Pssssst

Hey! Over here. It’s me, Captain Obvious. I’m one of Grumpus Maximus’s many alter egos. Kind of like that guy from the movie Glass, but all good, no beasts. Don’t tell him, but I snagged the keyboard when he wasn’t looking. I wanted to let everyone know that stock market volatility is back. You already knew that? Of course you did, that’s why I’m called Captain Obvious. What you may not have noticed is that the volatility is spreading. It’s in the bond market now as well as the stock market. Even the U.S. housing market is starting to tremble in certain places.

I told GM that he should’ve written about volatility months ago, but he said too many Financial Independence (FI) bloggers were already writing about it. Plus, he hadn’t taken the time to determine if volatility posed any kind of risk to people’s pensions, or the pension funds that back them. I suspect he was just being lazy. Either that or too busy with his retirement plans to care about all three of his loyal readers. Well, I’m here to tell you that I finally convinced him to research the issue and write a post. Just remember that, when you leave your comments at the bottom of the page. Captain Obvious, out!

Topical Ointment

Is volatility bad for a pension fund? If so, why and how? If not, what kind of financial market conditions threaten pension fund viability? When should a participant in a pension plan pay attention?

These are the types of questions that started bouncing around in my head in November of 2018. They did so because stock market volatility made a sudden and dramatic return. However, I don’t tend to address topical financial issues all that much on the blog. Thus, no stories about cryptocurrency in 2017 when it was hot, or in 2018, when it was not. No outraged responses to Suze Ordman insulting the Financial Independence (FI) movement. And, especially, no articles on the return of volatility to the financial markets in the last quarter of 2018.

The world didn’t need another story on volatility’s return. In November and December 2018, you couldn’t swing a dead cat without hitting an FI blogger writing about volatility. Just Google Financial Independence, volatility, and 2018 and you’ll see what I mean. You’ll have to weave between numerous mainstream financial media posts declaring an end to the FI movement upon volatility’s return, but trust me, the FI-linked blog posts about volatility are there.

Three Legs are Better Than One

Unless you’re my one hardcore reader (Hi Mom!), you probably didn’t notice the lack of a volatility article on the blog during the 4th quarter of 2018. As pointed out by Captain Obvious above (yes, I knew he had the keyboard), I was a little pre-occupied. However, I was paying attention, if for no other reason than my personal investments make-up one big leg of my three-legged retirement stool.

In case you’ve never heard of the three-legged retirement stool, then let me channel my inner Captain Obvious and man-splain some stuff to you. The three-legged retirement stool is a planning method for retirement using a pension, personal savings/investments, and Social Security as the three legs. It fell out of use in U.S. retirement planning circles because most workers in the U.S. don’t have access to a pension. Also, as I wrote about in Part 18 of the Pension Series, Social Security is at risk. Thus, one leg of the stool is missing for most U.S. workers, and the other is wobbly for the generations of U.S. workers retiring after the Baby Boomers.

Snap Back to Reality

Back to my point, I was concerned about the volatility, but didn’t know what it might do to my (or anyone else’s) pension. As a result, I didn’t know if it was an appropriate topic for the blog. But, I made a note to research the issue and found the time between June and August 2019 to complete it. As happens sometimes in life, I serendipitously but unintentionally synchronized it with another bout of volatility in U.S. and World markets. I say that because of geopolitics (i.e. the China-U.S. trade and currency wars), U.S. Federal Reserve Bank fiscal policy (i.e. the switch from hiking interest rates to cutting them), and oil price movement (i.e. U.S. and Iranian military clashes) spiked volatility.

As a result of my research, I discovered that the answers to my volatility questions (above) are case dependent. That’s the same as many other pension-related questions like “How safe is my pension?” or “Should I quit my pensionable job?“. In other words, it all depends on the specifics of your pension. As a result, it’s probably worth starting with the basics and moving on from there.

What’s Volatility?

Great question. To put it simply, volatility is the amount that an investment’s value swings over time. Some investments, like stocks, are known for their volatility. Bitcoin is another, more recent, example of something with a history of wild volatility. There’s an entire website dedicated to nothing but Bitcoin’s volatility. It’s got a great FAQ and is worth the read for the beginner on the issue of volatility. Alternatively, if you want to know why cryptocurrencies swing so much, here’s a link to a good article explaining why. Reader beware though, a Foreign Exchange (FOREX) and cryptocurrency trading site hosts the article. My citing it in no way constitutes an endorsement of FOREX or cryptocurrency trading.

