Pensioners are under attack. As we reported yesterday, ECB front running has driven yields down and with them the discount rate that companies use to determine the present value of their liabilities. This has had the rather unfortunate effect of increasing EU pension deficits by nearly a fifth in the space of just 12 months, prompting employers to consider measures such as upping the retirement age in order to mitigate the pain.
In an even more disconcerting turn of events, we learned this week that in order to pay a €1.5 billion IOU to the IMF, Greece is borrowing from the public sector via 15-day repo. While Greece’s biggest pension fund IKA has assured everyone that this is actually standard practice and noted that characterizing the transactions as anything other than the ordinary course of business was akin to fear-mongering, following the money trail here leads us to the following rather disturbing conclusion:
Should [the plundering on the public purse prove to be anything other than temporary, the local population will promptly exhibit very angry tendencies once it is revealed that the "radical left" government plundered Greek pensions to pay the IMF which could then immediately turn around and use the fund to pay the Kiev government, which in turn could pay Putin to keep the gas running. Where Greece will find an additional source of funds to replace this Pension "repo" was not quite clear as of this writing.
Against that backdrop, we turn to Illinois where Mike Shedlock (via UnionWatch) reminds us pension plans on the whole are some 61% underfunded. Recall from a piece we posted last November that Illinois’ problem is in fact so large that “it would take three years of a complete government shutdown, during which the entire general fund went toward pensions, just to break even. No funding for schools, no money for public safety and nothing for health care and human services.”
And that’s the good (err better) news. The bad news is that in one particularly egregious case — that of the Illinois General Assembly Retirement System (GARS) — the shortfall is more like 84%.
The above chart shows “smoothed returns” that even out the 2007-2009 dip as well as the 2010-2014 blast higher. Illinois resorted to using “smoothed returns” to minimize the effect of the 2007-2009 dip. But now, with the rally, Illinois wants to use actual market returns.
On a non-smoothed (market) basis the numbers are slightly better. Non-smoothed, the total deficit is $105 billion instead of $111 billion.
Let’s be generous and assume the lower $105 billion number. The US Census Bureau shows there are 4,772,723 Illinois households.
The potential taxpayer burden to make up the deficit is $22,000 per household.
Shedlock goes on to note that despite the exceedingly obvious trend towards permanently lower yields, pension plans simply haven’t adjusted their investment rate assumptions to conform with the new (para)normal:
In the US, pension funds have not made 1.25% promises or even 4% promises, but rather 7.0%+ promises with the 10-year bond yielding about 2%.
Annuities promise 6% or so. Illinois promises range from 7.0% to 7.5%. How you get 7.5% in a 2% world?
The correct answer is: you don’t.
The result is the same relentless hunt for yield that’s driven stocks and other risk assets to nosebleed valuations (or, in the Fed’s words, mission accomplished). And it means that increasingly, pension funds are taking on more risk to meet their contributions.
Public-plan managers may see little option other than to double down on risk. In 2013 nearly half of state and local plan sponsors failed to make their full pension contribution. Moving from the 7.5% return currently assumed by Calpers to the roughly 5% yield on a 38%-62% stock-bond portfolio would increase annual contributions by around 50%—an additional $4 billion—making funding even more challenging.
...and from the NY Times:
...as interest rates began their long fall, pension funds faced a dilemma. Staying heavily invested in bonds would force governments either to set aside more cash upfront or to cut pension promises. So instead, pension funds radically changed their investment strategies, embracing investments that produce higher returns but also involve more risk. This shift has replaced an explicit cost with a hidden one: that lawmakers will have to divert more tax dollars into pension funds, cut back on benefits or both when stock market crashes cause pension fund asset values to decline.
The particularly unnerving part of the story is that this has been going on for years. Consider the following from an academic study penned by researchers from Notre Dame and Maastricht University:
In the past two decades, U.S. public pension funds uniquely increased allocations to risky investments, especially as more members retired. We explain this increase by the incentives from their distinct regulation linking the liability discount rate to the expected return on assets rather than to the riskiness of their promised pension benefits. Their increased risk-taking allows them to maintain high discount rates, even as interest rates decline, underreport the underfunding and is associated with an annual underperformance of 60 basis points.
While risk-taking may be on the rise, it’s not translating into tangible results. A 2014 report from a panel commissioned by the Society of Actuaries shows funded ratios falling…
… the percentage of funds that are underfunded rising…
...and investments in “alternatives” and equities increasing while the portion of funds devoted to fixed income has continually declined..
In the end, they’ll be fewer pensionable salaries in Europe as corporations cut back, Greeks will just have to hope their government finds a way to pay back the cash being plundered from public coffers, and in the US, taxpayers will ultimately be on the hook for unfunded liabilities.