American Pension Crisis: How We Got Here

My adopted home of Charleston might have been ranked the “Best City in the World,” but the state of South Carolina is earning a less distinguished label as a harbinger of the country’s worst pension crises. And yes, that’s crises—plural—because U.S. state and local government pensions have “unfunded liabilities” estimated at more than $5 trillion and funding ratios of just 39%.

What does that mean, exactly?

When a company or government pledges to pay its long-term employees a portion of their salary in retirement—a pension—the entity estimates how much it (and its employees) will need to set aside in order to make those payments in the future. An underfunded pension is one that simply doesn’t have sufficient funds to make its promised future payments.

Corporate pensions in the United States are in trouble, with the top 25 underfunded plans in the S&P 500 alone accounting for more than $225 billion in underfunding at the end of 2015. But states and municipalities are in even worse shape. This week, the Charleston-based Post and Courier estimated that South Carolina’s shortfall alone was at $24.1 billion, more than triple the state’s annual budget!

How did we get here?

There are two glaring reasons for our current pension crisis: poor investment decisions and greedy assumptions.

Pension actuaries assume that contributions to the plan will grow by investing the principal in stocks, bonds, mutual funds, hedge funds and private equity investments. Just like retirement planning for a household, the prudent investor assumes a conservative expected growth rate. But, almost universally, the big pension plans assumed more aggressive rates—because that permits them to commit less of their own cash to the plans.

As pension expert Andrew Biggs points out, this problem is especially pronounced with state and local governments. Compounding the problem of higher-than-responsible rate-of-return assumptions, the investments have performed poorly.

While some of this performance is certainly attributable to the whims of unpredictable markets, we also see evidence of a highly technical syndrome that plagues institutional investors known as knuckleheaded decisions. Its most notable symptom, trying to outsmart the market, all too often results in buying high and selling low.

The following brilliant chart courtesy of The Post and Courier says it all:

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Why did states, municipalities and companies do such a poor job?

The institutions on which financial laypeople have relied to help solidify their retirements simply have fallen prey to the same behavioral biases that affect each of us, individually, in investing.

Wishful thinking led to unacceptably high growth assumptions and therefore lower-than-necessary contributions. Then, highfalutin’ investment managers made poor portfolio decisions that were further compounded by failed attempts to bail out their bad choices. Honestly, a humble DIY investor with common sense could’ve done better.

What can you do about it?

You’re not going to be happy about this, but it’s your only option: When doing your retirement planning, consider underweighting any pension payments you expect to receive, especially if yours is underfunded.

There is an independent federal agency, the Pension Benefit Guaranty Corporation (PBGC), that effectively insures many pension plans—but it is not guaranteed by the full faith and credit of the U.S. government. Oh, and the PBGC is also underfunded, itself.

And if the U.S. government has to get involved in bailing out an “expanding and escalating” pension crisis, it could have broader (less-than-savory) implications.

If you have a pension, examine it. If you’ve not yet retired, most pensions give you an opportunity to elect how your pension will be received. If you have the option to receive a lump sum payout on the front end instead of a pledged stream of income in retirement, you may consider that option seriously. But please remember—if you or your investment advisor makes the same knuckleheaded investment decisions that we’ve seen evidenced in the pension fund debacle, you may be in even worse shape than if you relied on the pension’s stream of income.

Then, whatever decisions you’ve made, we can all do well to consider the South Carolina state motto: Dum spiro spero.

While I breathe, I hope.

This commentary originally appeared December 9 on Forbes.com

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Tim Maurer, CFP®

Tim Maurer, CFP®, is a Wealth Advisor at Buckingham and also serves as our Director of Personal Finance. Tim’s second book, co-authored with best-selling author, Jim Stovall, is The Ultimate Financial Plan: Balancing Your Money and Life. He is a CNBC contributor and also writes weekly for Forbes.com. He is a graduate of Towson University.

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