Pension Plans – Dennis Tubbergen

The Next Economic Storm?

As I noted last week, I expected there was a possibility of more stock upside last week given how oversold stocks were when the current rally started. I view the current rally as a countertrend with more downside ahead.

As many savvy readers of “Portfolio Watch” have undoubtedly noted, there is a growing divergence in the precious metals markets between the spot price of gold and silver and the reality of the pricing of real metals.

While the spot price of silver is around $19.50 per ounce, anyone looking to invest in silver knows that it’s impossible to find an ounce of tangible silver for that price. For example, a one-ounce silver American Eagle silver coin sells for $34 to $37 per ounce currently.

Pre-1965 ‘junk” or “90% silver” sells for around $32 per ounce. Even a 100-ounce silver bar, assuming you are comfortable buying in that quantity, sells for between $23 and $24 per ounce.

As far as gold is concerned, a 1 oz. gold American Eagle coin sells for between $1850 and $1900 per ounce even though the spot price of gold is at least $200 less than that.

This disparity in price between physical metals and the spot price of metals has always existed but has been growing of late.

It is just one phenomenon that exists due to the artificial economy created by fed policies over the past decade-plus.

One of the other threats that I have been writing about occasionally for several years is the huge problem of pension underfunding. While many companies no longer offer a traditional defined benefit pension, many state and municipal governments do. And many of these plans are so far underfunded, benefits cannot possibly be paid to pension recipients as promised.

There are a couple of reasons for this in my view.

One, pensions have suffered under the Federal Reserve’s artificially low-interest rates over the past dozen years or so. A traditional, defined benefit pension plan is funded so that there is enough money in the plan to eventually pay promised benefits to pension plan participants. Contributions are made to pension plans based on an interest rate assumption. Therein lies the problem.

Despite interest rates being at historically low levels, pension plans were not required to adjust their actuarial assumptions to reflect reality. As a result, many pensions are now woefully underfunded.

Two, many public pensions paid by states and municipalities are ridiculously rich, at least in my view. While this is true in many states, an article was recently published describing the very generous pension benefits being received by many retired Illinois employees (the article also reveals some very exorbitant salaries for public servants. Here is a bit from the piece (Source: https://openthebooks.substack.com/p/why-illinois-is-in-trouble-132188):

So, just who is making all of this money?

Meet the Illinois government employee $100,000 Club. It’s comprised of 132,188 public employees and retirees who earned a new ‘minimum wage’ of $100,000 or more.

While crime skyrockets in the neighborhoods, test scores plummet in the public schools, and inflation decimates private-sector paychecks, the Illinois public employee class is living the good life.

Our auditors at OpenTheBooks.com found nearly 500 educators in the public schools with salaries between $200,000 and $439,000. In small towns, city managers made up to $341,300. Three doctors at the University of Illinois at Chicago earned incomes between $1 million and $2.1 million.

Barbers trimmed off $104,000 at State Corrections; janitors at the Chicago Transit Authority cleaned up $143,634; bus drivers in Chicago picked up $242,812; and suburban community college presidents made $418,677.

Public schools (43,500) – Last year, 26,904 educators earned six-figure salaries while 16,592 retirees pocketed $100,000+ pensions. However, test scores plummeted with only 31-percent of students reading at grade level.

Big salaries: Eighteen school superintendents made $300,000+, among them Edward Mansfield (Homewood Flossmoor D233— $434,323); Michael Lubelfeld (North Shore School D112— $392,952); Gregory Jackson (Ford Heights D169—$379,465); Kevin Nohelty (Dolton School D148—$373,626); and Blair Nuccio (Indian Springs D109—$355,154).

Big pensions: Eighteen retired school superintendents received $300,000+ in retirement pensions, among them Lawrence A. Wyllie (Lincoln-Way CHSD 210 – $361,787.64); Henry Bangser (New Trier Township HSD 203 – $351,676); Gary Catalani (Wheaton-Warrenville Unit SD 200 – $350,113.08); Laura Murray (Homewood-Flossmoor CHSD 233 – $344,450); and Mary Curley (Hinsdale CCSD 181 – $334,540.20).

There are several legal loopholes for individuals to access state funding through private associations, nonprofit organizations, and state legislative bodies.

