The Biggest Story of the Week

Or the year. Frightening.

I’ve been wondering why the impact of the financial crisis on the overall retirement “system” hasn’t gotten more attention in the media. We already knew the system was in bad shape before September 2008. According to the Fed’s Survey of Consumer Finances, in 2007, only 60.9% of households where the head of household was age 55-64 had retirement accounts . . . and their median retirement balance was $98,000. Given that the stock market has fallen by over 50% from its October 2007 peak – and that, for decades, the standard investment advice has been that stocks do better than any other asset class in the long term – we would be lucky if that median balance were more than $70,000 today.

The Bloomberg article linked to above describes the fragile state of state and local pension systems. These systems suffer from two major problems today. One is that even if they had been managed in a reasonable way, the fall in asset prices over the last year would have blown a huge hole in their long-term solvency.

The second, and the focus of the article, is the perverse behavior that is caused by accounting rules governing pension funds. The key question for a pension fund is whether the assets it has today will be enough to pay off its future liabilities. The assets are relatively easy to value, at least most of the time; the future liabilities are relatively easy to predict actuarially (although unanticipated developments, such as a sudden change in life expectancy, could mess up that calculation); but the hard part is estimating the rate of return on the assets. So . . . public pension funds are allowed to assess their long-term solvency using assumed annual rates of return, generally around 8% per year. Of course, as we know, things don’t always work out that way: the Vanguard Balanced Index Fund (which indexes virtually all U.S. stocks and bonds) has an average annual rate of return of 0.9% over the last 10 years, and even since its inception 1992 its annual return is only 6.0%.

These optimistic assumptions are bad enough, because they allow underfunding of pensions. But what’s even more bizarre is the behavior this causes. As the Bloomberg article explains, local governments issue pension obligation bonds to raise cash for their pension funds. These bonds usually pay fixed interest rates, say 6%, and the proceeds are then invested in risky assets. But the magical thing is that because you are allowed to assume an 8% return, for pension accounting purposes, the difference between 8% and 6% is free money! Well, it’s free money as far as this year’s assessment of the pension is concerned. In the long term, of course, it’s a crazy investment strategy (and a mistake many people make – comparing a risk-free interest rate you borrow money at with a risky expected rate you hope to earn). And the results in the future are predictable: either higher taxes, or yet more value-destroying pension obligation bonds. Sometimes people get caught saying stupid things, like Christine Whitman saying, “You’d be crazy not to have done this. It’s not a gimmick. This is an ongoing benefit to taxpayers,” but it’s really a systemic problem.

Our retirement “system” has four main legs: Medicare, Social Security, corporate or government defined-benefit pensions, and private saving (IRAs, 401(k)s, etc.). Right now it looks like Medicare and Social Security are the stronger legs.

Note: The Bloomberg article refers disapprovingly to Jon Corzine’s proposal to reduce state pension contributions during the recession. I actually agree with Corzine, at least on principle. When the pension fund’s assets fall because of a recession, you don’t want to force the state to make up the difference immediately, because that would be extremely procyclical – it would cripple the state budget right when you want to be spending more, not less. The converse, of course, is that when the economy is good and tax revenues are high you should over-contribute to the pension fund – not just make up for the recession years, but also build up a surplus. We’ll see if that happens.

41 thoughts on “The Biggest Story of the Week

  1. James,
    I think you don’t see more about this in the “news” for two reasons. First, ordinary Americans are not well trained in knitting together information from disparate sources to create a wholistic picture. So what’s happening to the investment banks, for instance, doesn’t necessarily mean anything to them regarding pension or retirement savings. And no one in the media really wants to draw clear, stark lines, mostly because the media is partly complicit in the current financial crisis (since they didn’t ask hard questions when times were “good”) and they fear backlash.

    Second, since many Americans decided not to save for retirment, there is a cognative disconnect where in people aren’t clamoring for more information because then they willhave to admit to personal mistakes.

  2. You know, these pension funds that are hurting could really plug their holes and help each other out by buying up each others’ bond issues. Sure, it’s just shuffling money from one pile to another and back again, but isn’t that what governments do best anyway?

