Another Ticking Time Bomb

"Now, stop that whining, Willard!...
Willard, I know this is dangerous, but if we can save one human life...
Oh, that's the way you feel about, huh?...
Look Willard, control yourself now...
Listen Willard, according to this, there's a... Er, how long has that thing been ticking?...
About 5 - 6 minutes, huh?...
Huh?
Oh!... Er... nothing, Willard, nothing... we're just gonna have to work a little faster than I thought!" - more of Bob Newhart's Defusing A Bomb skit

As I mentioned last week, in this blog I will delve into the United States pension funds as the second in my two part series on Black Swans.  As I mentioned before, there are plenty of other problems but these two struck me as the most plausible and threatening of the multitude of issues facing the globe and in particular the United States.

According to a survey conducted by Towers and Watson a consulting firm, the United States pension assets stand at $30 trillion.  This is an enormous figure (as are all numbers these days).  The problem however is not the size of the number, it is the way that the benefits are calculated.

The first thing we need to do is gain an understanding of how a pension fund works.  A pension fund is a legal entity into which tax payers or workers add money and out of which retirees draw payments.  Over the years assets accumulate and it is expected that this fund earns returns which offsets inflation expectations and preserves the life of the fund.  So there are two things to consider here; first off is how much is being added to or subtracted from the pot in the form of contributions and distributions, and second is what are the expected returns to the asset pile versus the expected payouts and inflation.

The first part to the equation is based on demographic shifts.  If you have a large base of young employees and a small base of retirees the incoming payments from the workers more than offset the withdrawals.  Once the balance changes withdrawals exceed incoming payments.  As the baby boomers are rapidly aging and retiring this shift is happening right before our eyes.  Drains are being felt in Social Security and other pension funds that for years have relied on an ever increasing pile of assets to cover the payouts.

In this case the future retirees have to rely on the returns of the assets to cover the expected future payouts.  This is similar to a life insurance company which calculates the average life expectancy of the policy holders and then factors in the returns on the policy payments to come up with a cost for the insurance.  The problem is that a large number of these pension funds have underestimated the life expectancy of the retirees AND have over estimated the annual returns.

With the rapid improvement in medicine people are living longer and longer.  As I mentioned before, the life insurance industry is now running life expectancy tables to age 120.  The longer that people live the more that the funds have to pay out.  In the past retirees left the workforce around the age of 60 but life expectancy was only 10 years more.  Now life expectancy has increased by 50 years but people still expect to retire at 60 and live off their pensions.  This is a complete mismatch and spells disaster for these funds as the assets will be exhausted way before the youth of today retire.  This problem however is easily solved, just raise the age at which you are able to draw on the fund and voila, instantly fixed.  The problem is that this is political suicide so as long as it can be reported that the funds are solvent everyone can brush this under the rug for another year.

So the way to take care of this problem is to produce returns high enough to cover all of the expected withdrawals.  At present a lot of these funds have modeled 8% returns.  The idea is that you can go out and borrow money around 4% and then earn 8% and the spread will magically cover the future draws on the fund.  This is a huge leap of faith and one that is creating an even bigger future problem.  Sure this solves the problem of reporting but the gap between actual returns and budgeted returns is large and growing.  In the current market environment where the 10-year treasury is yielding only 2%, to think that you can earn a blended rate of return north of 6% is madness.  In order to achieve this huge risk has to be taken and that is not a word that should be attached to a retirement account! 

The rub is that for the last few years this risk trade has been working admirably.  The stock market is up over 100% so achieving these goals has been relatively easy.  The problem is that when the market corrects these funds are going to be left high and dry.  As Warren Buffet says, "You never know who is swimming naked until the tide goes out."  If and when the tide goes out these funds will be left owing not only their retirees but also the investors lending them the money.  Essentially these funds in a vein attempt to "protect" the fund have margined the account.  Margin increases risk as you are leveraging the asset base to maximize profits.  Just like the banks are dong with derivatives.  As an interesting side note it came out that when JP Morgan had its "Whale" problem at one point they lost $415 million in one day! 

Consensus says that if the government was prepared to bail out GM and Goldman Sachs how could they let the pension fund of say California die?  And certainly they cannot, but the burden that this will place on the Federal Reserve would be so extreme that I find it hard to believe that there would not be a market panic far worse than that felt in 2007.  Should this ever occur the taxpayer (you and I) would now be footing the bill for government pensioners and this would not be met with open arms, not to mention that the municipal bond market would suddenly be lumped into junk status.