Retired Chicago Mayor Richard M. Daley (D) double dipped pension systems for nearly $249,636. Daley made $158,076 per year in pension payouts after a short eight-year career as a state senator plus another $91,560 per year in city pension payouts for his 22 years as the mayor of Chicago.
Three top paid earners within the municipal-government pension system work for private associations – not government. Brad Cole of the Illinois Municipal League pulled down $437,447, up from $407,656, (2020). Peter Murphy, executive director of Illinois Association of Park Districts, made $357,816, while Brett Davis, executive director of the Park District Risk management Agency, brought in $342,405.
Former Illinois Governor Jim Edgar (R) double dipped pension systems: General Assembly pension ($186,660 per year) and University Retirement System pension ($90,336). Last year, Edgar’s total payout in pension heaven? $276,996

Since Edgar left the governorship in 1999, we estimate that he earned $2.4 million in compensation from the University of Illinois (2000-2013) and another $2.5 million in pension payments from his career as legislator, secretary of state and governor.

While this is a small sampling from just one state, it represents the problems with public pay and pensions in many states. “The Wall Street Journal” recently [published a piece on this very topic (Source: https://www.wsj.com/articles/pension-funds-plunge-into-riskier-betsjust-as-markets-are-struggling-11656274270):

U.S. public pension funds don’t have nearly enough money to pay for all their obligations to future retirees. A growing number are adopting a risky solution: investing borrowed money.
As both stock and bond markets struggle, it’s a precarious gamble.
More than 100 state, city, county and other governments borrowed for their pension funds last year, twice the highest number that did so in any prior year, according to a Municipal Market Analytics analysis of Bloomberg data. Nearly $13 billion of these pension obligation bonds were sold last year, which is more than in the prior five years combined.
The Teacher Retirement System of Texas, the U.S.’s fifth-largest public pension fund, began leveraging its investment portfolio in 2019. Next month, the largest U.S. public-worker fund, the roughly $440 billion California Public Employees’ Retirement System, known as Calpers, will add leverage for the first time in its 90-year history.
While most pension funds still avoid investing borrowed money, the use of leverage is spreading faster than ever. Just four years ago, none of the five largest pension funds used leverage.
Public pension funds are “operating more like hedge funds in some cases,” said Joseph Brusuelas, chief economist at accounting firm RSM. “They’re treading on very risky footing doing things like this.”
Pension funds historically invested very conservatively, favoring relatively low-yielding fixed-income investments. Calpers had all its money in bonds until 1967.
Funds suffered significant losses in the 2000-02 dot-com bust and the 2008 financial crisis. Those setbacks, coupled with years of insufficiently funded benefit promises, left the funds as a whole well over a trillion dollars short of the asset level they ought to have. The level is dictated by a formula that includes their obligations and their targeted investment returns.

It is just a matter of time before there are major US public pensions with funding problems that will affect payouts.

Should the federal government attempt to help as it probably will, such assistance will be funded by more currency creation. This will add to the inflation problem that we are all presently experiencing and punish pension recipients who have well-funded plans as well as retirees who have accumulated assets in 401(k) or other defined-contribution plans.

I have gone on record since the beginning of 2022 with my forecast that the Fed will at some future point reverse course and cease tightening in favor of more easy money policies.

Studying the historical behavior of groups of politicians concludes that this is how this story always ends.

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Pension Plan Problems?

In this weekly post, I comment frequently on Federal Reserve policies largely because Fed policy is the primary driver of economic and investing conditions.

Over the past dozen years or so, the Fed has created currency literally from thin air, a process known as quantitative easing, and has kept interest rates at artificially low levels.

History teaches us these policies create a prosperity illusion for a while but, in the end, reality emerges and the price for such reckless policy is paid.

An astute observer who is doing his or her own research can now see the beginning of reality emerging. One such reality is the extremely difficult position in which pension managers now find themselves as a result of the Fed’s low-interest-rate policy.

During this week’s RLA Radio Program, I discuss this in detail.

There are two types of pension plans – a defined contribution plan and a defined benefit plan. A defined contribution plan is the retirement plan with which you are probably most familiar. One example of such a plan is a 401(k) plan. This type of pension plan is known as a defined contribution plan because the contribution to the plan or investment in the plan is what is ‘defined’ or determined.

For example, in a 401(k) plan, you determine the contribution, and the ultimate benefit received at retirement is dependent on the amount of the contribution and the investment results of the plan.

The other type of retirement plan is a defined benefit plan. This is most commonly a pension plan where the monthly benefit at retirement is defined. The plan is then funded by the employer to an extent as to ensure that the plan can meet the monthly retirement payment obligations to the retiree.

There are several variables that determine the level of employer funding to a defined benefit plan; the number of years until the covered employee retires, the amount of monthly retirement income the employee is to receive (usually determined by a formula involving a number of years of service and employee salary) and the investment results of the plan.

As you might imagine, pension assets need to be invested in a way as to maximize safety as well as returns. In a low-interest-rate environment like the one we’ve seen for the past 12 years or so, it’s exceptionally difficult for a pension fund management team to get reasonable returns and maintain safety.