  3. Great and timely post. Let’s assume that most state and municipal defined benefit pension funds had a negative return over the last year of (30%)… probably optimistic. The asset base will be down accordingly, even if “smoothed” by the actuaries. Meanwhile, liabilities will tend to remain unchanged. It will be interesting to see if these same actuaries continue to allow an 8% future return assumption.
    Social Security, with its self adjusting mechanism, remains the most soundly funded pension scheme in the world.

  4. 401k-type Retirement plans aren’t for everyone. My mother and father-in-laws made, on average, 50-60K a year combined, lived extremely cheaply (paid 30K cash for their house), and saved cash. Now retired, they live relatively well. Travel some. That said, they come from modest means and have low expectations. If you want to fly to the Caribbean once a year and have two homes, drive a BMW or whatever, then you have to take risks. And the downside is that you might lose money. I think people are having buyer’s remorse now. Anyone that has a 401k feels like a mini-Madoff victim now.

    Question: Isn’t this really the reason behind DJIA’s slump–no one’s buying so prices are depressed? “Normal” people are realizing that the stock market is NOT a risk-free zone. Returns are NOT guaranteed, even as market proponents tried to convince us otherwise.

  5. Another issue is that the banks have been complicit it pushing public agencies to borrow for arbitrage, and continue to do so through this economic crisis.

    While state retirement funds may be “smart” to avoid the sales jobs, the latest is the big push to cities and local school districts to borrow to fund retiree health benefits for GASB compliance, which in California are the obligation of the local district. These smaller agencies are not always staffed to understand the downsides which are left unexplained in the sales presentations, leading to pretty ugly deals.

    The banks make money on potentially three sides of the deal–the borrowing transaction fees, the holding of premium and essentially secured debt (CTA – 6.8% looks great right now) instead of reselling, and the reinvestment of the bond proceeds.

    It may just be the only “perfect” investment for banks right now, and it deserves far more scrutiny.

  6. Oops. Bogle & Buffett have been on the case for awhile. It happens in every bear market.

    The public policy issue is whether to rescue defined benefit plans but not defined contribution plans.

  7. “You’re putting a bigger burden on your children,” he says. “It amounts to a transfer from tomorrow’s taxpayers to today’s employees.”

    The boomer generation, having undersaved and overspent for 30 years while proclaiming their children lazy and shiftless, now want to retire in style – and have their children pay for them, as well as the 12 trillion dollar federal debt.

    And they still complain about their children – who, btw, work more hours for less (real) pay than they got.

    The sad thing is – this is a generation with vast political power, which found it convenient to back the Reagan anti-tax philosophy when they were in their peak earning years, and now finds it convenient to commit current earners to more debt.

    I re-iterate: this is debt that should never have been issued, and as such does not deserve to be honored. It _cannot_ be paid back in full; any attempt would destroy the economy and cripple productive employment of resources. Retirees will need to accept a lower standard of living, and this will ultimately be delivered through inflation.

    The beneficiaries of lower taxes back then (1980s) accumulated significant wealth, and are now taxing productive employment to pay for their wealth accumulation – wealth that was retained by forcing public institutions to engage in debt financing.

    The rational – and ultimately necessary – response to this is to tax accumulated wealth, and that will occur in the form of inflation.

    And this is unfair to those funds which actually kept current and were operated honestly. Their accumulated wealth will be devalued to fund past consumption. (If it already hasn’t been devalued by the equity and bond markets.)

    No matter what, _someone_ is getting hosed.

    Of course, the deep problem raised in this article is that modern medicine is keeping people alive longer, but not necessarily keeping them productive longer. This parallels our other bioethical issues. Namely, at what point do we say that rather than spending 3 million USD to keep a cancer patient alive 6 more months, that money would be better spent on neonatal care, education, infrastructure, preventative care, new antibiotic research, etc…

    So the real problem is that we have gutless pandering politicians who avoid hard questions, and voters who like to be pandered to, to be deceived, and to sell out their children.

