Submitted by Eric Peters, CIO of One River Asset Management
America’s state pension plans were underfunded by $1.35trln in 2016. The S&P 500’s +19% rally in 2017 helped reduce the underfunding to $1.26trln. But by the end of 2018, the gap had grown to a new $1.5trln high. It didn’t help that in 2018, every major asset class underperformed US Treasury Bills (that only happened at the outset of WWI, the Great Depression, and under Paul Volcker). You see, the average state pension assumes it will earn a 7.15% investment return every year, forever and ever.
Before the 2008 crisis, state pension plans were 14% underfunded. The avg plan lost -24% in 2008 and never fully recovered. The structural challenges facing these systems are so great that not even the longest economic expansion in US history, the most enduring equity bull market, record high corporate profits, and record low unemployment, has been sufficient to return the plans to health. The average state pension plan is now 31% underfunded. Kentucky is the worst and is 64% underfunded. CO, CT, IL, and NJ are roughly 50%.
20 state plans are less than 66% underfunded. From 2012-2017 their returns exceeded their 7.15% long-term forecasts, and so you would have expected them to have improved their funding ratios. In fact, their funding ratios deteriorated by another 5 points. In 2001, the average state contributed 3.7% of its revenue to its pension plans. That number has more than doubled to 7.4% today. Because pension costs have grown faster than revenues, states have had to divert $180bln since 2007 to make additional contributions. And still, the math does not work.
GMO publishes 7yr real-return forecasts for various asset classes. They assume an average of 2% inflation. They now forecast -2.7% average real-returns for large cap US equities (each year for 7yrs). +0.1% average real-returns for US small cap equities. +1.2% for int’l large cap equities. +2.3% for int’l small cap equities. +5.0% for emerging mkt equities. +9.5% for emerging mkt value equities. -1.6% for US bonds. -3.5% for int’l bonds (currency hedged). -1.1% for US inflation linked bonds. +1.3% for emerging debt. And +0.2% for US cash.
Imagine that the GMO forecasts are somewhere in the right zip code. If you add any combination of their forecasts, you come up with an aggregate return far below the 7.15% that the average state pension plan estimates they’ll generate on their portfolio. The only asset class with a forecast above 7.15% is emerging market value equities (which will probably see inflows for this very reason). And as today’s underfunding grows inexorably with each passing year, the Federal Gov’t will be forced to add money, turning to MMT to make the math work.
Once upon a time they built a system. They promised state workers a pension. At the system’s birth, the nation was in a Great Depression, stocks were in free fall. So naturally, the system’s creators invested in safe bonds. For decades, system membership expanded, assets soared. World War II came and went. The cost to win was enormous, the federal government incurred a staggering debt. To grow its way out of that obligation, politicians repressed interest rates for decades.
The economy soared, the stock market too. Two decades after that war ended, the real (inflation-adjusted) value of stocks had tripled. So of course, the system voted to invest 25% of assets in equities. A devastating bear market ensued almost immediately. For the next couple decades, the real value of US equities fell by two-thirds, while interest rates soared along with inflation. In an act of investing genius, the system doubled down and lifted its statutory 25% limit on equities in 1984. For 15yrs the pension system made magnificent investment returns.
Into the 1999 market euphoria, the system voted to increase worker benefits, reduce the retirement age, and cut contributions. A market crash erupted immediately, knocking the system to its knees.
The next bear market arrived in 2008, delivering a mortal blow. The damage was so great that despite a 300% gain in the real value of equities from the 2009 lows, the system remained woefully underfunded, unable to meet its obligations in the absence of extraordinary future returns.
But Shiller PE stock valuations were at 30, equal to the 1929 high, and only surpassed in the dot com bubble. Worse yet 10yr interest rates were only 2%. So, unable to entirely ignore reality, the plan lowered its forecasts for future returns to 7.15%. But that forced the system’s participants to increase contributions. Which they agreed to do, but with the understanding that the system would take even greater investment risks to ensure it can meet future obligations.