Monday, March 16, 2015

Potential Pension Pain

I came across some interesting data on retirement assets lately provided by the Investment Company Institute.

As of the end of the third quarter, 2014, total U.S. retirement assets were $24.2 trillion. To put that in context, U.S. GDP for 2014 was an estimated $17.7 trillion.

U.S Total Retirement Market
(trillions of dollars)
Credit: Investment Company Institute

Retirement assets have increased by $10 trillion (+71%) since 2008. GDP in 2008 was $14.7 trillion. Therefore, U.S. retirement assets have increased by $10 trillion in six years while the total economy has only increased by $3 trillion. This is a clear indication of the Federal Reserve QE program that has inflated the value of financial assets.

Another way to look at it is that retirement assets equal about 1.4x GDP today.

In 2008, these assets only represented .7x of GDP.

For perspective, in 1985 retirement assets were .5x of GDP, in 1995, .9x of GDP and in 2005, 1.1 of GDP. Some of this increase is due to the aging of the population but a large amount of the increase is the result of the inflated value of financial assets due to QE.

Since the financial assets in retirement plans are largely a claim on future income and earnings of the economy, you have to wonder how reliable those asset values are right now looking to the future.

Anyone saving for retirement should not be too comfortable with their account balances right now. I would expect rougher waters ahead.

What I also found interesting is that IRA's (Individual Retirement Accounts) have more assets than company-sponsored defined contribution plans today. IRA's are now also approaching the same amount of combined assets as are in government and private sector defined-benefit pension plans.

By comparison, in 2000 defined benefit plans had nearly double the assets ($5T to $2.6T) that IRA's had. That is a pretty significant change in the space of fourteen years.

All of this is remarkable when it is considered that IRA's were first introduced in 1975 and Roth IRA's were not enacted until 1997.

Another interesting chart from the ICI data compares retirement assets with unfunded liabilities. This chart is downright scary and should serve to be a cautionary tale as to why politicians and the governments "they manage" should not be allowed to offer defined benefit plans. Politicians make the promises and the taxpayers have to write the checks for the inevitable shortfalls.

U.S. Total Retirement Entitlements
(trillions of dollars)
Credit: Investment Company Institute

Please note the unfunded liabilities as a % of retirement assets for the various defined benefit plan sponsors.

Private Sector        2%

State and Local     24%

Federal                 57%

Of course, defined contribution plans and IRA's are always fully funded. They will only pay out what the assets are worth in the long term. The participants takes all the risk of market declines.

Unfortunately, most of the participants in DC plans and IRA's are also assuming the risks for market declines in the assets of governmental DB plans as well. Any underfunded amounts will be made up in increased taxes on the private sector in the future in order to make the pension promises to government workers. And these plans are already significantly underfunded right now.

If retirement asset values drop, expect a lot of pain and pent-up anger. It will not be pretty.

Federal Reserve Charts on Historical Levels of Underfunding of DB plans.

Private DB Pension Funds
Unfunded Ratio

State and Local Government DB Pension Funds
Unfunded Ratio

Federal Government DB Pension Funds
Unfunded Ratio

Notes on this chart from The Federal Reserve: Federal government DB pension plans were largely unfunded for several decades, as illustrated above by an unfunded ratio of close to 90 percent of total liabilities of the sector in the 1970s. In the 1980s, the FERS--which was designed to be essentially fully funded--was introduced to gradually replace the CSRS, leading to a decrease in the unfunded component of federal DB pension liabilities. Additionally, in recent decades, the Treasury Department has been required to make "catch-up" payments to the federal DB pension funds from its general fund in order to gradually close the funding gap in federal DB pensions. As a result, the unfunded component has decreased from about 90 percent to about 58 percent of total DB liabilities of the sector.

One important difference between federal and S&L (or private) DB pensions, however, is that federal DB pension funds are invested almost exclusively in special-issue, nonmarketable Treasury securities. As a result, unlike private and S&L pension funds, the "asset holdings" of federal DB pension funds are not assets that can be sold in private markets in order to fund future benefits. Instead, they represent claims on the Treasury, and therefore the balances of the federal pension funds are available for future benefit payments only in a bookkeeping sense.

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