Editor's Note: The Early Look below was written by Hedgeye Financials analyst Josh Steiner on April 21st. "The bottom line is that very difficult choices will need to be made by pensions, courts and politicians in the coming 10 years, and it seems unavoidable that pension promises will be broadly reworked," Steiner writes. "Either Americans will slowly awaken to the fact that they don’t have enough saved for retirement..."
A thought-provoking read...
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“Everybody talks about the weather, but nobody does anything about it.”
– Mark Twain
Yesterday, I was asked to write the Early Look – the topic suggested was US Housing. To paraphrase my colleague, Christian Drake, the most remarkable feature of the recent housing data is probably the abject lack of anything remarkable. With that in mind, I chose a different topic.
The American retirement crisis has arrived, and it poses a long-term structural millstone on domestic growth for years to come.
The Washington Post ran an article yesterday entitled “One of the nation’s largest pension funds could soon cut benefits for retirees”.
Back to the Global Macro Grind…
The pension fund requesting a benefits cut turns out to be the Members of the International Brotherhood of Teamsters, and counts among its members more than a quarter million truckers from Texas, Michigan, Wisconsin, Missouri, New York and Minnesota. Notwithstanding its notorious ties to organized crime in the 1960s/70s, the Central States Teamsters is not unlike many DB pension plans; in 1980 they counted 4 active participants for every retiree, today there are 5 retirees for every active participant.
While the worker/retiree pyramid inversion is the proximate cause of today’s problem, the catalyst is a law passed in late 2014 that allowed multi-employer pensions like the Central States Teamsters to request permission from Treasury to cut benefits in order to maintain longer-term solvency of the fund. For reference, over 10 million Americans have their pensions through multi-employer pension plans.
The Teamsters asked for a 23% reduction in benefit payments, but some will be more affected than others. The article describes a husband and wife – both Teamsters – whose benefits will be reduced by 57%. Without the cuts, the pension argues it will be insolvent within 10 years. With them, it has a 50% chance of surviving another 30 years.
Private Corporate Defined Benefit Pensions look better, but are they really? Based on data from Milliman, one of the largest providers of actuarial products and services in the world, the picture isn’t pretty.
Milliman maintains an index that tracks the top 100 corporate US pension funds (HERE). Here’s where the index stood on 3/31/16: $1.37 trillion in assets and $1.76 trillion in liabilities producing a shortfall of $390 billion and a funded ratio of 78%. There’s a widely-held myth in pension accounting that plans funded at 80% are in good shape. This is simply not true – pensions need to be funded at 100% (for more on why, see HERE).
What I found surprising was that the $390 billion funding deficit is close to its all-time high even though the S&P 500 is just inside of its all-time high.
Equally surprising are the assumptions embedded in future returns. In order to reach 100% funded status, the funds will need to earn returns of +11.2% per annum going forward. The base case, just to stay at the current ~80% funding level, would require +7.2% returns per annum, while their bear case assumes positive returns of +3.2% and would result in funding levels declining to 65%.
Now consider the longstanding relationship described by Cliff Asness between current CAPE ratio levels [aka Shiller PE] and forward 10yr market returns (HERE). What he shows is that there’s a near perfect relationship between forward 10yr returns on the S&P 500 and starting CAPE ratio multiples over the last 85 years (see table below).
The market is currently trading at a CAPE ratio of 26.4x, which puts it in the 10th [the most expensive] decile. Forward 10yr real returns from this decile have averaged just +0.5% per year over the 1926-2012 period. The best period saw returns for this decile of +6.3% per year, while the worst saw losses of -6.1% per year. In other words, the base case pension return scenario (+7.2% per year) is 1% higher than the best return ever observed in the last 85 years of market history starting from this level of market valuation, and that’s just for those plans to stay at 80% funded status!
What about the States and Local Government Pensions? Two things are clear.
First, the sacrosanctity of state and local government pension obligations has already frayed. The NY Times (HERE) describes the precedent-setting cases of Detroit, where a judge ruled that public pensions could be reduced in bankruptcy, and Stockton, where pension giant CalPERS came under judicial fire for insisting no adjustments could be made to the pension side of the liabilities in Stockton’s bankruptcy.
Second, the current benefits promised are, in many places, simply untenable. Let’s take NY as an example. As a NY resident, I’m always curious when I see the local town/school budget information and was genuinely shocked by a report I read a few years back on retirement spending at the NY County/Local level in 2011, 2012 and 2013. For those interested, the data can be found in this second tab of this excel file (HERE), but allow me to summarize a few of the highlights.
