Underfunded pensions, mainly for government employees, are a disaster waiting to happen, and the concern about underfunded pensions is rising daily as the number of newspaper articles on the topic increases.
While most corporate employers shifted from pension plans to 401(k) plans after the early 1980s, governments still offer pensions to employees. Those pensions have left retirees and taxpayers in a bind that has fueled political battles while continuing to enrich investment consultants and managers. The result is that overly optimistic estimates of investment returns, which determine how much governments must pay to fund the balance, have left many plans massively underfunded even as the plan administrators and advisers who managed them received huge fees.
Those most likely to be hurt and hurt the most are retirees and taxpayers. The money to pay future retirement benefits to government workers such as firefighters, policemen and teachers comes from two sources: contributions made by governments to the funds, (from taxes) and investment growth. The more the funds’ investments grow, the less taxpayers must contribute.
To ensure that there will be enough money to pay retirees’ benefits later, contributions must come in every year, but the calculation of how much depends on future investment returns. Thus, the assumed future rate of return on investment is critical. The higher the assumption, the less taxpayers must contribute.
Most countries, like the United Kingdom, Canada, the Netherlands, Sweden and France assume a conservative return, so their pension plans are very well-funded. By contrast in the U.S., the assumptions are not at all conservative. U.S. funds assume an average return of 7.6 percent.
For context, low-risk U.S. government bond would provide only 2.5 percebt or 3 percent. So 7.6 percent implies lots of risk. That is why a study performed by the Pension Task Force of the Actuarial Standards Board concluded that U.S. government pensions are underfunded by $5 trillion. In other words, if those pension funds tried to buy annuities from insurance companies to fund the future benefits they have promised, they would be short $5 trillion.
The Pension Task Force recommended that pension funds switch to using a “market rate of return” as a method to guarantee future benefits for retirees. The expected rate of return would be lower, so the government employers would need to contribute more.
Political resistance to this change is very strong. The additional contribution by governments, via taxpayers, could be as much as three times the current rate. The necessary cuts in other government services is political poison. Consequently, the pension plans continue to assume an unrealistically high return. They hire consultants and money managers who happily claim they can achieve the target. The reality is that they cannot.
Then there are the fees. Both consultants and investment managers charge high fees. These fees come from pension funds and, ultimately, from taxpayers, unless they default on the promises to retirees. The whole operation becomes a vicious circle.
Many of the high-profile hedge funds have abysmal results, yet large amount of gains have gone to them as fees. The fact that hedge funds and private-equity funds have performed terribly for their investors along with high fees is no secret. In fact it is well documented. Yet pension funds continue to patronize these investments.
The reasons are plainly political. Lowering the assumed rate of return would draw the wrath of taxpayers. Cutting pensions to retirees would be a disaster for them. Note that this situation has already started, even in California. Politicians don’t want either to happen, though perhaps for different reasons. So they “kick the can down the road.” If many government pension funds fail to have sufficient funds to pay their retirees, the burden will suddenly fall on state governments and ultimately on the federal government.
The reality of the numbers is a sobering reminder that the needs of retirees, who are the ultimate investors, the taxpayers, who are the guarantors, and the desires of investment advisers and managers are not always aligned. We could use some strong leadership in this area.
Mark Sievers, president of Epsilon Financial Group, is a certified financial planner with a master’s in business administration from the University of California, Berkeley. Contact him at [email protected].