Defined Benefits Plans Are Ticking Time Bombs

Dear Reader,

Queensland…beautiful one day, further in debt the next.

The Queensland State Government is a shocker. Our Treasurer, Comrade Jackie Trad, is hopeless when it comes to managing the state’s finances.

As reported in the AFR December 2019 (emphasis added):

Queensland’s total debtwhich was already the worst in the nation — was due to top $90 billion by 2022-23.

The solution to our state’s parlous debt situation? Public sector job cuts? Privatisation?


According to the AFR, our Treasurer Trad has something far more ‘creative’ in mind (emphasis added):

…a move by Treasurer Jackie Trad to raid the defined benefits superannuation scheme for public servants to create a new Queensland Future Fund to tackle debt…

How much will this ‘smash and grab’ operation net?

…the decision to take $5bn from the surplus of the public servants’ defined benefit superannuation fund for a new debt offset account…’

The Australian 14 February 2020

Queensland’s newly formed debt offset account

The State’s newly formed debt offset account — sorry, Queensland Future Fund — is expected to offset how much debt?

According to the AFR:

Queensland Investment Corporation [QIC]  would be asked to invest the [raided] money which is expected to deliver returns of about $400 million a year which would be used to pay down debt and interest payments.

QIC expects the $5 billion to generate about $400 million, an 8% return.

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Of course, no one knows what the actual outcome will be…that’s in the lap of the markets.

Comrade Trad’s desperate actions to ‘paper over’ her appalling lack of budget discipline has far reaching consequences.

Defined benefit plans are ticking time bombs…all over the developed world.

Employees — in both the private and public sectors — have been promised guaranteed indexed pensions in retirement.

The pension payment is determined by an individual’s years of service and final average salary.

These plans were commissioned into existence in an era when life expectancies were much lower than today AND risk-free interest rates (government bonds) were much higher. Honouring promises was a whole lot easier.

Not today.

Actuarial calculations — educated guesses on the life expectancy of members; estimated rates of return; future contribution levels — provide a guide as to whether the plan has sufficient funding to meet its obligations.

In Queensland, the number crunchers reckon there’s more than enough in the pot to meet present and future promises…that’s assuming their assumptions are correct.

But, what if members — on average — live much longer? Or, what if estimated future returns are much lower?

Should either or both these variables spring a nasty surprise, then ripping $5 billion out could render the fund incapable of meeting — in full — its promises.

Surely, even our hapless treasurer is aware of the trouble brewing in defined benefit funds in the US?

United in varying states of distress

Some of the more troubled US private and public sector funds have suspended annual indexation and/or reduced payments or in more dire cases, temporarily ceased payments.

The breaking of pension promises has so far been largely contained to smaller municipal funds and company schemes.

In the pension ocean, these plans are the plankton, but what about the whales?

And in terms of states, they don’t come any bigger than California.

If California were its own nation, it would be the fifth largest economy in the world. With a GDP of $US2.9 trillion, California would slot between Germany and the United Kingdom in the world’s top economies.

Business Insider

CalPERS (California Public Employees’ Retirement System) is the fund that manages the pension and health benefits for California’s public sector employees.

The following graphic is from ‘CalPERS — Comprehensive Annual Financial Report Fiscal Year Ended June 30, 2019’:

Money Morning

Source: CalPERS

[Click to open in a new window]

A few things to note here…

The figure of…70.2%…funded. Or to put it another way, CalPERS is 30% UNDERfunded. CalPERS lacks sufficient capital to meet its obligations.

How do the administrators plan to fix this rather serious problem?

With a two-pronged approach…

Assume the fund will deliver a 7% rate of return each year.

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The fund’s performance of 6.7% was just shy of the forecast return…so all good…except, these are the very best of times for markets.

What awaits when the cycle turns and markets head south?

And, the second prong?

Tap the taxpayers.

According to The Sacramento Bee, CalPERS…

…is in a decades-long process of increasing funding to get to 100 percent. State and local governments and school districts have to pay extra until the fund reaches 100 percent.

These are lessons Queenslanders should take heed of. QIC is unlikely to deliver the expected 8% per annum.

And, when returns DO turn negative and the defined benefit fund is declared UNDERfunded, taxpayers WILL feel the government’s fingers reaching deeper into their pockets.

There are 712,000 retirees and beneficiaries relying on CalPERS being able to honour its retirement funding obligations.

And as CalPERS stated in its Annual Report (emphasis added):

Retirement benefits play a vital role in the state’s economy. The most recent Economic Impacts of CalPERS Pensions in California report shows that the $18.9 billion paid in retirement benefits during Fiscal Year 2017-18 to California retirees and beneficiaries generated $23.5 billion in economic activity that supported jobs and increased business and tax revenue. The economic impacts are significant throughout the state, and especially in smaller communities.

The honouring of those pension promises has far reaching economic consequences. Any disruption — suspension of indexation and/or reduction in payments — would have deflationary ramifications…less money going around in the system.

Think about this highly probable scenario.

Markets turn from up to down and the fund falls well short of its expected 7% per annum return.

And, the market downturn triggers a recession that leaves taxpayers unable to provide the additional coffers needed to keep the fund solvent.

What if the unfunded status drops closer to 50 or 60%?

