Pensions: Collapse is Inevitable in a ZIRP World
If you are still living in the illusion of a state pension you should seriously reconsider keeping your remaining wealth in these funds. I am not a financial advisor, however, Daniel Amerman is. Mr Amerman details what we reported in July 2016 when we published Pensions: Underfunded, Underperforming and Unable to Pay. The situation continues to deteriorate and pension funds, especially the ones “managed” by the state, are not only missing the investment goals, some are actually beginning to show a negative rate of return.
Daniel begins a very detailed in-depth analysis of the current state of pensions by explaining how bad the situation has become.
“When it comes to the massive underfunding of public pension funds, which many are relying on for their future retirement, Dan Amerman has crunched the numbers, done the math, and, based on his analysis, says the truth is not pretty. How is it all going to end up for millions of Americans? Dan explains what’s happening, how we got to this point, and how we should expect this to play out in the years ahead.”
The analysis that is the subject of the podcast interview is copied below, however the interview went far beyond the analysis in discussing the implications for taxpayers, pensioners and individual investors, as well as public finances in the US. There is also a discussion of the potential for bail-ins of California pensioners, versus a federal bail-out of the California system by taxpayers in other states.
Pension Shortfalls Could Be 4X To 7X Greater Than Reported
“Shortfall” is the soft-sell version of negative return on investment. If someone has $10,000 in a pension plan and leaves it for the next several years, rest assured it may all be gone and if it is not gone it will be far below the original $10,000 deposited.
How would a bail-in or bail-out work? The reality of the situation seems to be something like this – the people who work for the government are not producers and their income is 100% tax payer funded. If, for example, 15% of a states employment is government employees, that 15% will only recycle tax dollars, they will not generate new tax dollars. Now we have a negative feedback loop of 30%. That still leaves 70% to be made up by producers that generate tax dollars/payments. How many of those 70% are going to be willing to send an additional 15% of their income to bail-out a flawed, failing system for someone else to be able to relax and go to the beach while they are still slaving away to support this failure? I would hope that a lot of those tax generators would be very unhappy and very vocal.
If there is a bail-in the people that have worked their entire lives, followed the rules and done the right thing will now lose a portion, a significant portion, of their retirement fund due to poor management, lies and deceit produced by the fund “managers”. Either way, bail-in/bail-out, a lot of people get hurt and a lot people will be completely wiped out.
The reported shortfall for the California Public Employees Retirement System (Calpers) is $139 billion – but that is based upon investment assumptions that may be unlikely in current markets.
As developed using a 40 year financial model and recent actual results, the real present value shortfall could be in the $500 billion to $1 trillion range, which is 4X to 7X as great as reported.
Calpers is used as a real world example to explore nationwide issues that could change our financial futures – and our choices – as investors, taxpayers and pension beneficiaries.
The California Public Employees Retirement System is the largest public pension in the United States. It is considered to be the bellwether for pensions nationwide, and among the most sophisticated of long-term investors.
Calpers also faces an extraordinary dilemma. It is drastically underfunded, even using relatively aggressive assumptions about future long-term investment returns. These assumptions do not take into account the current policies of the Federal Reserve and other central banks. As analyzed herein, when lower returns are taken into account, there can be a multiplying of the shortfalls – and a multiplying of taxpayer burdens.
Above are the most recent full year results for Calpers, for the fiscal year ending June 30th 2016. Calpers has a target return of 7.5%. For the most recent fiscal year they had an actual total return of 0.6%, meaning they came up short by 6.9%.
Calpers ended the fiscal year with assets of $295 billion, but they needed $434 billion to be fully funded – assuming they can earn 7.5% on average for each year in the future. The difference between those two amounts is a shortfall of $139 billion. Source
Brother, can you spare a billion? Yeah, I didn’t think so. When you begin talking about, in one year, a managed fund losing $139 billion it seems to be time to reevaluate the situation. Please keep in mind this is not the only large pension fund that is in very serious trouble. Welcome to the world of Zero Interest Rate Policy (ZIRP) that has been brought to us by those lovely folks at the Federal Reserve working in conjunction with the Treasury Department of the United States and the criminal banking cabal on Wall Street.
Let’s review how all this impacts the typical CalPERS investor – put on your hard-hat as this is where the rubber-meets-the-road and details how an investor is being treated and what they should expect in coming years. Unless, of course, we awaken one morning and the Federal Reserve has decided we should keep our own wealth and not allow them to steal anymore. Fat-chance of that happening.
To isolate the importance of the investment assumptions without getting bogged down in the complexity of the economic and actuarial assumptions, we are going to use a round number illustration of the dilemma faced by Calpers and other pension funds.
We are going to assume that Calpers is investing to cover even annual payouts over the next 40 years. Using a bit of reverse financial engineering, if $434 billion is full funding, and 7.5% is the investment rate, then 40 annual payments of $34.5 billion can be supported.
So this means total payments of $1.378 trillion can be supported, which are consolidated in the graph above.
Pension funds share an assumption with individual financial planning as well as other forms of long term investment to support obligations, and that is the idea that we can estimate today what our earnings will be not only next year and the year after, but (on average) for decades into the future.
