C&B Notes

Huge Shortfalls in Pension Plans

Government pension plans certainly look like an impending disaster.  Many governments have made promises that they will ultimately be unable to keep:

The numbers can boggle the mind. Mercer, a consultancy, reckons the hole in final-salary corporate plans in America was $512 billion at the end of September, the highest figure since the second world war. The average corporate pension plan had a funding ratio (the proportion of liabilities covered by assets) of just 72%, down from 81% at the end of 2010. In Britain the Pension Protection Fund reported this week that the aggregate deficit of the schemes it insures stood at £196 billion ($309 billion) at the end of September; the average funding ratio was 83%.

Those numbers look tiddly beside the public-sector pension deficits. In 2009 Joshua Rauh of the Kellogg School of Management at Northwestern University and Robert Novy-Marx, then at the University of Chicago’s Booth School of Business, estimated that the deficit of American state and local-government pension plans was $3.1 trillion. Mr Rauh reckons that the deficit is now $4.4 trillion. In other words, a cool $1.3 trillion has been added in two years.

This problem is exacerbated by actions of central banks.  In their efforts to spur lending/spending they are artificially manipulating rates down, lowering the real expected returns on plan assets while concurrently increasing the present value of plan liabilities.  The U.S. is not the only one facing this issue:

Oddly enough, the Bank of England has played its part in escalating the costs of other British pension schemes.  The aim of QE* is to lower bond yields. This raises the liabilities of pension funds (since it takes more money to deliver the same pension). The Pensions Corporation, an insurer, reckons the first round of QE increased the British pension hole by £74 billion.  Regulations require that this hole be closed within ten years, costing companies £7.4 billion a year, money that could have gone into building factories and employing new workers.  The National Association of Pension Funds has called for an emergency meeting with the regulator; the hope is that the contribution rules can be eased a bit.

Of course, not all government entities are acknowledging this reality (nor are private corporations, as the article explores elsewhere):

These figures will not be accepted by everyone.  Many states still discount their pension liabilities by the assumed rate of return on their assets, often around 8%.  But this is a highly dubious assumption.  Government bodies still have to pay the pensions, regardless of whether they achieve those returns or not.

Instead, some Warren Buffett-like principles ought to apply.  If a promise to pay someone money in the future isn’t a debt, what is it?  And if a debt shouldn’t be recorded at cost, how should it be recorded?  A company might borrow $50m in the bond markets to build a factory, after all, but it cannot record the debt on its balance-sheet at less than $50m on the ground that it expects to earn a higher return from the factory than its cost of borrowing.

>> Click here to read the full story from The Economist

*Quantitative easing (QE) is an unconventional monetary policy used by central banks to stimulate the national economy when conventional monetary policy has become ineffective.