Our Nuts Are in Danger
By: John Mauldin | October 11, 2019
Life would be so much easier if we didn’t have to worry about our financial futures. Though I suppose we don’t have to worry. Animals don’t. Squirrels instinctively store away nuts and thus live through winter without much thought.
We humans have retirement winters, and we’re more sophisticated than squirrels. We generally outsource the job of managing our nuts/money to professionals. All well and good if we save enough and if the professionals do their jobs right. As we saw last week, the elected squirrels who run Social Security haven’t evolved to face changing conditions. Our Social Security nuts are in danger.
But the problem is even bigger. Today I want to continue this theme using some recent corporate news as our springboard. Economic changes have made future planning increasingly difficult for government retirement systems, private pension plans, and individual investors. How do you generate a reliable income stream for an uncertain but potentially lengthy lifespan in a world where interest rates are barely above zero and possibly below it?
The easy answer is “save more,” but that strategy has limits. We all have current expenses. Yes, we can live simpler lives, but we can’t save 100% of our income. Yet that’s what it will take in some scenarios.
If you’re starting to envy the squirrels, you aren’t the only one. Big Gaps
Remember “defined benefit” pensions? That is the kind of plan in which the employer guarantees the worker a set monthly benefit for life. They are increasingly scarce except for small closely held corporations. My US accountant has set up well over 1,000 defined benefit plans, including two for me. His primary customers are dentists. The same rules apply for small closely held businesses as for large corporations. These plans can be great tools for independent professionals and small business owners.
But if you have thousands of employees, DB plans are expensive and risky. The company is legally obligated to pay the benefits at whatever the cost turns out to be, which is hard to predict. The advantage is you can use some hopeful accounting to set aside less cash now and deal with the benefit problems later. The problem is “later” comes faster than you would like, and procrastination can be a bitch.
At some point, the risks outweigh the benefits, which is why few large companies have open DB plans these days. But the plans are often still in effect for older workers, and the amounts are large and frequently underfunded. Companies are slowly dealing with the problem.
And that brings us to the lesson for today. On October 7, General Electric (GE) announced several changes to its defined benefit pension plans. Among them:
• Some 20,000 current employees who still have a legacy defined benefit plan will see their benefits frozen as of January 2021. After then, they will accrue no further benefits and make no more contributions. The company will instead offer them matching payments in its 401(k) plan.
• About 100,000 former GE employees who earned benefits but haven’t yet started receiving them will be offered a one-time, lump sum payment instead. This presents employees with a very interesting proposition. Almost exactly like a Nash equilibrium. More below…
The first part of the announcement is growing standard. Employers prefer 401(k) plans because they transfer investment risk to the employees. Other than the matching payments—which end when the worker quits or retires—the company has no future obligations.
The second part is more interesting, and that’s where I want to focus.
Suppose you are one of the ex-GE workers (and I’ll bet I have some readers in that group) who earned benefits. As of now, GE has promised to give you some monthly payment when you retire. Say it’s $1,000 a month. What is the present value of that promised income stream? It depends on your life expectancy, inflation, interest rates and other factors. You can calculate it, though. Say it is $200,000.
Is GE offering to write you a generous check for $200,000? No. We know this because GE’s press release says:
Company funds will not be used to make the lump sum distributions. All distributions will be made from existing pension plan assets in the GE Pension Trust. The company does not expect the plan's funded status to decrease as a result of this offer. At year-end 2018, the plan's funded ratio was 80 percent (GAAP).
So GE is not offering to give away its own money, or to take it from other workers. It is simply offering ex-employees their own benefits earlier than planned. But under what assumptions? And how much? The press release didn’t say.
If that’s you, should you take the offer? It’s not an easy call. First, you are making a bet on the viability of General Electric. In September 2000, GE stock traded at $58+ per share. As I write this it is $8.45. The board has slashed dividends and the dividend yield is now only 0.47%.
As of April, GE had $92 billion in liabilities in its pension plan, on assets a little below $70 billion. Commendably, the company is “pre-funding” $4–5 billion into the DB plan. As we will see, however, this is chump change to the actual obligations.
In various ways, the choice GE pensioners face is one many of us will have to make in the coming years. GE isn’t the only company in this position. You’re still affected even if you don’t have a DB plan. Lots of people are reaching retirement age to find they only have 80% (and often less) of their “fully funded” amount. They have to fill the gap somehow. Most often, that means reducing expenses or working longer, if you’re able. Rising Pressure
When GE says its plan is 80% funded under GAAP, it necessarily makes an assumption about the plan’s future investment returns. Here’s what they say in the 2018 annual report.
I dug around and found the “expected rate of return” was 8.50% as recently as 2009, when they dropped it to 8.00%, then 7.50% in 2014, to now 6.75%. So over a decade they went from staggeringly unrealistic down to seriously unrealistic. They still assume that every dollar in their pension fund will grow to almost $4 in 20 years.
That means GE’s offered amounts will probably be too low, because they’ll base their offers on that expected return. GE hires lots of engineers and other number-oriented people who will see this. Nevertheless, I doubt GE will offer more because doing so would compromise their entire corporate viability, as we’ll see in a minute.
In any case, more companies will do such things and affected workers won’t be happy. We’ll see the same in state and local government pensions, which are often even more underfunded and have even more absurd investment projections. These are becoming untenable and lump sum offers like GE’s help highlight that fact.
This, in turn, will raise pressure on plan sponsors to reduce those projections, which will increase the amounts they must contribute to their plans, which (for the corporate ones) will reduce earnings.
See where this is going?
We are right now entering an earnings season that may not be disastrous but doesn’t look too impressive, either. It is getting harder to justify the valuations investors place on many stocks.
If you take out the buyback activity from companies themselves, and the index funds and ETFs that buy indiscriminately as yield-starved investors give them more cash, who is really buying stocks in any major way? And what happens when they stop buying? If you’re holding stocks, you better have an answer.
Victoriously Breaking Even
In last week’s Social Security discussion, I noted a fatal flaw in ideas to convert the system into private accounts. Two flaws, actually: 1) Most people don’t know how to invest successfully and 2) now is a terrible time to learn.
(Note, that probably doesn’t include you. You’re reading this letter so you have at least some basic economic and financial literacy. But you represent maybe 5% of the population.)
I dislike saying “it’s different this time” but it really is. Today’s conventional investment wisdom came from an era when there was this thing called “risk-free rate of return.” Everyone could count on earning something, though perhaps not much, without risking it all. Inflation might erode your principal over time but you could at least see it coming.
Now there is no such option. Banks and Treasury securities pay zero, almost zero, or slightly below zero in some places. Don’t like it? Start adding risk. That is your only choice now.
We are in a world where simply breaking even counts as a victory… and that is a serious problem if you need to fund a long retirement... Read Full Story »»» DiscoverGold