And, what about employees in the private sector?

The February 2020 Milliman report on the health of America’s largest corporate plans, was titled ‘Milliman 100 PFI [Pension Funding Index] funded ratio plummets to 85.7%’.

Here’s an extract (emphasis added)…

As we enter the 20th year of reporting the Milliman 100 Pension Funding Index (PFI), the funded status of the 100 largest corporate defined benefit pension plans fell by $73 billion during January. The funded status deficit swelled to $273 billion due to a decrease in the benchmark corporate bond interest rates used to value pension liabilities.

Based on expected lower interest rate returns, the number crunchers have estimated the funds are UNDERfunded by close to US$300 billion…that’s hardly a rounding error.

The following chart provides some valuable insight into what the future may hold for these funds.

Money Morning

Source: Milliman

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In previous good times (pre-tech bubble bursting and pre-GFC) strong returns put the funds into surplus.

But something interesting has happened since 2009. The long and strong market has NOT delivered the returns needed to put the funds back into surplus.

That tells you something about the sheer volume of liabilities — pension promises — that are building within these funds.

Again, what happens when the cycle turns and funds start racking up negative returns?

Will the corporate sponsors be able to make good the shortfall?

Maybe. Maybe not.

If there’s a severe recession, then bottom lines are going to be adversely affected.

If the corporates are forced to tip the defined pension fund tin, then earnings shrink even further.

Falling earnings multiplied by a lower PE multiple, takes share prices down…further compounding the problem.

Could those companies then be forced to stop paying dividends to meet pension fund obligations?

That’s a very real possibility…especially when you consider what future returns for these funds might be.

The following chart based on estimated (blue line) and actual (red line)12-year returns from a ‘balanced’ portfolio — 60% shares/30% bonds/10% cash — should send shivers down the spine of defined benefit fund administrators.

The forecasting model dating back to 1928 has a 93% accuracy.

Money Morning

Source: Hussman Strategic Advisors

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The current forecast is for the traditional balanced fund to earn ZERO per cent per annum for the next 12 years.

That’s a long way short of the 7% per annum needed by CalPERS and other funds to just tread water in their currently UNDER-funded status.

The Pension Benefit Guaranty Corporation — the US Government agency established in 1974 to guarantee the pensions of failed corporate plans — made this sobering admission in its latest annual report…

The Corporation is in a difficult financial position today. The Single-Employer Program continues to see improvement; however, it still faces considerable risk. The Multiemployer Program faces a crisis that threatens the retirement security of millions of American workers, retirees, and their families. Without reforms, our Multiemployer Insurance Program — the backstop that is the last resort for retirees when a plan fails — is very likely to become insolvent in 2025, leaving participants and beneficiaries with significantly less than the level of benefits guaranteed by the PBGC. The alarm bells are ringing, and legislative changes are necessary.

Difficult financial position. Insolvent in 2025.

How many current (not, future) participants are we talking about?

…the Corporation provides retirement security for about 1.5 million participants and beneficiaries in more than 4,900 plans that have failed since PBGC was established.

That’s a lot of households.

Please remember all these funds are struggling AFTER benefiting from the longest bull market in history.

When bull turns to bear, these funds are going to be faced with a serious reality.

What’s happening in Queensland is part of a global story…one where hope is triumphing over reality.

Hopes for an 8% return, in an environment where government bonds are paying less than 2%, will be dashed.

Hopes for pension promises to be fully honoured, will prove to be misplaced.

The deflationary impact of shrinking retirement incomes — lower pension payments and lower dividend payments — will mean hopes for tax revenues do not eventuate.

The reality is this cycle (like all previous cycles) will rotate from up to down.

When it does, the chronic underfunding in defined benefit plans will create doubt over the payment of these promises.

And if people are a little suss about receiving their promised pensions…they’ll rein in their spending.

Defined Benefits Plans will become mockingly referred to as ‘Deflation Breeding Plans’.


Vern Gowdie,
Editor, The Rum Rebellion

Vern has been involved in financial planning since 1986.

In 1999, Personal Investor magazine ranked Vern as one of Australia’s Top 50 financial planners.

His previous firm, Gowdie Financial Planning, was recognised in 2004, 2005, 2006 & 2007, by Independent Financial Adviser magazine as one of the top five financial planning firms in Australia.

In 2005, Vern commenced his writing career with the ‘Big Picture’ column for regional newspapers and was a commentator on financial matters for Prime Radio talkback.

In 2008, he sold his financial planning firm due to concerns about an impending economic downturn and the impact this would have on the investment industry.

In 2013, he joined Fat Tail Investment Research as editor of Gowdie Family Wealth. In 2015, his book The End of Australia sold over 20,000 copies and launched his second premium newsletter, The Gowdie Letter.

Vern has since published two other books, A Parents Gift of Knowledge, all about the passing of investing intelligence from father to daughter, and How Much Bull can Investors Bear, an expose on the investment industry’s smoke and mirrors.

His contrarian views often place him at odds with the financial planning profession today, but Vern’s sole motivation is to help investors like you to protect their own and their family’s wealth.

Vern is Founder and Chairman of The Gowdie Advisory and The Gowdie Letter advisory service.

The Rum Rebellion