The Ol’ Pension Blues

Story Highlights:

• Corporate and public pensions are underfunded, a fallout from the market plunge and from under-contribution.
• The same pension worries surfaced in the late 1980s and in 2002, and it turned out underfunding fears then were greatly overstated, as they likely are now.
• Corporations contributing more funds to pension plans could be a positive for markets if the extra funds find themselves into stocks, as they did in 2003.
• Underfunded pensions are a widely known phenomenon—meaning the negative impact is likely already largely priced into stocks.

The holidays are coming, and we can only guess what's on corporate and public pensions' wish lists: A big wad of cash. Pensions of all stripes are finding themselves underfunded—meaning liabilities (payment obligations to employees) are greater than what's in the bank—a fallout from the market plunge and from under-contribution. The average public pension plan is 35% underfunded, and 92% of corporate pension plans were underfunded at the end of last year.

Solutions to the underfunding issues aren't promising. Aside from Santa's generosity, options include cutting back on benefits, contributing additional funds to retirement plans, or declaring bankruptcy and falling into the safety net provided by federal pension insurers, like the Pension Benefit Guaranty Corp. The recent market surge has helped some, but many pensions are still in the red.

There are worries the pressure to balance pension plans will hold back or even depress economic growth. When corporations shift funds to retirement plans, they do so at the expense of future profits and growth. Some corporations have reduced operations and expenses to maintain pension contribution levels. Employees at companies with underfunded pensions may feel uncertain about retirement benefits and perhaps cut back on spending and/or investing in stocks. Underfunded public pension plans are likewise a worry. Many public pensions are legally bound to provide stated benefits, meaning options to balance liabilities and assets are fewer. And a state or municipal bankruptcy would heavily weigh on taxpayers—not ideal given today's weaker economic environment and high unemployment.

However, the ol' pension blues aren't new. The same worries surfaced in the late 1980s and in 2002, and it turned out underfunding fears then were greatly overstated, as they likely are now. Why? Many pension funds, corporate and public, invest in "alternative investments," like hedge funds and private equity. Following bear markets, companies adjust downward their return expectations for the pension plans. (Similarly, expectations are generally adjusted upward during flush times, leading to under-contribution.) This downward adjustment increases the present value of future assets while the low interest rate environment increases the present value of liabilities, making pensions seem more underfunded than they really are otherwise. A function of accounting! Indeed, accounting for pension fund liabilities is complicated and highly subjective—it tends to extrapolate the most recent phenomena into the future, a common cognitive investing bias.

This isn't to say the pension losses over the last year weren't real. However, the overemphasis on the underfunding issue isn't warranted. Even in 2006, before the recession and bear market, public pension plans were underfunded by $361 billion, and that didn't hold back more growth, nor did it trigger economic or market collapse. Plus, corporations contributing more funds to pension plans could be a positive for markets if the extra funds find themselves into stocks, as they did in 2003.

Underfunded pensions are a widely known phenomenon—meaning the negative impact is likely already largely priced into stocks. More than a market-crushing event, this is likely one more brick in the wall of worry markets like to climb. Though pension plans' balance sheets don't look rosy, investors needn't lose their holiday cheer.