Underfunded Pensions and Systemic Risk

Here comes the rain again
Raining on my head like a tragedy
Tearing me apart like a new emotion
--Eurythmics

Managing a pension fund is similar to saving for retirement. Just like each of us needs to determine how much money to set aside for when we're no longer working, pension fund managers must determine how much to set aside for all of those payments to retirees down the road.

Naturally, when you put money into a retirement account, you're unlikely to let it sit there idle. You'll try to grow those funds through investment vehicles like stocks, bonds, etc. It follows, then, that determining how much to contribute to your retirement account is influenced by the return that you expect on your investments in the account.

The basic rule is this: The higher the expected return on investment, the less you have to set aside in order to achieve your retirement goals. A simple example helps demonstrate. Suppose that you'd like to have a million dollars available to fund your retirement beginning 40 years from now. If you expected no return on your savings, then you would need to set aside $25,000 for each of the next forty years to obtain $1 million. However, if you're able to realize annual growth of 7% on retirement fund investments, then you would only need to contribute about $5,000 annually to meet the $1 million goal in forty years.

Pension managers go through a similar process. When many pension funds were created in the 20th century, returns on investment portfolios consistently averaged 8-12% annually. Pension managers began to bake those return assumptions into their decision-making processes for determining how much new money to put into the pot. Because they assumed 8-12% returns in the future, pension managers contributed less new funds than they would have added in anticipation of lower return scenarios.

Then the unexpected happened. Realized returns on pension fund investments began dropping. Interest rates on long term government bonds fell into a secular decline. Because pension funds traditionally over-weighted their asset allocations toward fixed income instruments, as bond yields fell, so did portfolio yields and annual returns.

In an effort to win back some of the returns lost in fixed income, pension fund managers shifted asset allocations toward more stock exposure. Stocks, of course, are generally riskier, and, under normal conditions, throw off less income, than bonds. Moreover, because every time stock markets take a dive, funds with large equity exposure lose a big chunk of value, funds carrying significant stock exposure are more subject to capital loss.

The last 30 years have seen a steady decline in pension fund investment returns. Today's returns are far lower than the assumptions used by pension managers years ago when they were determining how much new cash to sink into theirs funds to cover future payouts to pensioners.

What that means is that many pension funds today are chronically underfunded. Investment returns are lower than expected, and not enough new cash has been injected into pension funds to make up for the shortfall. This is similar to individuals who did not contribute enough to their retirement nest eggs over the years because they assumed that the returns on their investment positions would be higher than they turned out to be.

How to deal with underfunded pension situations? Ideally, pension fund sponsors would simply raise a bunch of cash and dump it into the fund the plan adequately. But think about it. If you as an individual have not saved enough for retirement over the course of many years, then how realistic is it for you to make up the difference when you are older? Many organizations with pension obligations face a similar problem. They simply don't have the resources to allow them to make up ground lost from years of chronic underfunding.

To reduce some future liabilities, some pension plans are offering lump sum buyouts to prospective pensioners. By dangling one time cash payments in front of some participants in exchange for them agreeing to exit the plan, pension managers hope that many of these people, using 'a bird in the hand is worth two in the bush' line of thinking, take the money and run. The managers' hope is that, by buying some participants out of the plan, the monetary resources remaining will be more capable of fulfilling monthly payment obligations to pensioners still in the plan. At best, however, buyouts more likely offer a way to reduce the degree of underfunding rather than to eliminate it.

Another option is for pension plans to default on their future obligations. Cease payments to pensioners. Or pay only a fraction of what was initially promised. Some of this is already occurring in chronically underfunded pension plans in the public sector involving teachers and government workers.

In the private sector, most corporate pensions are insured by the Pension Benefit Guaranty Company. The PBGC is a federally chartered corporation designed to take over private sector pension plans that go bust and cover monthly payouts to pensioners up to a certain amount. Unfortunately, the PBGC itself is thinly capitalized, meaning that it would not take many pensions defaulting at the same time to bankrupt the insurer.

It is here, I think, where serious risk lurks. A pension insurer that is essentially an agency of the federal government carries an implicit promise that the government will make pensioners whole--even in the event of a systemic crack-up that drains the PBGC's capital reserves. With so many pensions so chronically underfunded, the chances of such a systemic event cannot be ignored.

Where would the federal government get the resources to make pensioners whole? Taxing and/or borrowing are possibilities but politically unpopular. Federal tax rates are near the upper bound of political expedience, and federal debt levels are at $23 trillion and growing by the minute.

More likely is that the federal government would opt to monetize (i.e., print money) to pay pensioners. Send pensioners monthly checks for monetary sums created at the click of a mouse. Such a policy would create a form of 'helicopter money' infamously suggested by former Fed chair Ben Bernanke.

The inflationary implications of such a bail out policy are obvious. Specifically for pensioners, these people would be getting the nominal monthly paychecks originally promised them, but each dollar paid would be worth less due to the increasing supply of dollars in the system. The effect, from a purchasing power standpoint, would be as if the original pension plan defaulted on a fraction of the original promised payments. The systemic consequences could be far worse. As history indicates, once inflation toothpaste is out of the tube, it is difficult to put back in.

The bottom line is this. If you believe that pensions are chronically underfunded, then there is a significant likelihood that pensioners will not receive anything close to their promised monthly payments in real purchasing power terms. Inflationary bailouts designed to make pensioners whole are likely to do anything but.