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Re: nlightn post# 87523

Sunday, 04/23/2017 7:54:27 AM

Sunday, April 23, 2017 7:54:27 AM

Post# of 187099
Why Your Pension Is At Risk
Seeking Alpha
Apr. 21, 2017

Summary

-State and local government pensions are extremely underfunded.

-Demographics are making matters worse.

-The assumed rate of returns is unrealistic.

-Time is not on your side. Action must be taken.

Pension liabilities are in the news again. Therefore, I decided to put together an article on this most pressing issue. I've written on this topic many times throughout the last few years and most recently March 17th. I described state and local pension funds as being in extreme danger. For just a refresher, here are a few quotes I made reference to in that previous article.

Combined across all states, the price tag for unfunded pension liabilities is $17,427 for every man, woman and child in the United States. By most measures Illinois ranks worst, with unfunded liabilities of nearly $193 billion in 2015 according to Moody's. Illinois has 66 billion in its pension coffers to cover pension obligations of $233 billion. In fact, state pensions in Illinois are 71% underfunded.

Today I would like to address this issue from a more comprehensive point of view, but before we get started, here are some basic principles of calculating these liabilities. In determining how much is to be funded there must be an assumption made regarding the rate of return of the plans assets. Today the average assumption made by actuaries for pension plans is between a 7% and 7.5% rate of return.

The actuaries must also consider the age demographics of the plan. Simply put, you must anticipate the number of participants moving into retirement at any given point in time. If you have an aging group of employees you will be paying out more as this group leaves the workforce.

There are two methods in which a shortfall of a pension liability can be recouped.

First of all they must be funded adequately. You see, there must be some vehicle in place to fund pension liabilities. In case of a state and local pension plans, they are funded through legislation and tax revenues. Unfortunately, some of these plans have not been funded for many years.

Secondly, a portion can be gained through higher than assumed rate of returns. For example, instead of earning 7.5% (assumed rate) you earn 10%. In this case your unfunded liability would be reduced by the difference. Finally, your unfunded liability could be altered by a different age demographic. For instance, having a younger average age in your employee pool you extend the number of years before you start paying out benefits.

I know, I've been talking about state and local governments unfunded pension liabilities for some time. In all fairness, I should describe the most unfunded government pension plan of all, our very own Social Security Fund. It is by far the most neglected pension plan in our history. Please note, I referred to this as a pension plan and not an entitlement program.

Here are the facts, the baby boomers are approaching the time in their lives where they soon will receive full benefits from Social Security. This group constitutes 25% of our population. At the same time our working population is shrinking (ages 25 to 54). Currently, all Social Security payroll deductions are for the most part being spent to fund current Social Security recipients. As you can see, the demographic portion of the equation is not good.

To make matters worse, Congress has been borrowing against this pool of Social Security assets since the mid-1960s. These borrowed assets are clearly a liability and responsibility of the U.S. Treasury -- i.e., tax payers. The pooled assets in the Social Security fund are invested in U.S. Treasuries, earning around 2.22%. As you can see this is a far cry from the actuaries assumed rate of return of 7% to 7.5% in the State and Local pensions across the country.

There soon will be a "come to Jesus" moment regarding our Social Security Trust Fund as well as our state and local pensions. Low rate of returns and an aging population are simply compounding the problem of unfunded pension liabilities throughout our country. It could be argued that the 7% to 7.5% assumption on the rate of returns of all pensions is overly generous.

Assuming the pension assets are managed in a balanced portfolio you would have about half of your assets invested in fixed income of some sort. In today's environment a 3% return on fixed income is fairly close to what you can expect.

With 50% of the assets invested at a 3% return you would have to earn around 11 to 12% on the equity side of the portfolio to achieve a 7 to 7 ½% total return. In today's environment 11 to 12% returns in equities is no simple task. The S&P 500 has averaged about 7.5% annualized return for the past 10 years according to Morningstar. That is close to a 40% shortfall of what is needed in equities to achieve the actuaries assumed rate of returns.

For just a second let's drill down into the two components mentioned above, demographics and rate of returns. Demographics is simple and something we really can't control. It's very definable and certainly irreversible. Sometimes these government entities can offer pension buy outs in an attempt to alter their demographics but for the most part they only make very small impacts.

