Hidden Liabilities

Investing may be “Tough Stuff” in theory, but practically, avoiding foreseeable losses is a sane defense.  One of the easier ones to see, even if not in detail, is unfunded pension liabilities.

Bloomberg recently published an article about the pension liabilities in cities.

The gist is that public pension are underfunded by a large amount.  The estimate by the Federal Reserve is “underfunded by $1.4 trillion.”  Any number with 12 zeroes is too big to comprehend.

The shortfall is the value of all liabilities that result from pension promises to employees less the value of all assets on hand to pay for them.  The assets are pretty easy to count but liabilities are based on many assumptions.

The number the Federal Reserve decided on is a function of those many assumptions and it is possible some may not turn out as expected.  The important ones are:

  1. How many years will the pension be payable.  Greece has learned that early retirement is very costly.  How many years depends on how old the person will be when they retire and how long they may expect to live after they retire.  There are many things working against the pension plans here.
    1. Many plans allow for fairly early retirement, usually as a function of the total of age and years of service.  Early retirement stretches the time retired.
    2. People live longer now than they did in the past.  Most plans have not adjusted their rules to account for that even though it can materially stretch the payout period,
    3. There are more females in the workforce and females live longer than males.  Again longer payouts.
  2. The monthly payment may be higher in future.  Inflation indexed pensions are popular but more costly.
  3. Investment yields may be lower than some hope for now.  California Public Employees Pension System estimates their investments will earn 7.2%.  In their last fiscal year they earned 2.4%.  CALPERS is a $300 billion fund.  Coming up short 4.8% is a serious number.  Nearly $150 million. The teachers fund did better but still was 3% short of their target.
  4. Workforce reductions can have a big effect.  Layoffs tend to hit young people more.  If the average age of the workforce rises, the average time to receive contributions and invest shrinks.  Large capital needs there.  I know of a case where a workforce reduction and the resulting pension liability wiped out 30 months of earnings.

Chicago is a good example of what happens when the shortfall becomes known.  Their bond rating went to junk and new issues cost 8%.  An individual can borrow for less than half of that.  That interest increase reduces the money available to catch up.  Double whammy.

Cities and other governments have the biggest problems but they are not alone.  Large corporations with defined benefit pension plans (ones where the future payout is guaranteed) are at risk too.  Many have switched to defined contribution plans (ones where the payout is whatever the assets will allow) wherein they have no risk.  Chrysler and Boeing switched theirs plan in 2014.

When buying securities be sure you understand how the company’s defined benefit pension plan would be affected if investment returns remain low or if people start living longer.  Some companies could be subjected to massive earnings swings.  A 1% drop in expected yield has huge capital effects.  Even more profound effect when compared to corporate earnings.

It is good to pay attention to recorded liabilities, but the big risk is in the latent ones. If you cannot judge simply refuse to play.

Contact: don@moneyfyi.com  

Don Shaughnessy is a retired partner in an international public accounting firm and is now with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.

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