) your employer both deposit cash into your 401(k) account. You decide how to invest the money and hopefully do well. More to the point, a defined-contribution plan does not require your employer be on the hook for poor investment results. The one on the hook is you.

Defined-benefit plans now exist mainly in state and local governments, where unionized workers have more influence over management and elected leaders come and go. Politicians, by their nature, often think no further ahead than the next election. Their path of least resistance is to promise workers the moon and let their successors figure out how to pay for it.

Guess what? The future is here, and it turns out the guesswork and assumptions about the future were really, really bad. As in, if you are just about to retire or have only been retired a few years and have a pension, you may be seriously screwed.

Hot Potato Pensions

I get a creepy déjà vu feeling every time I write about public pensions. I’ve been preaching about them for more than a decade now, and the situation keeps getting worse. Obviously the politicians are ignoring me – and not without reason. Clearly, I underestimated their ability to postpone the inevitable. Nevertheless, I firmly believe a train wreck is coming. The math has never worked well, and now ZIRP/NIRP is making it much worse.

Fixed-income markets are tailor-made for funding future liabilities. Suppose you sign a contract in which you agree to pay your supplier $1 million exactly one year from now. How do you make sure you will have the cash on hand when the time comes?

The most conservative way would be to put $1 million in a lockbox right now, with instructions to open the box and disburse payment on the agreed date.

Back when CD and Treasury bill rates were 5%, you could just buy a series of $100,000 CDs for $1 million. When the time came, you handed over the principal and kept the interest accrued. You covered your obligation and still had $50,000 to use however you wanted.

That is roughly how defined-benefit pensions used to work, with longer time spans and much larger numbers. My example also has an advantage they don’t: certainty on how much cash you will need at maturity and the exact amount the investment will make in the meantime.

A pension plan that covers thousands of retirees can make educated guesstimates as to how long those pensioners will live. Professional actuaries are uncannily good at this when the population is large enough.

The far bigger challenge is to determine the expected rate of return on the pension’s assets.

That number is a hot potato, because it determines how much cash the employer must contribute each year to keep the plan “fully funded.” The laws require the sponsor of a pension plan to maintain a fully funded position. However, they allow a great deal of flexibility in how “fully funded” is defined. Assume higher returns in the future and you can get away with spending less money in the present. Furthermore, because we are dealing with large numbers over long time spans, small changes can make a huge difference.

The state and local officials responsible for these plans want to assume higher returns so they don’t have to raise taxes or cut other spending. So, as politicians often do, they shop around for someone who will give them the answer they want – along with plausible deniability should that answer turn out to be wrong. This is why we have a thriving “pension consultant” industry.

Almost without exception, public pension plans still assume very optimistic future returns. They base those projections on long-run past performance and assume the future will be like the past. CALPERS, the California public employee plan that is the nation’s largest pension, is in the process of reducing its base forecast from 7.75% to 7.5%. Even this tiny change was enormously controversial. Revenue-challenged local officials all over the state looked at the difference it made in their mandatory contributions and flipped out.

I have talked to numerous board members on multiple enormous public pension boards. Many of them would privately like to reduce their projected returns, but they know it is politically impossible to do so. Other simply say, This is what my consultants tell me, so I have to go with their expert opinion, don’t I?”

The return assumptions are a blend of past stock and bond market returns. This is where ZIRP starts to hurt. Bond returns have the advantage of being more predictable than stock returns, but now they are predictably low. Inflation-adjusted returns on Treasury and investment-grade corporate bonds are either zero, below zero, or not far above zero. They are certainly nowhere near the 5% or more that was once common.

If you can’t assume decent bond returns, can you make up the difference with higher stock returns? That’s not easy, either. Today’s behemoth pension funds don’t simply invest in the stock market; to a large extent, they are the stock market. It is mathematically impossible for all or even most of them to achieve above-market returns. They are just too big.

As I often say, long-run stock market returns are a function of economic, population, and productivity growth. Some companies always outperform others; but in the aggregate, stocks can’t outpace the economy in which they operate. If the economy grows slowly, then over the long run stock values will, too.

Growing slowly is exactly what the entire developed world has been doing and appears set to continue doing for years to come. If 2% is the best GDP growth we can hope for, then we are not going to see stock market returns over the next 20 to 30 years at anywhere near the 8% or 10% that many pension trustees assume.

If investment returns aren’t sufficient for pensions to pay the benefits they promised, all the consequences are bad. State and local governments must then implement some combination of higher taxes, spending cuts, or benefit reductions. All three hurt.

The same reality applied if you’re running your own pension. If you don’t save enough and/or fail to achieve your expected returns, you will face some unpleasant choices: work longer, live more frugally, or die sooner.

From Frying Pan to Fire

If ZIRP is bad, NIRP will be far worse for retirement planning. Bond-return assumptions will have to be even lower and potentially below zero. This situation would wreak havoc on every pension fund – but that’s not even the worst part.

Most asset allocations are generally in the ballpark of 60% equities and 40% bonds, so that is the standard portfolio we will be discussing. Other allocations will make some differences but not change the general direction. In other words, “your mileage may vary” – but probably not by much.

In an ideal world – which is the world that pension consultants live in – equities will return 10% nominal, and bonds will return 5%. A 60/40 portfolio blend will then yield an 8% overall return after fees, expenses, and management costs.

It doesn’t require a great deal of head scratching to realize that a negative interest rate environment is going to bring overall bond yields down below 2%. That paltry yield will drop the blended portfolio rate to 1.2%. How long can that low return last? Ask Japan. When we saw the advent of zero interest rates in the US seven years ago, no one thought they would be in place this long. No one.

The reality is that in our mega-debt world, long-term interest rates are going to be low for quite some time. One thing that could change that would be inflation’s charging back against consensus expectations. I don’t think the Fed really makes much of a move until inflation is over 3%. FOMC members would actually like to see 3% inflation for a while, though they will never say that. But then at some point they will have to make a move, and that is going to be exceedingly uncomfortable whenever it happens. But for the nonce, we are in a low interest rate environment.