Pension Apprehension

I have a bunch of pieces “ganged up” to go on real estate, international economics, government policies, market risks, and a book review on “Think Twice,” but tonight the topic is pensions, with a side order of Bill Miller.  Hopefully I will get to the other topics next week.

Defined benefit [DB] pension plans have run into the perfect storm: lousy equity returns and low high-grade bond yields.  It makes the last great pension crisis in the late ’70s look good — at least they had higher yields back then.  Thus this article from the Washington Post.  Many pension plans face almost impossible odds of catching up, raising the odds significantly of more plan terminations, where the two main losers are healthy defined benefit plans, who will have to pay higher amounts for PBGC coverage, and pensioners with high benefits, because those benefits will be cut.

That places pension plan sponsors in a bind.  What to do?  Take more risk, contribute more assets to bridge the funding gap, terminate the plan, or declare bankruptcy?  It is worse for US states, who can’t declare bankruptcy.  And municipalities don’t have the PBGC behind them; the pension liabilities are difficult to shake.

Why are there these problems?  Three reasons:

  • Actuarial funding methods were too optimistic for sponsors, and led them to underfund.
  • Investment assumptions were too generous, which also led to underfunding.
  • We have a cultural problem where we hide deficits/profit shortfalls through adjusting pension assumptions, or trading lower salary increases for pension benefit increases, which don’t hit the bottom line immediately, but increase funding needs for years to come.

With life insurance reserving, we use assumptions that are conservative for reserves and capital.  Pension reserving is best estimate.  If a life insurance reserve is inadequate, it must be raised to adequacy.  Pensions have a lot more flexibility, even with the recent legal changes.  It should not have been that way — pension reserving should have required pre-funding and conservative reserving.

We had boom years in the ’90s, and most DB pension plans were overfunded for a while, but the boom gave the illusion that returns would be stupendous for a long time, and companies stopped contributing as much or at all to their DB plans.  Some of that was IRS policy; the IRS did not want companies hiding income by contributing to the employees’ DB plans.  Thus the IRS capped the degree of overfunding at the time when overfunding was needed.

The states have their own issues in that it was always easier to defer making payments to the DB plans, because no one wanted to raise taxes, or defer spending plans.  Now the true costs have come home to roost because of the financial crisis.  Not only are interest rates and asset values lower, but tax revenues are down significantly, and unlike the US government, the states can’t print their way out of it; there are no foreign buyers that think they have to buy the states’ debts.

I have said before that it is foolish to take more risk in order to try to get ahead of the pension promises.  Periods of debt deflation are not kind to those taking risks.

That applies to defined contribution [DC] plans as well.  This article in Time suggests that 401(k) plans be scrapped, which are a type of DC plan.  A few notes:

  • 401(k) plans were an accident that got shoved into a piece of legislation for providing supplemental savings benefits.  It was probably design for a special interest, but was discovered by an then-obscure Ted Benna, who started a practice around it.
  • Whoulda thunk that it would get bigger than DB plans?  Few thought it possible until the early ’90s.
  • During the boom years, few questioned the abilities of plan participants to direct their own investing.  The bust years have made that inadequacy plain.  Average people don’t know how to allocate assets.  They are either too conservative or aggressive.  Few choose the middle ground of a Ben Graham 50/50, or a DB plan 60/40 (stocks/bonds).
  • Participants are also not well equipped for receiving and managing a lump sum of assets at retirement.  Few will buy an immediate annuity for part of their funding needs, smart as that is.  They also will not limit themselves to withdrawing only 4% of assets per year at most.

As for the Time article, I take issue with this phrase: “This isn’t how retirement was supposed to be.”

Oh please, retirement is a modern innovation that only the developed world achieved, and only because they had more than enough children (with technological development) to fund the economic growth of the entire system.  Now that developed countries are down to replacement rate or less, the only way these systems hold together is through tax subsidies or optimistic assumptions.

The world is not so bountiful that everyone can have an easy time after age 62, without taxing others to make it happen.

Now, the 401(k) was not a bad idea, but there were limitations:

  • People did not contribute enough.  They should have contributed to the max, but many only did it to the degree of the match, and and some did little to nothing.
  • They were too aggressive or too conservative, which led to greed, panic, and underperformance.  A middling allocation would have served most well, and could have been maintained through good times and bad.
  • Perhaps it would have been better to have had trustee-directed plans, where participants could have chosen the amount to save, but trustees would have invested for them.  One can’t easily tell when bad markets will come, thus it pays to have dispassionate advisors do he investoing for those that will give in to fear and panic.
  • People were poor at choosing how to distribute their 401(k) assets — few chose immediate annuities, for two reasons: it means the forfeiture of assets for a stream of cash for life, and insurance agents don’t want the money locked up; they want to earn multiple commissions.

Some of the large insurance companies are offering deferred income benefits, i.e., pay so much today, and we will give you an income of such and so at age 65, if you are still alive then.  They are not yet common, and will say that it is a tough benefit for insurers to fund.  Not many fixed income assets are not long enough to fund such a risk.

Regarding the termination of DB plans, and their replacement with DC plans, I predicted that 15+ years ago.  Why?  As the Baby Boomers got older, there would be no way that a corporation could afford the huge benefits, because the pension funding methods were back-end loaded, as I said before.  Corporations had to pony up a lot more to fund the retirement of a 60-year old than a 25-year old.  Corporations that did not terminate their DB plans would lose investors to those that did terminate, becausetheir profits would be a lot lower.

And, If the IRS had not made it tough to overfund DB plans, perhaps we would have more of them today.  Alas, it is not so.

So, what can I say?  Don’t blame 401(k) plans for broader societal trends.  Corporations would have had to terminate their DB plans simply due to demographics.  Also, understand that the economy is limited, and stocks are not magic.  Stock don’t guarantee a good return or even a positive return.  Also, don’t blame 401(k)s and other DC plans for people not investing enough.

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Okay, time for the side dish.  So Bill Miller has had a comeback over the year to date.  Big whoop.  He is still behind the S&P 500 over the last 10 years, though over the last 19 years, he is still ahead by 1-2%/year.  This is not as impressive as John Neff, by any means.

What has fueled the returns of Mr. Miller?  Low quality companies bouncing back from a crisis that the Government/Fed bailed them out of.  What Bill Miller does not do is value investing.  Value investing is not “buying them cheap,” but buying with a margin of safety.  Financials have not had a margin of safety for a long while.

Given that I think that companies with a lot of debt will underperform in the future, so do I think the Bill Miller will underperform as well.  That is an area where he he been sloppy in the past; given the weakness in the current economy, it will bite him again.