America’s Pension Nightmare – Making a bad situation even worse

Now let’s add the 8 percent rate of return into the equation.  Considering the extended period of low interest rates and volatile stock market returns, if we use a more reasonable rate of return such as that on "risk-free" government bonds (he said with tongue planted firmly in cheek), the average funding ratio for all public pension funds drops from a scary 83 percent to a sleep losing 45 percent.  Using this risk-free rate of return, the 50 United States state pension funds that have $1.94 trillion in assets and $5.17 trillion in liabilities  end up with a funding ratio of only 38 percent and unfunded pension liabilities of $3.23 trillion.  To put this $3.23 trillion figure into perspective, the publicly traded debt of the states is currently $0.94 trillion.  This will force state governments to raise addition funds through the issuance of additional debt at the same time as the federal government is gorging itself on an already strained bond market.

 

Let’s step back and take a look at that 8 percent number again.  Since the Fed, in its great wisdom, has seen fit to maintain a very long period of historically low interest rates, pension fund managers have been forced to look far and wide for investments that will give them a return that keeps their funding gap to a minimum.  This was an easy task 25 years ago; long, risk-free government bond rates averaged 10 percent and the P/E ratio for most American stocks was less than 10.  Things are now substantially different.  Long bonds are yielding 4 percent on a good day and the P/E ratio for American stocks is over 20.  This makes reaching that magic 8 percent number very, very difficult and pension managers are actually having to work for a living.  This low rate of return on long bonds has forced pensions into investing in more and more risky products.  As Canadians, we need look no further than to watch the changing portfolio of the Canadian Pension Plan Investment Board (CPPIB) as shown here:

 

Note the increase in equity holdings as a percentage of the total Canada Pension Plan portfolio.  Also note the massive hit that the portfolio took in 2009 when the market tanked.  That’s Canadian’s future pension income that is being invested in increasingly risky products despite the Investment Board’s protestations to the contrary.

 

Pension managers are now using a 60% equity/40% bond mix as a benchmark for pension management. If this is the case, stocks must return 11 percent so that the low yielding bond returns are averaged up to the magic 8 percent return.  While this sounds easy, over the past ten years, the stock market has proven to be increasingly volatile making an 11 percent rate of return anything but a sure thing.  As well, by investing in equities, as noted above for the CPPIB, pension principal is no longer guaranteed and accumulated funds can disappear as if by magic.

 

Mr. Faber goes on to look at the example of Japan.  Japan has experienced a very lengthy period of very low (think nearly zero) interest rates and a stagnant stock market.  Here is a graph showing what has happened to the Nikkei 225 since 1984 showing how hard it is to guarantee a reasonable rate of return from Japanese equities and how easy it is to pick a loser:

 

Here is a graph showing what has happened to Japan’s 10 year bond rate since 1987:

 

Pretty hard to get a reasonable return on a Japan 10 year bond too, isn’t it?  We have to keep in mind that Japan’s economy has been subject to the world’s longest quantitative easing experiment by the Bank of Japan and one need look no further than these two charts to see how well it has worked for the country.  One would think that Mr. Bernanke would have taken notice before imposing QE1 and QE2 (and possibly QE3) but, apparently not.