This is the continuation of a 10 part blog series entitled, "10 MACRO HEADWINDS IN THE FACE OF INVESTORS."
We often hear about the laws of unintended consequences. We are witnessing some unintended consequences regarding pension funds and the long term effects on retiree's (or future retiree's).
Pension plans run calculations each year estimating how much that they will need to contribute to the plan so that they could meet the required benefits in the future. Future pension assets are nothing more that the past contributions into the funds combined with the growth rate of those underlying assets (investments). Pensions then estimate how much they need to contribute and use an estimated return for those investments at about an 8% rate.
However, many pension plans (especially those for state and local governments and many unions) have under-contributed into those plans. To make matters worse, the growth rate on those contributions are turning out to be far less than an 8% rate of return.
Pension plans need to be somewhat conservative in their investments. This is for good reason as the need short term liquid assets to pay the benefits of those already in retirement.
If a pension plan runs an asset allocation model of 50% stocks and 50% bonds, they can generate an 8% return by getting either 10% from stocks and 6% from bonds or the reverse.
Unfortunately, not only have stocks not returned 8+% returns over the past number of years but it is highly unlikely that bonds will return anything close to 8% either. How could they with the Fed manipulating interest rates to historical lows (around 2% on U.S. Treasury Bonds).
If pension plans invest half of their assets in bonds that pay 2%, the return on their equity holdings would have to be 14% so that the total return comes out at the 8% required rate of return in their actuarial models. Is it reasonable that stocks/equities are going to return 14% in future years when GDP growth is stalled to crawl?
That leaves pension plans in quite a predicament. A lower rate of return on investments would require much higher contributions to keep pace. But that can't and isn't happening with major cutbacks in state and local governments because of budget cuts across the board due to the slow economy.
As a result, you can't avoid the inevitable. There won't be the required funds to pay what was promised to many baby-boomers who are either approaching retirement or are currently in retirement. The money just isn't there.
With so many baby-boomers coming into their retirement years, we have a collision on our hands of what is required for them to sustain their standard of living and what is available. Social Security and Medicare benefits need to be reduced. Pension funds won't be available based on what is promised. Personal savings are inadequate and debt levels are high.
Since the majority of the economy is consumer based spending (70%) and the biggest component of spenders is the baby-boomer demographic, it's hard to imagine that this segment of the population is going to fuel a big, strong, and growing spending economy over the coming years.