Wednesday, August 22, 2012

Why Pensions Matter

Most of what we have to say about pensions can be found in our article on the subject.  US Pension Liabilities   The market still does not seem to notice what lies ahead.  The entirety of the pension space is underfunded by a staggering margin.  What makes this more alarming is the fact that many accepted actuarial and asset return assumptions are grossly misstated.

To further break this down for new readers, consider the following simple example.  A pension fund has assumed liabilities of $100,000,000.  They are using the accepted US life expectancy of 78.2yrs as a variable input in estimating the length of benefit payments per participant.  Finally, the fund has determined current cash contribution requirements by estimating that the value of the assets owned by the pension plan will appreciate at 8% per annum.

The economy has been contracting and the company has struggled to fully fund the plan's contribution requirements over the past 4 years.  During this period, health care related costs have been rising.  This has caused upward pressure on outflows related to delivering promised care to plan participants.  The company in our example is a technology firm and its employees have lived a healthy than average lifestyle.  They are outliving the 78.2yr life expectancy of the average American which was used when making plan assumptions.  Also, the plan has modeled 8% per annum asset appreciation in their assumptions.  We are currently in a negative real rate environment which has caused the plan to return between 1-2% per annum, further widening the funding gap.

When improper assumptions are adjusted, the plan is found to have actual liabilities of $120,000,000.  The company is forced to make one of only two choices:

  1. Ask the current employees to double their contribution to the plan each pay period in order to help prevent the plan from failing
  2. Reduce benefits immediately in the form of lower monthly payouts and less healthcare related services     
Which of these two options do you think the parties involved will be in favor of?  We will tell you exactly what will happen as human nature is easily predictable.

Current employees will demand a reduction in retiree benefits noting that the under-funding occurred long before their employment.  Retirees will demand that current employees contribute more as they deserve the benefits that they were promised.

We don't necessarily care who wins this argument.  What we concern ourselves with is what sector will desperate pension fund managers seek out when 1-2% returns are no longer acceptable?