Naked and Underfunded

The law of unintended consequences is not a new idea, in fact John Locke was the first cat to bring it up over 300 years ago. Locke said reducing interest rates wouldn’t benefit borrowers the way it’s intended but would simply take income away from “widows, orphans and all those who have their estates in money.” Locke saw a number of unintended consequences from dropping rates from 6% down to 4%, namely that the people who would be hurt the most would be the people who needed the money the most. 

What do you think he would have to say about the unintended consequences of negative rates? One of the most critical unintended consequences of negative rates, that is just beginning to play itself out, is the massive under funding of pension plans. While naked and underfunded is a fun way to go through college, it’s a real problem if you’re a pension plan.

Back in 2007, the pensions of the companies in the S&P 500 were fully funded. Now, 9 years later, not so much. As a whole, the S&P pensions are underfunded by $375B, $225B of this is isolated in just 25 companies. The reason for this is that as yields continue to fall, liabilities rise at an exponentially quicker pace than assets. For instance, assets of the S&P pensions have increased by 10% since the Crisis, while liabilities have increased by 40%. But this isn’t just a problem for private pensions. 

Back in April, a public pension fund that represents union truck drivers across a number of states, filed to have the retirement benefits of its constituents reduced. 
The plan currently pays out about $3.50 for every $1.00 it takes in, which leaves it short about $2B a year. If the plan doesn’t get bailed out, or significantly reduce the benefits it pays, it’ll be out of money in 10 years. 

Now typically speaking, when a plan like this becomes insolvent, a government insurance fund gets activated so that pensioners still receive some benefit, even though those benefits are dramatically reduced. There’s just one small problem, this government insurance fund is currently underfunded as well! The fund can’t possibly cover all of the participants, even at a dramatically reduced payout level. Are you Kidding ME?!

So pension plans of all types are underfunded and each time rates drop further they inch closer and closer to insolvency. The negative rate environment and the subsequent hunt for positive yield has led pensions to do everything they can, short of selling their mothers, to meet their short term cash flow needs. 

This has led to a ferocious appetite for bonds, which pushes bond prices higher and yields lower. The lower yields fall, the further out in duration the plans are forced to go. Why is this a problem? Remember earlier when I pointed out that the liabilities for S&P pensions had grown at 4X the pace of the assets? Well, the further out in duration pensions go, the more divergent that gap between liability and asset growth becomes. 

The more pensions buy, the more yields fall, and the more yields fall, the more underfunded the pensions become which forces them to go out further and further on the yield curve. Then the whole cycle repeats itself, until it can’t. This cycle is further exacerbated by the fact that the world is packing on 10-15% more negative yielding debt with each passing month.

But pensions aren’t just blindly buying longer and longer bonds to try and meet short term cash flow needs, they are now getting naked. For the first time since the Crisis, they are looking to the derivatives market to help bump their income. Pension funds in several states are now starting to sell options, known as being naked options, in order to benefit from the income this type of strategy produces. 

As a reminder, pensions and insurance companies tried something similar back in 2006. They sold options on “investment grade” mortgage backed securities, backed by the US housing market, which had never declined in value. They were betting that the housing market would never decline. Remember how that turned out? AIG anyone? But I’m sure this time is different. I mean, betting that the S&P 500 won’t decline while it sits at all-time highs with all-time low volatility, has to be a sure thing, right?

The South Carolina Retirement System just voted to include the writing of put options as a strategy going forward to increase their income. The Treasurer, Curtis Loftis, said, “I think it’s difficult to assess the true risk of these strategies. One of the great untold stories of the pension world is how we have underestimated risk.” Although Mr. Loftis was concerned about the risk of the put writing strategy, he voted in favor of it anyway. Are you freaking kidding me? The fact that this guy thinks this way and manages people’s post-retirement livelihood, absolutely blows my mind. Further, the fact that he has the cajones to say this kind of crap publicly makes me feel like I’m taking crazy pills. How much of YOUR money is in the retirement fund Mr. Loftis? I’m guessing none. 

South Carolina is not alone, the Hawaii Employee’s Retirement System, has now committed 10% of its $15B fund to the same put writing strategy on the S&P 500. Hawaii is planning to generate about $20MM a month in income from the strategy; as long as the options aren’t exercised. Crazy thought, what if the S&P actually declines at some point? 

I know most options contracts expire worthless, but what if they don’t? You haven’t seen selling until a massive number of people who are short puts, rush to hedge their downside exposure once the market starts to decline. Remember the Flash Crash on May 6, 2010? The S&P was down as much as 8% intraday, in large part due to this type of stampede effect. Sounds like more unintended consequences to me.

Don’t miss the message here. This is not a commentary on put writing strategies. This is a commentary on the mindset of the people making decisions which collectively impact the lives of millions of US citizens. The Number 1 rule of investing is “don’t invest in stuff you don’t understand.” It’s like the 10 Commandments, do you really need to be reminded “thou shall not kill?” 

Retirees from both public and private pensions are being led to the slaughter and they are defenseless to do anything about it. The central banks started this butterfly effect of unintended consequences, and now pension plans are causing their own by engaging in activities to meet immediate needs with a complete disregard for the long term ramifications. 

In my opinion, the people in charge of these pension plans are crapping all over the concept of fiduciary responsibility. Rather than implementing rational solutions like cutting benefits, the elected officials are kicking the can down the road to the next guy who holds their office. They don’t want to risk upsetting the very people they need to vote for them.

Imagine what happens to our economy when the pension search for yield ends horribly. A cascading number of people without income or with dramatically reduced income will wreak havoc on our economy. Not to mention the burden it would put on the US taxpayer, as the public pension plans look to the Federal government for a bailout. 

What started out as an attempt to jump start the Eurozone and Japanese economies, will end up with Bob, who drove a truck for 30 years in Idaho, having his income chopped from $4,000 a month to $1,000. Bob may not be a widow or an orphan, but there is one thing that hasn’t changed in 300 years. Government officials, elected and unelected alike, continue to implement policies designed with a short term perspective, and a focus on career risk, with no appreciation for the unintended consequences of their actions.