by John Mauldin, Thoughts From the Frontlines, Mauldin Economics
Highly Sensitive
Investing is Hard
Unfunded Security
Thoughts on Employment, Rates, and Fed Policy
Dallas, Denver, and Tulsa
Historically speaking, this phase of life we call âretirementâ is a new concept. The idea you could stop working at a certain age was unknown until quite recently. People worked as long as they physically could, then died quickly unless they had family or servants to care for them. That was normal and accepted.
Now, we have different expectations, at least in the developed world. We think life should end with a decade or two of relative leisure. The challenge is that leisure isnât free. The population that isnât working to support itself needs some kind of funding mechanism... and thatâs where it starts getting complicated.
Ideally, retirement would be self-funded, with people accumulating savings during their working years to be spent in retirement. This is easier said than done. Many people either canât or donât save enough, for a wide variety of reasons.
But the real problem is the large number who think theyâre ready for retirement but actually arenât. I described some of the reasons last month in Pension Sandpile, but itâs actually even worse. Not only are the sandpiles going to collapse, but millions will be under them when they do.
Today, weâll look deeper at this problem. As you will see, modern pension plans and retirement schemes depend on assumptions no one should take for granted, yet practically everyone does.
Highly Sensitive
The âunderfunded pension plansâ we hear about are typically defined benefit (hereinafter DB) plans. That means the beneficiaries (i.e., retired workers) are promised certain payments on a defined schedule for life. Sometimes they get healthcare benefits, too. What isnât defined so clearly is where the money will come from and how much is needed.
We need to understand the difference between âunderfundedâ and âfully funded.â Iâm going to try and explain this with a simplified example. (Readers with pension expertise will recognize Iâm omitting many details. Theyâre important but tangential to the point here).
Suppose you are in charge of a local governmentâs defined benefit plan: a fire department, for example. You know how many firefighters are vested in the plan, when they will reach retirement age and how much their monthly benefits will be. Add some life expectancy data, and you can build a liability schedule many years into the future.
Your estimate shows that in 2032 you will have 1,000 retirees each due to receive $50,000 a year. (Iâm using round numbers for simplicity). So, you need to have $50 million in cash available to pay themâbut you donât need it now. You have ten years to accumulate it.
With this knowledge, you can make a âpresent valueâ calculation. What amount of money do you need today to be confident you will have $50 million in ten years?
Of course, this depends on the return you can make between now and then. Assuming 3% annual returns for 10 years, $37.2 million now will become $50 million in a decade. The magic of compound interest.
But this is highly sensitive to your rate assumption. At 5%, you only need $30.6 million. Assume 7%, and itâs only $25.4 million. Conservatively assume 1%, and youâll need $45.3 million. (You can play with the math yourself here.)
Naturally, since we all like to keep our problems manageable, pension sponsors gravitate to higher-return assumptions. This lets them minimize the current yearâs contributions, thereby pleasing both taxpayers and firefighters, but it doesnât change the math. Problems will follow if future returns donât match assumptions.
Note this example is only about one year of future liabilities. The real picture is much more complex, with liabilities extending far into the future. We call a plan âunderfundedâ when its current path will make them impossible to pay at some point. And those assumptions can be optimistic. If you project a 7% return and only get 4%â5%, your pension consultant can say you are funded correctly based on the assumptions, but the real-world, bottom right-hand corner number will say something else.
Sadly, in so many towns and states, they take the rosy projections and move on because to take the less optimistic (if realistic) projection means you have to take money from the current budget that is for police and potholes and parks. Too often, the decision is to put off the pension contribution another year and then anotherâŚ.
And itâs critical to understand, pension benefits arenât optional. They must be paid as defined, and failure to do so constitutes default. In some states, governments are constitutionally required to pay the full benefit as promised. Seems fair, but what happens when pensions become 50% or more of your budget, and you want to raise taxes?
Itâs even more complicated, though, because the liabilities themselves also involve assumptions. I mentioned life expectancy. Thatâs fairly predictable in a large enough group, but things can change. A cure for cancer or heart disease would be wonderful for humanity, but a big problem for pension liabilities.
Then, thereâs inflation. Many (most?) DB plans include cost-of-living adjustments based on CPI or some other benchmark. That means the calculations have to reflect real returns. They donât need just 3% (or whatever target they pick) for ten years etc. They need 3% more than inflation for that period.
Positive real returns donât happen automatically, particularly in an economy as indebted as ours and with the kind of fiscal and monetary mismanagement as is now normal. Sheer size prevents giant plans from outperforming benchmarks. On a long time horizon, the best assumption is they will grow only to the extent the economy grows. Which, based on GDP in the last decade or so, means 2% real returns and probably less in the future. Few employers can afford the contributions needed to make a DB plan work at that rate.