This is an adverse side effect of the Fed’s artificially low-interest-rate policy and it’s now beginning to take its toll on pensions in earnest. So much so that some pension plans are now forced to either fund the pension plan to a greater extent to compensate for lower interest rates or subject plan assets to more investment risk.

This past week, “The Wall Street Journal” published an article that reported the nation’s largest pension fund, CALPERS, has now decided to take more investment risk to attempt to get the pension plan closer to being more fully funded.

The article headline and an excerpt follow (Source: https://www.wsj.com/articles/retirement-fund-giant-calpers-votes-to-use-leverage-more-alternative-assets-11637032461?mod=Searchresults_pos2&page=1):

The board of the nation’s largest pension fund voted Monday to use borrowed money and alternative assets to meet its investment-return target, even after lowering that target just a few months ago.

The move by the $495 billion California Public Employees’ Retirement System reflects the dimming prospects for safe publicly traded investments by households and institutions alike and sets a tone for increased risk-taking by pension funds around the country.

Without changes, Calpers said its current asset mix would produce 20-year returns of 6.2%, short of both the 7% target the fund started 2021 with and the 6.8% target implemented over the summer.

“The times have changed since this portfolio was put together,” said Sterling Gunn, Calpers’ managing investment director, Trust Level Portfolio Management Implementation.

Board members voted 7 to 4 in favor of borrowing and investing an amount equivalent to 5% of the fund’s value, or about $25 billion, as part of an effort to hit the 6.8% target, which they voted not to change. The trustees also voted to increase riskier alternative investments, raising private-equity holdings to 13% from 8% and adding a 5% allocation to private debt.

Borrowing money to increase returns allowed Calpers to justify the 6.8% target while maintaining a more-balanced asset mix, concentrating less money in public equity and putting more in certain fixed-income investments, fund staff and consultants said.

A staff presentation noted, however, that the use of leverage “could result in higher losses in certain market conditions,” a possibility that raised concerns for board member Betty Yee, the California state controller.

“Ultimately the question is, does the risk outweigh the benefit?” Ms. Yee asked.

Retirement funds around the U.S. have been pushing into alternative assets such as real estate and private debt to drive up investment returns to pay for promised future benefits. Funds have hundreds of billions of dollars less than what they expect to need to pay for those benefits, even after 2021 returns hit a 30-year-record.

Pledging pension plan assets as collateral to borrow money to invest in alternative assets after a year that has seen the prices of most every asset class reach record highs, what could go wrong?

While my crystal ball doesn’t work any better than anyone else’s does, you don’t need to be an investment guru to see that this decision is desperation on the part of this pension to get the returns the pension needs to meet retirement payment obligations to the pension plan’s participants.

As long as the investments in which the pension plan invests the borrowed money continue to rise to new highs, the pension management board’s decision will make them look brilliant.

A more likely outcome in my view would be that at some point in the near future, the investments in which the borrowed money is invested will lose value and the pension will be in worse shape than it is now.

That’s when the fund looks to the government and begins to beg for bailouts.

Trouble is, also at some point in the fairly near future, the government will be forced to rein in spending or risk the integrity of the currency. As Alasdair Macleod noted in his recent piece titled “Returning to Sound Money” (Source: https://www.goldmoney.com/research/goldmoney-insights/returning-to-sound-money):

The growth in the M1 quantity since February 2020 has been without precedent exploding from $4 trillion, already a historically high level, to nearly $20 trillion this September. That is an average annualized M1 inflation of 230%. It is simply currency debasement and has yet to impact prices fully. Much of the increase has gone into the financial sector through quantitative easing, so its progress into the non-financial economy and the effects on consumer prices are delayed — but only delayed — as it will increasingly undermine the dollar’s purchasing power.

Those are remarkable numbers when you pause and consider them. The M1 money supply has expanded by 230% per year since February of 2020. Given that economists are in near-universal agreement that the time lag between currency creation and the subsequent inflation is 18 months to 24 months, we haven’t begun to see the full effects of this currency creation.

The inflation that we are now experiencing is, in my view, a preview of coming events.

This will create a problem for pension plan investments as well as an additional problem. Pensions that have borrowed money to invest will likely see those investments perform negatively because of inflation and those pension participants who ultimately get a monthly income from the pension will see that pension buy a lot less.

Artificially Low Interest Rates and More Unintended Consequences

As I have been predicting for several years, underfunded pensions are beginning to get attention.

This is a topic that will continue to make more headlines as pension funding problems continue to get worse.

An often-ignored fact relating to pension funding is that the funding problems facing pension plans have largely been brought about by central banking policies around the world.

Many pension funds are still using extremely optimistic return assumptions; returns that are unlikely to be realized over the long term given the artificially low interest rate environment in which we find ourselves.

