Today we'll consider what may be a period of deflation ahead for us here in the U.S. While not likely, it's a definite possibility and is also something almost all living Americans have never experienced.
In any event, it's time we all recognize that today's dollar does not have the same value as yesterday's, and that tomorrow's won't have the same value as today's. We've long been aware of the effects of inflation and suffered through a serious bout of double digit rates in the 1970s. But deflation is a different animal and one with which most of us are simply not familiar.
So while it's best to avoid both inflation and deflation and maintain a stable currency over time, deflation is exactly what we're trying to avoid currently, and we don't yet know whether our efforts will be successful. Time will tell.
So let's focus on pensions and why they are in serious jeopardy of not being funded adequately. There's an underfunded situation now, and there's an assumption that investment returns in NOMINAL dollars will be boosted by 'normal' inflation rates.
Accordingly, the future returns are in serious jeopardy of being materially less than assumed by pension plan sponsors. And this likelihood of future investment underperformance relative to assumed NOMINAL performance is in no small part due to historically low interest rates and the possibility of a deflationary environment in the U.S. That's what our Federal Reserve is very much attempting to prevent by keeping interest rates at historical lows today and for the foreseeable future as well.
In a period of deflation, to be a debtor is not a good thing. So while borrowers or debtors like low interest rates, they also like high inflation. Not deflation.
Low interest rates mean debt servicing obligations are lower, and high inflation means that the principal amount of the debt owed becomes worth less over time.
The bigggest debtor is government, and the biggest beneficiary of high inflation rates is government, too.
The problem is that the two -- low interest rates and high inflation -- don't go together over a long period of time. That means something's gotta give.
Meanwhile, government obligations on future public public sector pension payments are seriously underfunded. Many such plans even contain automatic cost of living annual adjustments on the assumption that the cost of living will go ever higher, and that pension recipients should be protected against this higher rate of inflation.
But what happens when inflation stops? What do pension plans do when they receive low rates of interest and can't earn investment returns that they've assumed will be generated in an inflationary environment? All hell breaks loose, that's what happens.
In other words, the government has put itself, and therefore We the People, directly between a rock and a hard place. If interest rates go up, interest on more than $16 trillion in debt goes up as well. And if interest rates don't go up, investment returns on public sector pension funds are likely to fall far short of assumed returns. Either way taxpayers are at risk of losing in a big way.
IMF Sees Risk in U.S. Pension-Fund Strategies says this about the pension fund dilemma:
"U.S. public pension funds and life-insurance companies are building up potentially dangerous levels of risky investments that could threaten their solvency, the International Monetary Fund warned Wednesday.
It is a gamble that could harm not only on pensioners and insurance customers, but also on the financial system, the IMF said in its Global Financial Stability Report.
Returns from traditional investments and contributions have dwindled during the recession. And as the Federal Reserve lowered interest rates to try to revive growth, those firms have been unable to match their funding levels with future liabilities.
For example, the IMF says public defined-benefit pension plans won't be able to fund nearly a third of their future obligations based on their current portfolios. . . .
To be sure, the IMF says the Fed's actions are essential to reviving U.S. and global growth. But the cheap cash and low interest rates don't come without a cost. . . .
Most pension funds and insurance firms have cash on hand to weather near-term shortfalls, the IMF said.
"But a protracted period of low rates could depress interest margins further and erode capital buffers, potentially driving insurance companies to further increase their credit and liquidity risk," the IMF said.
The IMF said pension funds need to address their future funding shortfalls "without delay," through "restructuring benefits, extending pensioner's working years and gradually increasing contributions to close funding gaps.""
And The Pension Rate-of-Return Fantasy has this warning:
"It has been said that an actuary is someone who really wanted to be an accountant but didn't have the personality for it. See who's laughing now. Things are starting to get very interesting, actuarially-speaking.
Federal bankruptcy judge Christopher Klein ruled on April 1 that Stockton, Calif., can file for bankruptcy via Chapter 9 (Chapter 11's ugly cousin). The ruling may start the actuarial dominoes falling across the country, because Stockton's predicament stems from financial assumptions that are hardly restricted to one improvident California municipality.
Stockton may expose the little-known but biggest lie in global finance: pension funds' expected rate of return. It turns out that the California Public Employees' Retirement System, or Calpers, is Stockton's largest creditor and is owed some $900 million. But in the likelihood that U.S. bankruptcy law trumps California pension law, Calpers might not ever be fully repaid.
