Will 2011 Investment Markets Bail Out the Pension Funds?

Wall Street can't relieve budget-strapped public employers.
by | January 6, 2011

Girard Miller

Girard Miller is the Public Money columnist for GOVERNING and a senior strategist at the PFM Group.

The holidays are over. It's a new year for financial markets and the public pension community. Public officials are returning to normal work routines. Investors are reviewing their 2010 statements with an eye toward the future. So it's a good time to ask what the 2011 markets have in store for our pension funds. Will the coming year deliver investment performance that brightens the dreary outlook for employers facing whopping increases in their required pension contributions? Is it possible that a budding economic recovery and double-digit stock market returns will rescue the pubic sector from its retirement-funding nightmare?

To understand the dynamics of retirement plan finances in 2011, it is essential to understand five key concepts:

1. The Great Recession was a generational market collapse. Like the Great Depression before it, the 2008-09 Recession knocked the wind out of the lungs of the American economy, especially the housing market and related financial industries. Until mortgage foreclosures begin to decline in 2012, there is no reason to expect the American economy to grow rapidly enough to justify rapid and euphoric escalation of equity (stock) market valuations. A double-digit increase in the broad market averages is plausible In light of global growth and continued cost-management in the corporate world. But it is hard to see how stocks can grow much faster than their long-term averages. They have already recovered at growth rates typical of previous business cycle recoveries.

For perspective, the pension community must remember that the Great Recession was deeper than all business cycle troughs since World War II. Declines in output, employment and business activity were almost double the average recession. Likewise, the stock market fell by more than 50 percent, double the average decline of all recessionary bear markets in the modern era. The hole we dug was doubly-deeper than the average hole, and now we have to climb out of it. With unemployment above 9 percent and the economic undertow of underwater home mortgages swamping 22 percent of U.S. households, the prospects for a rapid recovery from today's levels are dim.

2. Pension actuaries and trustees already assume perpetual 10 percent annual increases in equity values as the baseline. Some public officials naively believe that if stocks earn 10 percent in a given year, their pension funds can afford to give them relief from employer contributions. What they don't understand is that the average pension fund, with a long-term actuarial return assumption of 7.5 to 8 percent, already expects its stock portfolio will produce a double-digit return every year for eternity. That is because stocks represent 60 to 65 percent of the total portfolio, and bonds will only return 4 to 5 percent in the next 30 years — and less if interest rates increase which depresses their prices.

The failure to account for business cycles and normal recessionary market declines in bear markets — and the mathematical necessity for markets to significantly outperform their long-term averages during expansion periods — is one of the true shortcomings of public pension fund leaders and their advisers. Policymakers assume that trees will grow to the moon forever, and in a straight line. Financial markets don't work that way.

So if the stock market returns 15 percent next year, which would make it a huge over-achiever by historical standards and well above today's Wall Street consensus, the beneficial impact on a typical pension fund's ratio of assets to liabilities is likely to improve its funding ratio by only 2.5 percentage points. If bond prices decline because the economy improves and investors no longer seek a safe haven, the prudently diversified pension fund will benefit even less. In today's world of 70 percent funding ratios for the average pension fund, that would move us up to 72 percent. That still leaves a 28 percent funding shortfall (representing more than a half-trillion dollars) to be amortized over the remaining lives of the employees. It's like making an extra monthly payment on your home mortgage: it reduces the future payments a little, but not enough to pay for a new car.

So even a 10 to 20 percent increase in stock market values will not restore the funding ratios to 2007 levels. In fact, a return of stock prices to peak 2007 levels will not bring the pension plans back to their 85 percent funding level that year, because they have lost four years of compounded investment growth that they had previously assumed. The Dow Jones Industrials Average (DJIA) would have to exceed 18,000 before 2012 in order to restore public pension plans back to their 2007 funding status.That would require an unprecedented increase, just to return us to 85 percent funding!

3. Actuarial smoothing will catch up in 2011. Many pension funds use "actuarial smoothing" to iron out the wrinkles in stock market returns by averaging market gains and losses over several years. During the recession and the market plunge to DJIA 6547 in 2009, these procedures disguised the level of underfunding and delayed the budgetary impact of portfolio losses on employer contribution rates. Now we have entered payback time, as the multi-year averages must now include those depressed portfolio valuations despite the market's recent recovery of two-thirds of its Great Recession losses.