  8. They have under saved because they did not have a good capital market to invest in – we should try the following capital market system:

    Capital markets are unstable. In the past there was no way to make them stable. But today we have computer power that can be used to make them stable. By using the greater computer power of today we can have a much higher turn over of capital in the capital market. This higher turnover will make the market harder to game or control and the market will no longer have the unstable run ups or declines. Who can change or control the market when say 20% of the capital is trading each day? So now that we have the compute power to provide for all these transactions that will smooth out the market how do we force people to turn over at a rate of 20% a day? Easy, put a cap gains tax of 0% (zero) on all gains of 7 days or less and put a cap gains tax of 90% of all gains of more than 7 days. The likes of Yahoo, Micosoft and/or Sun Micro Systems will give us the systems that will provide automated software agents to support turning over one’s investments every 7 days (based on the specs you give the agent). A system like this will make the financial markets work as smoothly as the local fruit market.

  9. On your last point – would it not make most sense for the pension funds to just keep buying at the same rate year after year? They get the benefits of dollar cost averaging, the market gets the benefit of predictable inflows, and it makes the whole issue a logistical one, not a political one.

  10. We just passed a stimulus with a mighty amount of state budget stabilization money. Since I don’t have the Act memorized, does anyone know (off the top of their heads) if there are guidelines which keep states from using stabilization funds to pay off pension losses or shortfalls?


  11. Many state governments face pension and retiree medical options that cannot be met. This was true before the economy collapsed and is doubly true now. The states are held hostage by public sector unions and Obama’s so-called stimulus package bails out the public sector unions much as the bailout of GM and Chrysler is a bailout of the UAW.

    A teacher in Ohio can retire at age 57 with a pension equal to his salary plus medical benefits. The pension fund that supports this was 80% funded on an assumption that actuarially certain costs could be met with an 8% average market return. That was last year. My guess is that these pensions are now 50% funded. This is nothing but creating the illusion of wealth through leverage – shorting T-bills to invest in junk bonds.

    We have been deluding ourselves for decades – making promises to each other that can’t be kept and banking on these promises. The goose that laid the golden egg is covered with parasites and getting sicker every day.

    By 2016 if not by 2012, it will become obvious that the draw-down of the Social Security trust fund cannot be financed because of the multi-trillion dollar deficits that Obama will run to buy off the constituencies of the Democratic Party and insulate politically-connected bankers from their errors.

  12. as a 66 year old male..still working… I agree with you wholeheartedly. Medicare part D is a boondoggle to the useless and lazy demanding elderly..we should be, as you say, investing in the young people. Adam Smith said it 220 years ago that democracies will only last about 200 years ie until such time that the electorate understand that they can vote themselves unlimited which time the whole house of cards comes crashing down. What we need is honest and bold visionaries and I dont see any out there..

  13. I understand that the major cause of continuing losses in the market is the ongoing shorting of credit default swaps- as Ben Stein said the other night, the speculators are killing the investors. Can anyone shed light whether this is so and how it can be allowed to continue?

  14. I’ll weigh in with an alternative thought….that the mantra of “long term buy-and-hold” investing is the best sales job the financial industry has ever perpetrated… almost approaches fraud! It suggests that you really don’t have to think, and many have not thought. It systematically avoids the selling decision and the idea that some days it is wise to get out of harm’s way. Further, it has lead far too many individuals and those responsible for pension plans to fund near term obligations with long term assets. The bulk of the investment industry deserves significant blame in the crisis that most surely will befall the baby-boomers.


  15. I heard Simon Johnson today on Terry Gross’ Fresh Air and on Lehrer’s news hour. I think he is spot on.

    Regarding the Bloomberg article and his comments on it, I have long wondered how it came to be that tax money is expected to pay for possible pension fund liabilities. I think this is nuts and needs to be changed. After all, most employees do not even get pensions, yet are expected to pay for those who do if their pension funds fail.

  16. In response to charles williams, it was Ronald Reagan who increased the national debt from 1 trilllion to 5 or 6 tirllion in 8 years and G. W. Bush who went form 6 trilllion to 11 trillion. Reagon and Bush took the S.S. inrreases created by Jimmy CArter and gave the wealthy a tax cut and gave S.S. Iou’s. Now there is not enough moneyto pay the IOU’s back. Remember the Lock Box talk during the 92 presidential campaign. well there was no lock box. It’s is not Obama’s fault that we are in the mess we are in it is the Republicans REagan, Bush1 and Bush2 faults.

