How the public pension fund crisis will affect everyone

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Many people dismiss news about the pension fund crisis because they don’t receive a pension and believe they won’t be affected. However, given that so many public pension funds are in crisis, it’s safe to say that everyone will feel the effects of it in one way or another.

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Taxpayers affected by the public pension fund crisis

In a post for The Street, Mark Hulbert explained why taxpayers should also be concerned about the public pension fund crisis. He noted that both state and local public pension funds are making unrealistic return assumptions. In some cases, governments have been trying to reduce benefits to retirees, but legally, not all of them are able to do so. Either way, it means taxpayers will be on the hook for the shortfall.

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He drew some comparisons between the public pension fund crisis and the student loan crisis. He noted that estimates put student loan debt at around $1.5 trillion, but unfunded liabilities held by public pension funds are significantly higher.

Pension funds had about $4.8 trillion in assets at the end of last year, and Goldman Sachs estimates that pensions are only about 60% funded. That suggests the shortfall is more than $3 trillion, making the public pension fund crisis about twice as bad as the student loan crisis.

Why pensions won't meet their return targets

The National Association of State Retirement Administrations said in February that the average public pension has an annualized return target of 7.22%, and Hulbert doesn't believe they will meet that. NASRA said 71% of public pension plans is invested in stocks and bonds.

Of that total, about two-thirds is in stocks, while the other third is in bonds. Hulbert considered the contribution bonds will make to the pension funds' return target, which is easier to do because bonds' yield is correlated with their long-term returns.

Based on Moody's Seasoned Aaa Corporate Bond Yield, he said bonds will return about 2.5% annualized. For pension plans to meet their annualized return target of 7.22%. he said stocks will have to return 9.5% annualized, which is highly unlikely.

Hulbert used seven valuation indicators to forecast the stock market's return over the next 10 years. They are the Buffett ratio, the price-to-sales ratio, the price-to-book ratio, the q-ratio, the dividend yield, the household equity allocation and the cyclically-adjusted P/E ratio.

An average of these indicators projects a 10-year real return of -2.4% annualized for the S&P 500. He said the range is between -9.4% and 2.4%. When annualized inflation of 1.2% is added in, he gets a nominal return of -1.2% annualized.

When combining these forecasts for stocks and bonds, he said the average stock/ bond portion of pension plans will return only about 1.7% annualized, missing the projection of 7.22% by a wide margin.

Alternatives to save the pension fund crisis?

Public pension funds have been increasing their allocations to alternative assets in hope that it will avert the crisis. NASRA estimates that alternatives now make up 19.3% of the average pension fund's portfolio.

The idea is that alternatives could produce much higher returns than stocks, but it seems unlikely that they will be able to make up for the wide margin pension funds are missing by in their return assumptions. Hulbert believes the research suggests the higher returns that are advertised for alternative investments are exaggerated.

He also noted that they are much riskier, which means they could produce much larger losses in an economic downturn. Given that a downturn has arrived, it seems unlikely that alternative investments will make that much of a positive difference in pension funds' portfolios.

Hulbert noted that the longer state and local governments put off realistic assumptions, the worse the pension fund crisis is going to get, and the more taxpayers will be on the hook for.