So what? . . . Calpers Chief Actuary Alan Milligan published a report suggesting that various state employee and school pension funds are only 62%-68% funded 10 years out and only 79%-86% funded 30 years out. Mr. Milligan then proposed—and Calpers approved—raising state employer contributions to the pension fund by 50% over the next six years to return to full funding. That is money these towns and school systems don't really have. Even with the fee raise, the goal of being fully funded is wishful thinking.
Pension math is more art than science. Actuaries guess, er, compute how much money is needed today based on life expectancies of retirees as well as the expected investment return on the pension portfolio. Shortfalls, or "underfunded pension liabilities," need to be made up by employers or, in the case of California, taxpayers.
In June of 2012, Calpers lowered the expected rate of return on its portfolio to 7.5% from 7.75%. Mr. Milligan suggested 7.25%. Calpers had last dropped the rate in 2004, from 8.25%. But even the 7.5% return is fiction. Wall Street would laugh if the matter weren't so serious.
And the trouble is not just in California. Public-pension funds in Illinois use an average of 8.18% expected returns. According to the actuarial firm Millman, the 100 top U.S. public companies with defined benefit pension assets of $1.3 trillion have an average expected rate of return of 7.5%. Three of them are over 9%. (Since 2000, these assets have returned 5.6%.)
Who wouldn't want 7.5%-8% returns these days? Ten-year U.S. Treasury bonds are paying 1.74%. There is almost zero probability that Calpers will earn 7.5% . . . anytime soon.
The right number is probably 3%. Fixed income has negative real rates right now and will be a drag on returns. The math is not this easy, but in general, the expected return for equities is the inflation rate plus productivity improvements plus the expansion of the price/earnings multiple. For the past 30 years, an 8.5% expected return was reasonable, given +3%-4% inflation, +2% productivity, and +3% multiple expansion as interest rates plummeted. But in our new environment, inflation is +2%, productivity is +2% and given that interest rates are zero, multiple expansion should be, and I'm being generous, -1%. . . .
In other words, you can't wish this stuff away. Over time, returns are going to be subpar and the contributions demanded from cities across California and companies across America are going to go up and more dominoes are going to fall. San Bernardino and seven other California cities may also be headed to Chapter 9. The more Chapter 9 filings, the less money Calpers receives, and the more strain on the fictional expected rate of return until the boiler bursts.
In the long run, defined-contribution plans that most corporations have embraced will also be adopted by local and state governments. Meanwhile, though, all the knobs and levers that can be pulled to delay Armageddon have already been used. . . .Sadly, the only thing left is to cut retiree payouts, something Judge Klein has left open. There are 12,338 retired California government workers receiving $100,000 or more in pension payments from Calpers. Michael D. Johnson, a retiree from the County of Solano, pulls in $30,920.24 per month. As more municipalities file Chapter 9, the more these kinds of retirement deals will be broken. When Wisconsin public employees protested the state government's move to rein in pensions in 2011, the demonstrations got ugly—but that was just a hint of the torches and pitchforks likely to come."
Pension plans are underfunded. Pension plan assumptions are based on the plan earning ~8% annually. This 8% is a blend of perhaps 10% for stocks and 6% for bonds. Implicit in both numbers is an inflation rate assumption of 4% or so.
If we are entering a period of minimal inflation and perhaps even deflation or at the very least super low interest rates, pension plans will be lucky to earn 4% based on a 50/50 mix of stocks to bonds and 6% based on stocks alone.
In that case, 6% on stocks with no inflation would be the equivalent of 10% on stocks with 4% inflation. Nominal versus real returns, in other words. Different dollars.
Either way 8% ain't gonna happen unless public sector pension plans invest 100% in stocks, and that ain't gonna happen either. It simply would not be the "politically correct" thing to do.
The problem with public pension plan funding and investment is real and likely to become worse over time.
How the government knows best gang will find a way out of this mess is unknown except for one possible fix --- private sector growth and public sector retirement funds being invested in the stocks of solid and growing American companies.
The problem with that 'fix,' of course, is that it doesn't fit the political narratives of the "progressives" and the concerns of an unknowing public.
To repeat, something's gotta give, and soon. Stay tuned.