The Entire Pension System Is A Ticking Time Bomb

Investment Research Dynamics

It’s been my belief that one of the primary reasons the Fed is propping up the stock market is to prevent a complete catastrophe in the nation’s pension system – both public and private.   The culprit is underfunding.  The underfunded of status of every single State pension fund is highly visible.  However, through the magic of GAAP accounting and widespread upper management corporate fraud, most private pension funds may be even more underfunded than State funds.

The pension fund “time bombs” are beginning to detonate.  While the troubles with the Chicago and Illinois public retirement funds have been widely reported, last week a $17 billion private sector “multi-employer pension pension fund” announced that many of its beneficiaries will soon incur payout cuts as high as 60%.  This was not mentioned in the mainstream financial media:   Central States Pension Fund payout cuts

This is what happens when payout liabilities “catch up” to an underfunded asset base.

The total size of the retirement asset market is around $18 trillion.  Media attention gets focused on State pension funds, nearly all of which are significantly underfunded. In fact, one study showed that as of last year every State fund was underfunded and the cumulative amount of underfunding was $4.7 trillion: LINK.   It’s probably safe to assume that corporate/private pensions are underfunded as well by at least that much.

Here’s a recent article from the Denver Post which offers a surprisingly candid assessment of the Colorado Public Employees retirement fund (PERA):

PERA’s unfunded liability rose last year (to $24.6 billion) and its state and school divisions — its largest — each finished at a funding level lower than the year before: 59.8 percent and 62.8 percent, respectively. These figures fluctuate, of course, but the funding levels for both are lower now than they were in 2010 when the system’s reforms kicked in.  LINK

For the sake of argument, let’s assume that on a “macro” basis, the amount of “base case” underfunding is around 30%.  This level assumes that all assets in every fund – public and private – are accurately marked to market.   But this is highly unlikely.  I know from an inside source at one public pension fund that the fund he helps manage has about 20% of its assets allocated to private equity funds.  A significant stock market sell-off would  annihilate the value of p/e investments.  Then there’s illiquid real estate and derivatives holdings. In general those are “mark to model” assets which are more likely “marked to fantasy.”

If a bona fide, independently audited “mark to market” exercise were performed on all pension funds – public and private – it is likely that the “base case” true level of underfunding is more like 50% rather than the 30% I suggested above.

Again, a serious stock market sell-off would incinerate the carrying value of those asset sectors.  This problem is compounded by the fact that the pension fund “hurdle rate” ROR is 7.5% – in some cases it’s still 8%.   These were realistic “bogeys” when Treasury bonds were yielding a “normal” interest rate.  The ZIRP policy of the Fed has destroyed the ability of pension funds to generate anywhere close to 7.5% on the fixed income portion of their assets, forcing most to overweight high risk equity bets and below investment grade fixed income assets (junk bonds, CLO’s, risky mortgage structures, etc).

“Underfunding” of a pension fund is the same dynamic as debt.  To the extent that a pension fund is underfunded, it “owes” that amount of money to fund.  But underfunding is worse than plain debt.  It’s a Ponzi scheme.  As cash payouts increase at a faster rate than cash contributions, eventually the fund hits the wall.  Just ask the beneficiaries of the Central States Pension Fund mentioned above.

When the Fed loses control of its ability to keep the stock market propped up – which will happen sooner or later – the pension fund collapse in this country will be the financial equivalent of a nuclear apocalypse.