  17. One of the benefits which businesses got relative to their employees was the shift of responsibility from the employer– the defined benefit plan– to the worker, the defined contribution plan, which placed investment risk on the worker in the form of a savings plan. This represented a large benefit to many businesses (I have seen the numbers). It is sad to see we could have provided more to our employees in retirement benefits given what many of our businesses have lost over the last decade better to spend on that than some of the things that were spent on.

  18. Things like this will make the future, for lack of a cleaner word, SUCK for the Gen X and Y’ers.

    Heard on Twitter today

    @prospectus-I gotta say, if you think you won’t get taxed again on your Roth IRA someday, I’ve got some beachfront property in Iowa to sell you

    He/She is probably right.

  19. The 401k defined contribution approach to retirement planning has largely proved a bust. It’s not hard to find the reasons. The average citizen has about as much idea of how to manage an investment account as they do about performing brain surgery. And they can hardly be faulted in an environment where the “professionals” have lost billions. I’m afraid this is one of those situations where good old paternalism provided it’s properly regulated is the better approach. When Bush was talking about privatizing SS a couple of years back numbers were being kicked around like for 80% of people SS were more than 50% of their income, for 40% of people they were 100% of their income. These numbers against the current background where the market is back to 1997 levels make me say thank god for FDR.

  20. Pulic pension funds are simply another underfunded government program. With 30 years of tax-cutting and 30 years of increased government spending, the only way to pay for prisons, Medicaid, education, AND pensions was add debt. The idea that there was a free-lunch because government could re-fund debt is now seen for what it is… a fantasy.

  21. It’s easy to whine about government spending and deficits. It’s difficult to shine a light on your own finances. And this syndrome is aggravated by the way in which official Washington has gotten so hung up on Social Security as being the be-all and end-all of our retirement crisis. In actual fact, Social Security is by far the most solvent part of the whole picture. The only thing that really puts Social Security under is a severe Depression COMBINED with ending immigration. At the rate we’re going we might just get there.

    Taxing the rich is a crucial part of the picture. They’ve had the equivalent of a lottery win over the past generation, even with the recent declines in their stock portfolios. But that alone won’t solve the problem. The other thing that has to give, and give now, is retirement benefits for the Baby Boomers. They’re going to have to slim down. As the system is presently configured, it amounts to generational theft. Nobody born after 1960 will be able to retire at all unless something is done.

  22. One of the first steps to take is ending the automatic increases in the pension amount. The pension should be sufficient for people to live on, but little more; if people want luxuries in their retirement they should make provision for that. I think having a safety net is essential – in fact it should be a safety mattress, because people can slip through the gaps in a net – but it shouldn’t be a particularly comfortable mattress!

  23. I wonder how many of the “assets” in the pension funds are AAA securities that are only rated as such because of a credit enhancement from AIG? The Bloomberg article talks about stock market losses, but do the pension funds have issues with caluations of CDOs and CDS’ as well?

  24. This post reminds me of something I heard about the Carlyle Group some time back. From what I heard, they had taken a teacher’s pension fund in Canada and just convinced those folks that Carlyle knew what was best for their money. So for me, the issue isn’t just how people’s pensions are being lost, I have reason to believe that these pension funds are already gone due to unsound financial planning and downright corporate theft. We will see how this one unravels in the next few months, no doubt.

  25. This is another very important topic that I’m confident that the federal government will not act upon until there’s a crisis…..and I mean elderly pan-handling on every street corner. Here’s the recipe for elderly impoverishment: allow companies to do away with pension plans, replace them with 401K plans that are voluntary….that is if the company even offers a 401K plan at all, provide little to no guidance to employees on how to invest the money in their 401K plans, give them the option to withdraw funds from their 401K’s when they change jobs…every 3 years or so, force people to tap into their home equity in mid-life to pay off credit card debt, uninsured medical expenses, college tuition, etc…..thus never building up any equity in their homes, add an underfunded social security program and voila.