So we don’t need to set aside almost $1.4 trillion, but $434 billion will suffice. Because $434 billion invested at 7.5% and evenly drawn down over 40 years will generate $944 billion in earnings. Every dollar available today (the purple bar) is assumed to generate another $2.18 in earnings (the green bar) over the next 40 years, and that is the rationale that enables governments and corporations to make much larger promises for the future than the cash that is actually being set aside today.
However, Calpers doesn’t actually have $434 billion. Instead, they have $295 billion, as shown in the purple bar above. There is a gap between what they have and what they need, which is a present value shortfall of $139 billion, as represented by the red bar. Full funding would be 100% or $434 billion, actual funding is $295 billion, or 68%, and the deficit is $139 billion, which is 32%.
We know the size of the purple bar, the investments on hand. We know that the red bar, the present value shortfall, is the difference between the green bar and the purple bar. But what we don’t actually know is the size of the green bar. It is all an assumption, in terms of being able to earn the average of a 7.5% annual rate of return into the indefinite future.
We also know Calpers only earned 0.6% in their previous fiscal year. Calpers earned a negative return of -3.4% on their equity portfolio last year. Interest rates in the United States are at near historic lows. Global interest rates are at the lowest levels in recorded history when we include the negative interest rates in Europe and Japan.
From that perspective, a 7.5% investment assumption seems outdated, or even antiquated. So a reasonable question becomes: what happens to the present value shortfall if actual returns are less than 7.5%?
As the next step, we need to consider what our new full funding amount is at various possible future returns. Remember – full funding being $434 billion is only accurate if we get a 7.5% return, meaning $2.18 in future earnings for each dollar on hand today, as shown in the rightmost column above.
If we drop to a 6.5% average return over the next 40 years, then there is only $1.83 in future earnings for each dollar on hand today – and we therefore now need $487 billion to be fully funded.
Much more dramatic is what happens if returns average only 4.5%. In that case, there is only $1.17 in future earnings for each dollar on hand to today. So, to be able to make all promised pension payments, the State of California would need to have $634 billion set aside today.
Again, this is a very similar dilemma to that which is faced by many individual retirement investors. If we don’t get the yields we assumed, then we either need to save a lot more money, or we may need to delay retirement, or we may need to reduce our retirement standard of living (or perhaps all three together). But yet, for many investors and savers today – a 4.5% rate of return would be highly desirable and quite difficult to achieve. What happens if we go much lower?
If Calpers were to roughly repeat last year’s results, and earn a 0.5% average return over and over again, then as shown with the purple bars, they would need to have $1.2 trillion set aside today to fully fund the promised pension payments.
At 1.5%, the State of California would still need to have over $1 trillion set aside to invest and use to make future payments. By going up to an average 2.5% return over 40 years, the amount of future earnings (the green bars) would dramatically increase – from $348 billion to $513 billion – but $865 billion (the purple bar) would still need to be available to invest today.
The far left columns with returns of -0.5% and -1.5% may seem quite bizarre, but such is the world in which we live today. The concept of negative interest rates is I think hard for most of us to grasp, but that is exactly what is happening with government debt in Europe and Japan.
Based on current interest rate levels, there has been discussion that if the United States enters another recession, then negative interest rates may come here as well. And if that were to happen and if low or negative economic growth were to also bring stock yields into negative territory, then there is an inversion, and more money must be set aside today than what will be paid out in the future.
Meaning full funding could require $1.5 trillion, or even $2 trillion. (The preceding is based on nominal interest rates, however in real or inflation-adjusted terms the United States already has negative returns and an inversion for many investors has already occurred, as explored in this link.)
However, Calpers doesn’t have $2 trillion set aside today, or $1 trillion, or $800 billion. It has $295 billion.
As you can see reconsidering a move away from these toxic assets may be in your best interest. I am not faulting the fund managers as they are doing what they can with the investments available to them. Keep in mind these funds have strict guidelines that must be followed as to what types of investments are allowed to be part of the program. Most of these pension funds are not allowed to stack gold and silver. They are not allowed to add mining stocks or other such “risky” investments. They are, primarily, only allowed to utilize the super risky, zero interest rate invest vehicles that the government tells them they can invest. You know the ones – the “AAA” rated mortgage backed securities, 10 year, 30 year bonds that are paying around 2-2.5%. They need to earn 7.5% for the next 40 years just to stay even. CalPERS hasn’t earned 7.5% in over twenty years. In order to get back to even, CalPERS needs to generate 7.5% for, at least, the next 50+ years. How many years until you retire? How many years are we suppose to take this and do nothing about it? What if people actually did the math to see if keeping their job was doing more harm than good? What if the math proves that keeping their job, and therefore, keeping their 401k/pension/retirement funds tied up actually costs them more than quitting their job and taking their retirement funds out now and placing them in something that actually earns a return on investment? What if 1% of the people reading this article found it to be more lucrative to quit their job, take the retirement fund and acquire physical gold and silver, mining stocks and other top performing equities? Would those 1% be way ahead or would they be unwise for looking out for themselves? This is not intended as investment advice, please do your own research, do the math and make decisions based on your particular needs and goals. My goals are based on my family and what we see as eternal risk when associated with these types of investments, therefore, I personally have nothing to do with them.
You may want to read the entire article that Daniel Amerman has put together. It is well worth your time. Click here to access.