Not In Kansas Anymore (NIKA)

The Pension Burden

In his June 17 weekly letter, John Mauldin discusses the extreme trouble that public and private pension plans face. Despite the stock market advances of the last two years, the amount of underfunding of private pension plans has actually increased. What's going to happen to them when the stock market doesn't perform above average?

Mauldin provides a strong argument as to why the stock market can't possibly perform nearly as well as the pension plan managers are hoping/gambling on to save their hides. The amount of underfunding in 10 years will be hundreds of billions of dollars, maybe even a trillion dollars:

Second, let's just look at the roughly $800 billion in assets. Let's look at a typical 60% stock, 40% bond asset allocation mix. Let's generously assume you can make 5% annualized on your 40% bond portfolio allocation in the next ten years. That means to get your 8% (assuming a lower average target) you must get 10% on your stock portfolio. Now, about 2% of that can come from dividends. That means the rest must come from capital appreciation.

Hello, Dow 22,000 in 2015. Care to make that bet with me? But pension plan managers are doing precisely that.

Earnings over long periods (and ten years is a longer period) grow about GDP plus inflation. Let's generously assume 6% earnings growth. A 22,000 Dow (or a 2500 S&P 500) means we will have to get back to bubble valuations, or P/E ratios into the high 20s for the largest cap stocks. Why? Because if earnings grow at only 6% and the market grows at 10%, P/E multiples have to get much larger. It is Back to the Future.

This all means that either corporate profits are going to go down as the companies pay more money into their pension plans (and reduced corporate profits will affect stock prices, thereby making the problem worse), or a whole bunch of pension plans are going to go under, with the taxpayers footing the bill. As we saw when United Airlines defauled on its pension plans, the taxpayers have to cough up $10 billion to take care of the United Airlines pension debt, and there are over a thousand more plans which are underfunded. And unfortunately, private pension plant managers don't seem to be trying to address these problems very strongly - they're pushing the hard decisions further into the future, where they can only grow worse.

But that's only for the private pensions. Public pension (city, county, state) promises are, if anything, worse, with even more underfunding. In ten years, these public plans may be underfunded by over 1.5 to 2 trillion dollars. Imageine what kind of effect that kind of debt obligation will have on local taxes - they will have to skyrocket in order to pay the debts.

Courts have consistently upheld the obligations of municipalities to fund the promised retirement programs. Unlike private pensions which can be cut or simply abandoned, public pensions will have to meet their commitments. Only four states allow for public pension funds to be cut retroactively. That means taxes will have to be raised or services cut to fund increased contributions.

There is a local tax and/or service crunch coming to a city near you in the next decade. If French entrepreneurs are voting with their feet to leave France (which is a beautiful place and one of my favorite countries to visit), you think US tax-payers won't move to cities and counties a little farther out with lower taxes and fewer commitments? The attraction of lower tax communities with fewer pension commitments is going to rise. This will drive down property values in high cost cities. Cities will need to raise taxes collected and this will start tax-payer revolts.

Since I'm on a doom and gloom roll, here, let's bring in housing. From today's MarketWatch weekly news highlights:

Debate all you want about the existence of a housing bubble and the possibility of its bursting, but there's no debate when it comes to this: A greater percentage of homeowners are now in riskier loans --that is, loans with terms likely to result in a steep rise in monthly payments at some point down the road.

Combine a steeper monthly payment with an unexpected financial crisis, and the picture gets pretty ugly, with the homeowner unable to make monthly payments -- and eventually forced into foreclosure.

The article goes on to talk about ways that many lenders are trying to help borrowers to get back on track to making their payments.

Both of these items - underfunded pensions and homeowners on the edge of missing monthly payments - are signs of an economic system with some terrible burdens (there are more than just these two). Any single issue might not in and of itself cause a massive crisis, but the combination of issues could well snowball, with small problems in one causing small problems in another, then another, then come back to worsen the original problem. Since the country as a whole doesn't seem to be doing much to avoid the problems, we'll just have to wait and see what happens.

Posted by Tom Nugent at July 22, 2005 07:50 PM