How did this dilemma begin?
Aren’t pension promises to pensioners unbreakable? Well, it depends.
A pension has many qualities similar to most investments, in that, past results are no guarantee of future performance. Other notable shifts happened to be around (1)the deceleration of traditional asset class returns, (2) the rise of the defined contribution plan in the 1970s, and (3) the passive (let’s just call it lazy) investment policy of large pension funds. Let’s unpack all of these reasons as we look at the pension crisis.
Traditional Asset Returns Aren’t the Same
Very possibly the double-edged sword that magnifies the pension crisis is the 1974 ERISA law that brought about the defined contribution plan. More commonly known as the 401(k), defined contribution plans like it effectively shift the retirement income obligations away from the company (i.e. pensions) to the employees. Here’s in example…
Let’s say Bob Sr. works in a steel mill all his life and is guaranteed that a portion of his salary will be given to him until he dies as long as he works a certain amount of years. A typical pension formula may look like this….
Highest 5 years of salary x number of years worked x pension factor OR 80,000 x 30 x 2.5% = $60,000/yr
Now company XYZ is on the hook to pay Bob Sr. $60K a year until he dies. Even if he worked from age 25 to age 55 and lives until 90. That’s a sweet deal!
How the Burden Shifted
Well in the late 70s, companies shifted this burden to the employee. It did a couple of things (thus the double-edged sword reference). First, it removed the pension obligation from their financial statements. Pension obligations are liabilities and liabilities need to be in access of assets in order for the balance sheet to remain healthy-looking. This has a direct impact on how analysts view a company and thus rate a stock (for Wall Street’s purposes). Next, it forced employees like Bob Sr. to become investment savvy overnight by having to learn how to provide retirement income for himself through a disciplined savings strategy called the 401k. The result? Largely a win for the companies and a loss for Bob Sr.
What “Passing the Buck” Ultimately Created
A 2016 survey by the CFP Board of Standards found that 4 out of 5 people are at least somewhat concerned about their ability to save. You’re probably asking how does this drive down the returns of stocks? It does because your typical 401k has anywhere from 8-20 choices(mostly stocks) which everyone buys. With no other alternatives, everyone buys stocks pretty blindly because they have to save for retirement. This just creates a cycle of asset buying that pushes prices higher resulting in lower returns.
Why a Passive Strategy Doesn’t Always Work
The investment managers at Calpers had to see this coming…or not. Because if they did, they would have shifted the investment policy statement to avoid the shortfall of 27% that most major public pensions are experiencing. In dollars, this equates to a shortfall between $1.6 and $4 trillion. So is the way forward different asset classes? Obviously. Studies have shown that more than 90% of your portfolio’s return comes through asset allocation or in other words not putting your eggs all in one basket.
I believe the pension crisis lies in a somewhat reluctant investment committee that decides to change strategy too late. Would the crisis have been totally avoided? Absolutely not. There’s no way Bob Sr. was going to be able to work fewer years than he lived retired and earn 75% of his salary. That was an unsustainable model for a lot of reasons…mainly globalization. With US companies shifting high-cost labor offshore to emerging markets to maintain profitability, margins were cut from the highs of the industrial age. During the age of technology, there is stiff competition all around the globe to get to market quicker and cheaper so companies couldn’t be tied down with pension obligations on their balance sheet.
The only way forward is through financial literacy and education. Bob Sr. is now challenged with teaching Bob Jr. about the value of money at an early age and the importance of investing and saving on his own so that he doesn’t depend on his employer to write him a check after he retires.
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