But the real problem is uncertainty. Defined benefit pensions are structured around so many assumptions about things no one can knowâthe long-term risks are incalculable. Thatâs why private businesses largely abandoned them long ago.
Those who have the luxury of imposing taxes think differently; hence DB plans are still popular in governments, which can transfer the problem to other people who didnât create it.
Investing is Hard
In theory, DB plans can work with conservative management and some good luck. Those are uncommon. They are a bit like banks in a fractional reserve system. Itâs a giant juggling act in which some jugglers are going to miss. You just donât know who or when.
The banking system works because it has a lender of last resort: the Federal Reserve System. DB plans likewise have an ultimate guarantor, the federally chartered Pension Benefit Guaranty Corporation (PBGC). It lacks most of the Fedâs powers and is itself underfunded. Even when PBGC works, the benefits it pays to workers in failed plans are often much less than the workers were promised. And it only covers private-sector plans, not the state or local governments where most of the problems lie.
As noted above, the private sector has mainly moved to 401K and similar âdefined contributionâ plans. Employers and workers contribute cash each year, after which the returns depend on how the worker chooses to invest. Employers like these plans because they donât create future liabilities for the employer. The risk doesnât disappear; it is simply transferred to the workers, who may or may not be able to retire with as much income as expected.
Here we have a disconnect. Many workers like 401K plans because they get to control their own fate. Othersâmaybe mostâhave no interest in making investment decisions and wish someone else would do it for them, as happens in a DB plan. Itâs not clear either group gets optimal results. Investing is hard even for full-time professionals. Sometimes it seems especially hard for full-time professionals.
Worse, workers get tempted to withdraw and spend their retirement funds every time they change jobs, which, in this economy, is pretty frequent. The tax penalty often doesnât deter them, particularly young people for whom retirement is a distant thought.
As a result, it is not a good assumption that someone is ready for retirement simply because they have (or had) a 401K or similar plan. Their assumptions may be as unrealistic as those defined benefit plan sponsors.
Then thereâs the awkward fact that many workers spend all or most of their working years without a 401K. Employers arenât required to offer them. Many donâtâor didnât until quite recently. IRAs are more widely available, but the worker must take some initiative to make it happen. People have other things on their minds. And even if they recognize the need, saving is tough when you are in the bottom 2%â30% of the income scale with a kid and high gas and food prices.
All that means the âunfunded pensionâ problem is far bigger than some firefighters and teachers not getting the retirement benefits they expected. Millions more will reach retirement age in the same (or worse) position because their 401K and IRA plans didnât perform or they didnât save enough.
Strong stock market performance and generally falling interest rates (which help bond returns) insulated us from the consequences of this for a long time. Those days are running out, I think.
âBut John,â you say, âThose who didnât plan or had bad luck still have Social Security. Theyâll be all right, even if their golden years arenât so golden.â
I wouldnât be so sure of that.
Unfunded Security
In the United States, we have a Social Security retirement system covering, more or less, everyone who ever had a job. It is financed by a âFICAâ tax levied on workers and employers. A retireeâs benefits are calculated from a formula that considers their age and the wages earned from all their jobs.
Functionally, Social Security is basically a giant defined benefit plan. Participation doesnât require any action on your part. You do have some discretion over when you retire, which can make a difference. Otherwise, just have a job, and everything else is automatic.
The original idea was that Social Security would be self-supporting, with taxes from a much larger number of workers supporting a smaller number of retirees. That has been mostly true, but is increasingly difficult. The latest Trusteeâs Report shows the trust fund that covers retirees and their survivors will be depleted in 2034.
In other words, Social Security is âunfundedâ in much the same way as many defined benefit plansânot a problem right now, but it will become one if nothing changes.
One hopes Congress wonât wait until 2034 to address this. Delay will make it harder, not easier. Retirement ages, means testing, and benefit amounts will probably be on the table. Some of this is long overdue. The world has changed since the 1930s when age 65 was considered âelderly.â We live longer, healthier lives now.
That brings us to another difference between Social Security and defined benefit plans. A DB plan is contractual. The employer and workers agree to do certain things, and it is very hard for the employer to escape its benefit obligations.
Social Security isnât like that. You donât have a contract with the government. Congress can change the rules any time, the fact that you paid all those FICA taxes notwithstanding. A 1960 Supreme Court case, Flemming v. Nestor, ruled Social Security is just another benefit program and FICA is just another tax. Paying the tax doesnât âearnâ you anything in return.
Congress wonât want to kick that hornetâs nest, of course, but it also doesnât have magical powers. Faced with limited revenue, limited borrowing capacity, and many competing spending plans, it will have to make hard choices.
I think history will look back and see this dream of a long, leisurely retirement was never sustainable or scalable for the whole population. Most of those who expect such a retirement will be sorely disappointed.