- Suffolk and Nassau counties each had direct retirement expenditures of $300mn in 2011. By 2013, those same counties saw direct retirement spending balloon to $481mn and $491mn, respectively. Those are increases of 61% and 64%, respectively over just two years.
- Westchester saw its payments increase from $275mn in 2011 to $439mn in 2013, a 60% increase.
- Other large NY counties look similar: New York (Manhattan): +51%, Kings (Brooklyn): +52%, Erie (Buffalo): +54%, Onondaga (Syracuse): +60%, Monroe (Rochester): +57%. In fact, from 2011 to 2013, the 61 counties of New York saw an average increase in direct retirement spending of 59% (median: 60%).
- Consider how much the growth in that one line item crowds out other areas of local budgets. When revenues and most spending categories are growing at 2-4% per year, it’s simply not possible to absorb 30% annual growth in retirement costs on an ongoing basis without either enormous tax increases or other expenditures seeing profound declines.
At the state level, things are just as bad. On paper (HERE), New York is considered a “Top-10” state for pension funding with ~93% funding vs its actuarial liability estimate. Compared with CT, which has just 55% of its actuarial liabilities funded (Bottom 10), or Illinois – the worst in the country – at just 43%, New York seems to be in good shape. The overall funding ratio for all the states is 73% based on the official reporting. Not great, but not terrible.
Digging a bit deeper, however, the State level problem appears more serious. Once again, the culprits are the assumptions for asset returns and liability discount rates. The fiscally conservative think tank, State Budget Solutions, a non-profit out of Virginia, has run the same analysis using a market-valued liability (HERE) and found that the 73% funded status system-wide drops to 39% once a little reality is injected. Using their methodology, New York’s funding status drops from 93% funded to just 47%, leaving a funding hole of $260 billion, the fourth largest in the country behind California ($640bn), Ohio ($287.4bn) and Illinois ($287.0bn).
The Big Kahuna, of course, is Social Security. Not to be outdone, in its latest annual long-term financial outlook, the Board of Trustees for Social Security projected the fund will run out of money by 2034, at which time only 79% of benefits will be payable. This one irks me the most, as it’s the only one I’m personally eligible for. By then, I’ll be 60 and will have paid into the system for 40 years. I’m pretty sure I’ll never see a dime of money in return.
What about Private Retirement Savings? In short, there’s no reason to expect it to fill the gap for the vast majority of Americans. A few facts to consider, from the Government Accountability Office (GAO):
- 29% of Households headed by someone 55 or older have ZERO pension or retirement savings
- Among those with savings, Households headed by 55-64 year olds, have median savings of $104k and those 65-74 years old have median savings of $148k. This level of savings would produce an inflation-protected annuity of just $310/mo and $649/mo, respectively.
- A TransAmerica survey done in 2015 found that 401k savers in their 20s had median balances of $16k, those in their 30s had $45k, and those in their 50s had $117k. 60 year olds had saved a median of $172k.
So, what can be done?
There’s no silver bullet here, but a partial solution will likely be that Americans will increasingly tap into their accumulated home equity, either through cash-out refinancing, reverse mortgages or downsizing.
The most recent Fed data (4Q2015) shows total US Owners’ Equity in Real Estate reached $12.54 trillion, up from $6.35 trillion in mid-2011. For reference, a little over half that wealth (~$6.75 trillion) is held by the ~30% of homeowners who own their homes free and clear. These households are fortunate in that they have a sizeable, monetizable asset.
The median US existing home ($223k) currently sells for roughly 4.25x the median US household income ($52k). Retirement guidelines call for saving ~8x your income, meaning that around 1/3 of homeowners could in theory tap the equity in their homes to cover ~1/3-1/2 of their retirement needs – in reality, of course, they still need somewhere to live, so the offset is somewhat less. For the other 2/3 of homeowners who are still encumbered, they’ll have some cushion, but it’s no panacea.
The bottom line is that very difficult choices will need to be made by pensions, courts and politicians in the coming 10 years, and it seems unavoidable that pension promises will be broadly reworked.
Either Americans will slowly awaken to the fact that they don’t have enough saved for retirement and will choose to save more, which will suppress growth today, or they won’t, which will suppress growth down the road. Most likely, we’ll see a mix of the two. It’s hard to see American economic growth sustainably re-accelerating to 3-4% in the coming decade in the face of this.
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 1.69-1.87%
Yours in risk management,
Source: Cliff Asness, AQR (An Old Friend: The Stock Market’s Shiller P/E)