  26. Assuming large portions of Obamas spending splurg end up getting derailed by both republicans and some democrats – then we can assume that the markets will be much higher 10 years from now than they currently are. That being the case, a dose of dollar cost averaging by the state, at this time of buying (we hope low) would be wise.
    Now, if this spending binge is allowed to actually be implimented then thats another story. But, it won’t matter because there won’t be a market.
    Your blog is thought provoking

  27. I am reading “While America Aged,” a great book by Roger Lowenstein that deals with this very issue. The stories about GM, the New York MTA (remember the strike? it was about pensions) and the San Diego debacle are scary. Pensions are easy to abuse, because politicians can please the unions without immediate spending. By the time the bill comes due, they are long gone.

  28. “One is that even if they had been managed in a reasonable way, the fall in asset prices over the last year would have blown a huge hole in their long-term solvency.”

    Did you mean to say that the fall in asset prices –wouldn’t– have blown a hole in their long-term solvency?

  29. Brian J – I think the point made is correct. Even if the pensions had been run efficiently, invested to the necessary levels, and monitored carefully, the recent falls would have made the pensions underfunded.

  30. The situation is a bit different than described here. About half of retirees today survive only with Social Security income – and most people’s remaining asset is the home they own that reduces their expenses. Medicare also helped keep costs down – but that this is the system that is unsustainable as is. The project debt here – if things continue – is much larger than what we have accrued to date. Thus, Obama needs to have forces pulling together to resolve the health care system and avoid incurring much higher deficit levels.

    For the other half of retirees, many of these people had pensions. The shift in recent generations has been to place the responsibility on us [IRA & 401k] rather than the pension system. It is the most recent generations that got the benefit of the US being such a large part of the global economy that they received benefits unsustainable to us.

    We boomers were just deluded with the two decade rise in stock & home values. And now we have to deal with what we had hoped to avoid facing. More saving to have a decent retirement. And fixing the system to ensure we leave things decent for our kids – as we had already done to help end the war & get the environment back on track.

  31. I’m writing to comment on the financial crisis and to let people know there ARE other options out there besides simply suffering and watching our savings erode. I moved to Costa Rica from the U.S. in 2005 and I can’t stress enough the difference in attitude between those in the U.S., and the American friends I’ve made in Costa Rica. Everyone is saying, “Thank God I am living here. I couldn’t imagine retiring in the States.” The fact is, thousands of Americans are retiring to Costa Rica to maintain their quality of life. The cost of living, climate and safety record are the main factors for most people. I pay $25 a month for electric, $5 for water, $25 for my cell phone, and my property tax is less than $100 a year! I also don’t have to pay for heating or air conditioning because where I live, in the Central Valley, it’s typically 70-85 degrees every day of the year. It doesn’t matter what your income bracket is, everyone can appreciate those numbers.

    Admittedly, it doesn’t make sense to come here on your own to explore retirement options–having a network of people you can trust will make the transition a lot easier. So, in 2006, I started a company called “Boomers in Costa Rica.” Our company introduces clients to experienced professionals and to the type of real estate options that are only from reputable sellers. We generally help explore retirement and investment options in Costa Rica. If you are interested in learning more, the website is

  32. Just an FYI for those not already in the know. The average American is not going to retire at 65.

    It’s not just the current economic crisis. It’s 10 years of basically 0 returns on the market from 2000 to 2007 (pre-crash). It’s the decade of inflation “out-performing” prevalent interest rates. It’s 25 years of trade deficits and the systemic de-industrialization of the country.

    When the pension funds come up short, the US government will be the back-stop. But without real internal economic growth, the pensions will be covered with “printed money” making the existing pensions all the less valuable.

    At the end of the day people at 65 will receive a pension. But the average pensioner is quickly going to realize that they are not going to make it to 85 on that pension.

    And honestly, my father and I discussed this in 1999 when talk at the time focused on a lack of jobs for new grad.

    The math is really obvious, if everyone plans to retire at 65 and live until 85 or 90, you end up with a populace where half the people are working and half are “sponging” (those under 20 and over 65). Given that we have the baby boomer “bump” we’re going to have even more than half of the populace slated for sponging. In an economy that’s already in massive debt! (there a whole blog post here)

    So the point remains, the average American is not going to retire at 65. Now is the time to accept that fate and start figuring out how work and survive until 70 or 75. I’m already planning to, so should they.

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