My longtime mentor Dr. Gary North always said the best retirement plan is âDonât retire.â He took his own advice, too, working almost to the end. Ideally, we should transition into a different kind of work that matches our changing abilities. Keep generating income however you can for as long as you can, reserving the portfolio assets until you really need them.
My part of this is helping readers like you make the most of your portfolios, however big or small they are. I intend to do it for many more years, too.
Thoughts on Employment, Rates, and Fed Policy
There is so much more we will cover in the future on pensions, but I want to make a quick comment on the Fed, interest rates, and policy.
First, the jobs report was fairly solid, with a 261,000 increase, 70,000 more than projected. It wasnât so strong that it totally crushed hopes of an early 2023 pause, so the initial market response was positive. Weâll see by the end of the day and next week. But there are some caveats.
First, this report continues a string of generally lower monthly job numbers:
âSmoothing out the monthly volatility puts the 3-month payroll average at 289k vs the 6-month average 347k, the 12-month average of 442k and the 2021 average of 562k. Thus, the slowing trend is now obviousâŚâ (h/t Peter Boockvar)
Second, government jobs were half the upside surprise. When looking at the Household Survey, we see LOSSES of 328K, and get thisâŚthose aged 45 to 54, which are prime earning years, had LOSSES of 406K. This shows a reluctance to hire and a willingness to cut more costly employees.
Third, the birth-death model added around 455,000 jobs, which was 100,000 more than the same month last year. I have been doing interviews recently where I point out the BLS employment numbers always miss the turning points, and the reason can often be found in the birth-death jobs assumptions. (Note: this is the birth and death of businesses, not people).
We are clearly at an inflection point. Jerome Powell seems ready to keep raising rates until he sees an unemployment number create more angst than the inflation number. We do not know what that number is. Certainly not this reportâs 3.7% unemployment (up 0.2%), which is historically still quite strong. I donât think Powell knows what inflation/unemployment combo will justify a pause. This is one of those âweâll know it when we (Powell) see itâ things.
I still think a 5%+ Fed funds rate and a 5%+ unemployment rate is as good a guess as any. And thatâs what it may take to drive a stake through the vampiric heart of inflation. Instead of blood, the inflation vampire sucks buying power and retirement lifestyles of those on the pensions we mentioned above.
Will the Fed only hike rates by 50 basis points at the next meeting? Maybe, but Powell made clear that a lower trajectory does not mean a lower ending Fed funds rate. As I have been saying for a long time, Powell sounds and acts like he found his inner Volcker. Those hoping for a
âpause and pivotâ may have to wait a lot longer than they think. I donât think Fed officials will cut rates until they see inflation under control and moving in the right direction.
Interestingly, once the Owner Equivalent Rent inflation numbers roll off and the current lower prices start showing up in the data, given all the other disinflationary forces out there in the supply chains getting fixed, we could see inflation retreat fairly quickly (over a quarter or two). THEN, just maybe, possibly, weâll get a rate cut or two.
In the meantime, the big wheel of interest rate hikes will keep on turning.
Dallas, Denver, and Tulsa
I will be flying to Dallas November 16 and hope to do an event there to meet clients and friends that evening before flying to Denver to speak at the CFA dinner with Vitaly Katsenelson. It will be quite fun. Then back to Dallas, meeting up with Shane to visit friends and go through storage (the joys of moving and realizing it all wonât fit into the container). After four years, maybe we need to move on, LOL. Except for my motherâs cookbook. I really want to find that! Then to Tulsa on Wednesday to be with my family for Thanksgiving.
My 50th reunion at Rice University was interesting and fun. More classmates showed up than I expected. We had a âgroupâ meeting, and someone asked what the one thing that we learned at Rice that really made a difference was. Lots of very good, uplifting answers. When asked, I said that Rice taught me that I was just average at some things. I came from a large high school, never really had to study, etc. One of those kids. It took me about 6â8 weeks to realize that I was not going to get the next Nobel in physics, assuming I could get through that first semester. It wasnât that I couldnât do the math, etc. I could⌠just not at the level of my classmates. (And I had to learn to study my ass off in a few weeksâgood training for my current life!)
Just like I donât walk onto the football field, I had to recognize where my talents lay. Turns out, I, over time, learned I had a talent for writing and interpreting data, and I could hold my own. It helps that I get to do what I love. It wasnât that I was completely average, which is the case for most things, except those at which I am quite below average (athletics). I just had to find a corner of the world where I could play at a higher level.
Follow your passion? I can get passionate about many things but still lack talent in them. So, follow your real talent and go there. Which brings up the question, which came first, the talent or the passion?
And you, gentle reader, make it possible for me to follow both passion and talent. Thank you so much. I hope my writing helps you follow your own path a little better.