4. Meanwhile, liabilities continue to mount. Stock prices may fluctuate, but retirees with substantial guaranteed pension benefits don't typically base their decisions to quit work and begin drawing benefits on the level of the stock market. Thus, the liabilities of pensions and retiree medical benefits (OPEB) plans will continue to grow. Actuaries have already taken that into account, but the point here again is that a pension fund must keep earning its assumed return or else it falls backward. American demographers call the Baby Boomer generation the "pig in the python" and that cohort group is now starting to turn their contributions into withdrawals. In a defined benefit plan, the costliest annual service accruals are those of employees who are near the retirement age, and we have loads of them approaching that gate.

5. Pension portfolios cannot painlessly achieve full funding in the coming business cycle. Unless pension trustees can find a way to repeal the business cycle, we have to model and plan for another expansion and recession of normal magnitude and duration. Since1926 when the financial industry began keeping track of stock returns systematically, there have been 14 bear-market recessions in 84 years. That works out to six years on average. Using 2009 as the official end of the Great Recession, we should reasonably plan for another recession in five years, with stocks thereafter declining 30 percent as they have now done in the past 14 recessions. The next (average) recession would thus reduce values in balanced pension portfolios by 20 percent because equities represent about 2/3 of the average pension portfolio. Meanwhile, it is now reasonable to anticipate an economic expansion running five more years with normal stock-market growth, as the baseline for projections.

To achieve full funding at the end of the next recession, pension portfolios in this scenario would have to reach 125 percent funding in 2015. From today's levels of 70 percent funding, that would require portfolios to grow by almost 80 percent, while throwing off additional returns to pay the bills for retirement benefits on top of that. Using just ballpark numbers, this would require the overall pension portfolio to grow by 25 percent annually. Stock prices would have to grow almost 33 percent compounded annually, which would catapult the DJIA above 40,000 before 2016. That's outright implausible in a world with a huge debt hangover.

After the generational rout we've recently endured, pension advocates can argue that nobody expects pension funds to attain full funding in five years. But even a goal of 85 percent funding after the next recession would require stock indexes to increase by well more than 20 percent annually in the coming five years, with the DJIA passing 25,000 by late 2015. Happy days would be here again, but that scenario would likely require a financial market bubble like the 1995-99 Internet bubble and the 2003-07 real estate bubble that brought us plunging markets and the Lost Decade in financial markets. And that's my point: it would take market exuberance equivalent to the last two financial bubbles to restore pension funds to funding levels comparable to 2007 in a four- or five-year period beginning now. And even that scenario would set up another market downturn that puts us right back in the soup again.

These mathematical points are commonly misunderstood by public officials, some pension trustees and by the labor lobbyists who tell state legislatures that they should not be alarmed because "the market will come back — it always has." These Pension Pollyannas grossly misrepresent the realities of pension fund finances.

I certainly don't advocate a mandatory return to full funding in five years on the heels of the worst recession in a lifetime. But the pension math illustrated here should clearly inform us how steep the hill ahead will be — and why employer contribution rates are doomed to increase for years to come. Those who postpone prudent funding with the fantasy of a stock market bailout should be required to fund their own retirement with a defined contribution plan and see whether hope and smokescreens will work for them in their personal finances.

The best-case scenario. The only viable hope that pension plans may have for relief from financial markets is a sustained economic expansion that can endure longer than the 84-year historical averages. From humble beginnings in 2010, this would require a sustained period of moderate economic growth, and an absence of speculative activity, geopolitical incidents or major financial meltdowns. It would also assume prudent public policies in a world economy driven by sustainable Asian and European growth and a rebuilding of American balance sheets.

That's the Goldilocks scenario. It's possible and plausible, but not a sure thing by any means. If we can sustain such an expansion for the next seven years, then it is conceivable that our public pension funds can dig themselves out of the hole we're in now. Equity market returns could then average a lower but more sustainable rate of double-digit increase, yet compound their way to levels that will restore public pension funding to the 85 percent level by 2020 even with a normal recession. I would urge pension trustees to take the advice I will follow for my own retirement portfolio: shift asset allocation much more heavily toward bonds as the expansion ages, to weather the next inevitable recessionary storm. The problem of course is that a more conservative portfolio mix will reduce investment returns and dampen the funding ratio if initiated prematurely. "Tactical global asset allocation" must become the dominant topic in fiduciary circles by 2015, I believe.

Meanwhile, everybody needs to feed the kitty and pay full actuarial costs to defray those unfunded liabilities. There won't be any free lunches in this decade.


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