More on Pension Funding as a Huge Problem in Need of a Solution

Pension funding in both the private and public sectors has become a very, very, very big issue.

In fact, most private sector companies have moved the risk of retirement savings and successful investing to their employees. Public sector unions are fighting that trend. My view is that 401(k)s are a good thing for everybody, individuals and companies alike. Our nation, too.

The arguments pro and con pensions and 401(k)s both are pretty much missing the main point. If (1) either pension or 401(k) plans receive scheduled contributions on a timely basis, and (2) those contributions are invested at rates of return of ~8%, all is well. If not, we won't be able to fund either a pension plan or a 401(k) adequately.

We'll skip the timely contribution part of the discussion for now, but that's largely a public sector issue where expenses and liabilities aren't recognized by government unless cash payments are made. Hence, politicians don't make required contributions on a timely basis and the unfunded liability eventually becomes insurmountable. Politicians in Illinois and other states are faced with that problem today. Some would call it dishonesty in government, but that's an oxymoron, or is it?

In any case, all plans for retirement, including individual 401(k) plans, must assume a certain level of funding and an average annual overall rate of return over time. Otherwise plan participants or sponsors will have no idea how much money to invest each year to achieve their long term objectives of having adequate funds for college, retirement pay or anything else.

Short-term-itis and long term investing tell two different stories. One details the current in-our-face-today problem and the other describes the long term situation and potential solution.  First, the problem.

Short Term

Top Pension Fund Sends a Warning says this about the "today" problem.

"For a second straight week, pension woes have been at the forefront of fixed-income news, offering sobering data for those who rely on such plans, as well as those who invest for the companies and municipal governments responsible for maintaining them.

A week ago, this column covered the role of pension obligations in the recent bankruptcies of three California cities, and how actions are being taken to address the chronic underfunding of public pensions. Reports out last week underscored just how widespread the problem is, and how it's not restricted to public pensions. Stagnant economic growth and historically low interest rates are creating an incredibly challenging period for pension-fund managers, both public and private, to find money to invest and to come anywhere close to their target rates of return.

THE CALIFORNIA PUBLIC EMPLOYEES' Retirement System, the nation's biggest public pension fund at $233 billion, reported a mere 1% return on its investments in its fiscal year ended June 30. Earlier this year, in an attempted acknowledgment of today's realities, Calpers had lowered its discount rate–an actuarial figure determining the amount that must be invested now to meet future payout needs—for the first time in a decade, to 7.5% from 7.75%. That represents combined assumptions of a 2.75% rate of inflation and a 4.75% rate of return.

Needless to say, a 1% annual return didn't come close to hitting any of those figures and doesn't engender confidence in the assumptions of institutional or individual investors alike. Calpers was quick to note that its 20-year investment return is still 7.7% and that the past year was challenging for everyone. But Calpers is a bellwether, and other systems are expected to report similarly disappointing returns, necessitating higher annual contributions in the years ahead to meet funding needs.

Later in the week, S&P Dow Jones Indices said that the underfunding of S&P 500 companies' defined-benefit pensions had reached a record $354.7 billion at the end of 2011, more than $100 billion above 2010's deficit. The organization reported that funding levels at the end of 2011 ran around 75%, on average, and that future contributions will constitute a "material expense" for many companies.


Fitch Ratings later released its own study of 230 U.S. companies with defined-benefit pension plans and found that median funding had dropped to 74.4% in 2011 from 78.5% in 2010, and that corporate pension assets grew just 2.9% in 2011 amid sluggish returns and a 6% decline in contributions.


Companies and governments long ago started trying to shift retirement obligations away from defined-benefit plans toward defined-contribution plans and other offerings that place more responsibility on employees to care for themselves. But if the top U.S. pension fund can eke out only a 1% return, nonprofessional investors tasked with providing for their own retirement needs are facing a pretty bleak outlook. This might be a particularly good time to think about ratcheting up that salary allocation for your retirement account. . . . 

TREASURY YIELDS CONTINUED to grind lower last week, on their customary diet of fresh euro-zone jitters and uninspiring economic data. On Friday afternoon, 10-year notes were yielding 1.458%, down from 1.489% a week earlier, and 30-year bonds yielded 2.547%, down from 2.576%."

Now, the solution to the problem.

Long Term

The Long-Term Argument for Dow 20,000 says this:

"AFTER the last several years, you don’t need a finance course to know that stocks are risky.

If you’ve looked at the fluctuating value of your own stock portfolio, you already have a visceral understanding of market volatility. These violent ups and downs provide powerful reasons for fleeing stocks — and for buying protection in the form of government bonds, even if their yield is minuscule.

Investors may have absorbed the arguments for avoiding risk so completely that they have lost their taste for it. That’s why a new position paper by Seth J. Masters, chief investment officer of Bernstein Global Wealth Management, is startling. Its title is “The Case for the 20,000 Dow.”

On Friday, the Dow closed below 12,900. Mr. Masters says it’s time to consider the chances that the Dow will rise by more than 7,000 points — an increase of more than 50 percent. He says the odds of that happening by the end of this decade are excellent.