Given this reality, many state’s pension managers are adjusting their actuarial assumptions to make them more conservative. This from “Chief Investment Officer” regarding the New York State Pension Fund:

In anticipation of a lower return investment environment, New York is lowering the long-term assumed rate of return on investments for the New York State and Local Retirement System (NYSLRS) to 6.8% from 7%.

New York State Comptroller Thomas DiNapoli made the announcement along with the release of the state’s annual report on actuarial assumptions.

“The long-term outlook for investors is changing and requires a more conservative approach,” DiNapoli said in a statement. “As in years past, we’re taking the responsible action of lowering our assumed rate of return now so we can better weather market volatility.”

New York is not alone in taking these steps. In reviewing many of the news reports over the past few weeks, there are a number of states taking similar steps.

In the case of New York, the state’s pension fund has had average annual returns of 9.32% over the past three years and 7% over the past 5 years.

Doesn’t sound like a problem does it?

But it is.

In order to get returns of those levels, pension assets have to be exposed to market risk.

This from “City Journal” (Source: https://www.city-journal.org/state-pension-funds-investments-debt) (emphasis added):

It’s a basic principle of investing: the greater the risk an investor takes, the greater the potential reward. But as any experienced investor can attest, increased risk can also bring bigger disappointment. That’s the case with state pension funds. To elevate returns, public-sector pensions have taken on more and more risk for nearly two decades. The result, however, has been lower returns, higher debt, and a mess for taxpayers, according to a new study by Fitch Ratings.

Since 2001, the study found, most government pension funds have boosted their share of investments in riskier financial vehicles, from volatile stocks to real estate. During this period, pension funds achieved median annualized returns of just 6.4 percent, well below the goal of 7.5 percent to 8 percent returns. Only one pension system has met its investing goals since 2001. No wonder, then, that the indebtedness of state systems increased from $33 billion to a staggering $1.5 trillion.

Back to central bank policies.

Because interest rates have been kept artificially low, the only hope a pension plan has to achieve targeted returns is to take more risk with assets.

Given that a 30-year US Treasury bond yields only about 2%, it’s impossible for a pension to reach its return goals by using safer investment vehicles.

Adding to the problem is this fact: as existing, higher-yielding bonds held by a pension plan mature, they are exchanged for lower yielding bonds. Since there is now about $17 trillion of government debt worldwide yielding negative interest rates, this problem is now unsolvable.

Imagine managing pension fund assets and having some of the bonds yielding 4% in your portfolio mature. Now, you have a choice to make.

You replace those bonds with new bonds with a slightly positive or even negative interest rate or you invest those assets where you have a chance to make a positive return.

Obviously, the latter is the only reasonably rational alternative, although I would argue it’s still not totally rational given the risk to which the pension assets are now exposed. It will take only one, overdue stock market correction to further widen the pension funding gap.

The implications and fallout of pension underfunding are severe and far-reaching. This from “Wirepoints” (Source: https://wirepoints.org/harvey-the-first-domino-data-shows-400-of-illinois-pensions-could-trigger-garnishment-by-state-wirepoints-special-report/) (Emphasis added):

You’d be mistaken to think Harvey, Illinois has a unique pension crisis. It may be the first, and its problems may be the most severe, but the reality is the mess is everywhere, from East St. Louis to Rockford and from Quincy to Danville. A review of Illinois Department of Insurance pension data shows that Harvey could be just the start of a flood of garnishments across the state.

Harvey made the news last year when an Illinois court ordered the municipality to hike its property taxes (already at an effective rate of 5.7 percent – six times more than the average in Indiana) to properly fund the Harvey firefighter pension fund, which is just 22 percent funded.

Now, the state has stepped in on behalf of Harvey’s police pension fund. The state comptroller has begun garnishing the city’s tax revenues to make up what the municipality failed to contribute. In response, the city has announced that 40 public safety employees will be laid off.

Under state law, pensions that don’t receive required funding may demand the Illinois Comptroller intercept their municipality’s tax revenues. In total, 368 police and fire pension funds, or 57 percent of Illinois’ 651 downstate public safety funds, received less funding than what was required from their cities in 2016 – the most recent year for which statewide data is available.

If those same numbers continue to hold true, all those cities face the risk of having their revenues intercepted by the comptroller.

This is not an isolated issue, far from it.

The chart, from the tax foundation, illustrates pension funding levels state-by-state. Only the States of Wisconsin and South Dakota have fully funded pensions.

Kentucky is last in the rankings with a state pension that is only 34% funded.

A stock market correction makes these already desperate looking numbers even worse.

The lesson here?

Interfering in free markets, no matter how noble one’s intent, often leads to intended, more severe consequences eventually.