Rate of return is certainly a variable that can be influenced by a number of factors. Believe it or not demographics is very much part of this equation also. On April 2 there was an article from BlackRock Retirement Institute titled "Demographics are Destiny." This is a very well written article and I encourage you to read it. Aging populations are contributing to two of the defining characteristics of the current economic environment: slow growth and low interest rates.

Economic growth is driven by increases in the labor force and productivity. As I indicated above, the labor force is shrinking and will continue to do so for some time to come. Due to lower birth rates our labor force, age group 25 to 54, is simply shrinking. This is not just a U.S. phenomenon it is one found throughout the developed world. Because of this lack of labor resources economic growth is certainly hampered both here and abroad.

Whether you like it or not, we depend on legal immigration to fill the void of laborers in this country. Immigration is a huge component to economic growth in this country. Because of this huge shortage of laborers we find ourselves in desperate need of immigration reform. Please note, I did not say "illegal immigrants." I suspect we will also see the working age expanding well into their 70s as another way of making up for our labor shortfall. You know what they say, 80 is the new 60 in this day and age.

Productivity on the other hand has been very low due to a number of factors, but certainly harder to explain than the shrinking labor force. I believe productivity is somewhat more cyclical. As you may remember during the 90s tech revolution, we had tremendous growth and productivity that touched almost every industry in the country.

I believe we are about to see that once again as the implementation of robotics is becoming a necessity. Robotics will play a significant role in filling the gap of a lost labor force and will improve productivity significantly. 3D printers will also play a major role in improving our productivity in manufacturing. Software, particularly in the practice of medicine will be yet another source of productivity gains going forward. Once again, technological advancement will lead the way to significant productivity gains. Nonetheless, slow productivity has been a tremendous drag on economic growth and I suspect it will be for some time to come.

The demographic factors, on the other hand, are simply too strong to be completely offset by expansion of the working age and the powers that be today do not sound too conducive to expanding immigration to fill this void. Corporate tax reform and deregulation could significantly help increase our economic growth. Immigration reform could be equally important going forward.

The aging population has significant economic ramifications. Older Americans are a drag on consumption and debt expansion. Therefore, we have a significant reduction in consumption as America ages. From a savings basis, this demographic does a fairly good job of squirreling money away for a rainy day. Most is invested in hopes to increase current income not for growth. Risk assets become less important at this age. This creates a huge demand for fixed income assets -- i.e., bonds, CDs, preferred equities and of course money markets.

This demand for fixed-income assets naturally drives down interest rates and increases the cost of investing in these assets. This in a large part is contributing to the low interest rate environment we have had for a number of years. According to our aging demographics, this trend will not change much over the next 10 to 15 years.

You're probably wondering by now how all of this applies to our unfunded pension liabilities we face nationally.

-Lower interest rates affects the expected rate of return of our pension assets. It simply reduces all returns.

-Lower economic growth due to falling consumption places a cap on the expected returns of the S&P 500.

-With demand for goods and services slowing outside of healthcare, economic growth is also capped.

-Global competitiveness is significantly impaired due to our corporate tax structure. Hopefully, tax reform is on its way.

Under these conditions the expected 7.5% rate of returns assumed in our pension plans in my opinion is a stretch. We must be more realistic in our assumptions to get a clearer picture of what is needed to right the unfunded pension liability issue. As far as our aging demographics are concerned, there is not much we can do. The situation is going to get worse before it gets better.

This $5 trillion deficit in just state and local pensions let alone the Social Security Trust Fund must be addressed. Hopes of growing out of this issue is unlikely. At some point in time a check will be written. The next time you see a politician ask them about how they plan to fix it. They will simply dodge the question and walk away. You see, the hard decisions that need to be made here are once again being kicked down the road. You see, along with hard decisions of this magnitude comes political suicide.

The only answer will be to raise revenues. Yes, that means higher taxes and increases in the retirement age -- neither of which any registered voter wants to hear. If we don't speak up, our elected officials will continue to keep their head in the sand and will continue to kick the can down the road for someone else to fix. If you are planning your retirement and are dependent upon some sort of pension, you should prepare for significant changes in your existing pension.

If you are younger with goals of accumulating wealth, look toward new technologies, robotics, medical software and any sector that will improve productivity for many years to come. Invest in the best of the best with the intention of owning them for a long time.

Unfunded pension liabilities should be one of our biggest concerns. We must become proactive to ensure we are protected against a looming financial disaster. Remember: The longer we wait the worse it will get.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

https://seekingalpha.com/article/4064254-pension-risk?page=2

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