For long-term investors right now, he says, stocks are a much better bet than bonds. “This argument may seem provocative,” he said in an interview. “But that’s only because market conditions are so unusual, and so many people have become so pessimistic.”

That pessimism is grounded in recent history, he acknowledged. The stock market is extremely volatile now, and stocks are being battered for all kinds of reasons. Take your pick. At the moment, major banks are being investigated for rigging interest rates. In the United States, the economy has hit a soft patch, and in a nasty election season the government is heading toward the so-called fiscal cliff, with spending cuts and tax increases set to take effect automatically at the end of the year.

In much of Europe, the economy has been contracting, and the finances and governance of the euro zone are unstable. On top of all this, in crucial emerging markets like Brazil and China, economic growth is slower than had been expected. And that is just a partial list of the factors weighing on the market. Quite often, stocks have been sinking for no apparent reason at all.

Even so, stocks over the next decade may be less risky, in some respects, than the supposedly safe market for United States Treasuries, Mr. Masters said. His underlying argument is that the world has faced dire conditions before, and markets and economies have bounced back.

“People are acting as though the world is going to end,” he said. “It might end, but we think it won’t, and we think that’s no way to live your life.”

Precisely because bonds are now extraordinarily overvalued and stocks are undervalued, in his view, stocks are extremely likely to outperform bonds over the next decade or two. The Dow Jones industrial average is likely to reach 20,000 during that time — and probably within the next five to 10 years, he said.

“Our projected stock returns may sound optimistic,” he writes. “They’re not. They are well below the long-term average for U.S. and global equities and based on conservative assumptions about economic and market conditions. Bonds, on the other hand, are unlikely to outpace inflation, because current yields are extremely low.”

Bernstein projects 8 percent median annual returns for a diversified portfolio of global and domestic stocks over the next 10 years, versus 2 percent for 10-year Treasuries. At that rate for stocks, “the Dow could hit 20,000 in five to 10 years,” Mr. Masters continues. “In the same time frame, the S.& P. 500, a more representative index, could hit 2,000.”

Annual stock market returns of 8 percent were, until recently, commonplace. At the moment, he concedes, they are not. And, in an interview, he said he was not predicting that stocks would actually rise 8 percent next year or in any given year but instead was presenting a “range of probabilities” for investment returns. “We don’t know where stocks will go,” he said. “And right now they are likely to be extremely volatile, which could feel very unpleasant.” . . , 

Over 10-year periods since 1900, stocks have outperformed bonds 75 percent of the time, according to Bernstein’s calculations. But today, bond prices are relatively high — their yields, which move in the opposite direction, are extraordinarily low — and stock prices are relatively high. So the firm sees the chance of stocks beating bonds over the next 10 years at 88 percent.

Stocks have been cruel and it is hard to love them now. Still, Mr. Masters writes, “We think that 10 years from now, investors will wish they had stayed in stocks — or added to them.”"

My Take

Both points of view are accurate. Short term we have a huge problem. Longer term we have a huge opportunity.

If we choose to encourage individual private sector risk taking innovation and initiative over government knows best "security," we'll get our debt and deficits under control, our economy will resume solid growth and our people will prosper.

In that case, Dow 20,000 within five to ten years isn't a stretch at all. Then retirement fund investments will earn the 8% or greater rates of return needed to fund a happy and healthy retirement for We the People and future generations as well.

If we keep growing government and don't make the necessary changes to our educational and medical care systems and don't emphasize private sector global competitiveness, our economy will suffer, unemployment will remain too high and there's no way retirement funding will be adequate to provide our expected comfortable old age benefits and future competitiveness as a nation.

So as a society we have to choose between emphasizing A or B.

Choice A ... Investing and earning 1% annually requires $1 today to result in $2 in 72 years. That's the rule of 72 at work.

{NOTE: Rule of 72 = the number of years money is invested and the average annual rate of return on that money invested will determine how long it will take to double the initial amount in nominal dollars. 1% x 72 =72 years to double.

Choice B ... Earning an average annual rate of return of 8% for 72 years will double our money every 9 years. 8% x 9 = 72. That's also the rule of 72 at work. Thus, one penny invested today and earning 8% annually on average will equal $5.12 in 72 years. Nine doubles over 72 years, in other words.

That's the magic of compounding an inital single penny over time at 8%. Accordingly, investing and earning 8% annually requires less than one half of one penny today to grow to $2.56 in 72 years. That's the same rule of 72 as in A above.

Will we choose to go down the road of A or B? It's our choice.Will it be $1 or less than one half of one penny that we invest? Or something in between?

The private sector self reliant global competitiveness way or the public sector collective government knows best approach to economic growth? Limited government and self reliance or big elitist government and unaffordable entitlement promises made, but not delivered, for one and all?

Now that we know both the problem and the solution to our retirement, employment, fiscal and other economic woes, which path forward will we choose?

I'm betting on Dow 20,000.

Thanks. Bob.