What’s Risk?

Risk, often associated with volatility, is the potential that an investment might lose money instead of making it. Investors typically seek higher gains through riskier investments, knowing that the trade-off is larger volatility. In other words, “nothing ventured, nothing gained“. Over the short-term, volatility can be dangerous if an investor needs (or wants) to sell. Conversely, as JL Collins points out on his blog, on a long enough timeline with the correct type of investment, risk typically turns into nothing more than volatility. Meaning an investor patient enough to wait out volatility can sell when the value of the investment is up and make money.

Mitigating Risk

There are many methods for mitigating the risk that volatility poses. One is avoiding singular investments. Buying stock in a singular company always runs the risk of something as simple as a bad fiscal quarter, or, complex as a game-changing shift in the company’s market, causing the stock price to plummet. The drop in stock price caused by a bad quarter isn’t typically fatal for an investment. However, the drop from a game-changing event can be fatal. Just look at what happened to Sears in a post-Amazon world.

Don’t forget that something as unpredictable as stupidity can force a company into bankruptcy too. If you don’t think that can happen in the modern-day, then you should Google Enron. Thus, it’s much safer to invest in a basket of stocks or an entire index worth. If one stock fails then you have numerous other stocks in that basket (or index) that hold their value, and hopefully, increase over time.

Diversity in your investment portfolio can also help manage risk. This means buying different types of investments whose volatility don’t typically move in parallel. Stocks and bonds are the standard examples of this. When the stock market is up, typically returns in the bond market are down. The opposite generally holds too, when bond values are up, stock market values aren’t. What’s currently going on in the U.S. bond market (August 2019) is a perfect example. Stocks have plummeted over several trading days driving up investor demand for bonds, which offer safety from the current volatility and risk. When demand for bonds goes up, so too does the price.

Which Brings Us to Pension Funds

Before we get to the interplay of risk, volatility, and pension funds let me explain how pension funds generate their money. At their most basic level pension funds bring money in as contributions, and send money out in form of lump sums and annuities. In the case of corporate pension funds, inflows are typically contributed by workers and/or their corporations. In the case of public pension funds (other than the U.S. Federal level), workers often contribute some amount based on their pay scale, while the government entity they work for contributes the rest, courtesy of the taxpayer. In either case, inflows are typically used to purchase new investments. Ideally, these investments grow over time (30-years or so) to pay future pensioners.

It’s important to note that over time well-run pension funds build up large enough pools of assets to cover all future liabilities. Or, put another way, the pool of assets should grow really big before workers start to claim their pensions. The composition of those asset pools varies from pension fund to pension fund. However, pension funds tend to invest in some combination of stocks, bonds, real estate, private equity, and commodities. Alternatively stated, they spread their investments over multiple asset classes. Fund managers do this to limit the fund’s exposure to volatility in any singular type of investment class. Thus, if the stock market tanks but drives bond prices up, then it’s more fiscally sound to sell bonds to generate that month’s or that quarter’s annuity money.

Theory vs. Reality

Now, in reality, pension funds don’t sell large portions of their assets just to cover their pension payments every month. They usually keep a certain amount of cash in reserve, which smooths out the risk posed by volatility even more. Pension funds do this because they are always paying out benefits to retirees (annuitants), even in volatile times. Thus, they keep enough cash in reserve to pay out annuitants for a few months to a few years. This way, pension funds don’t sell assets when their values plummet due to market volatility. By keeping cash on hand, they can pick and choose which assets to sell when the time is right (i.e. when their value is up, instead of down).

At least … that’s how it works for healthy pension funds. Some pension funds are so sick that they’re selling assets every month, be the market up or down. They do this to cover payments to current annuitants. If those pension funds have more current contributors (i.e. young workers contributing to the fund) than current annuitants (i.e. retired workers drawing pensions) they can typically weather moments of extended volatility.

The Dreaded Death Spiral

However, pension funds with more retirees drawing pensions than young workers contributing to the pension fund, often end up in what’s known as a death spiral. This means the pension will run out of money to pay current and future annuitants at some point in the foreseeable future. Volatility usually exacerbates the death spiral, hastening a quicker end.

Of course, in those cases, intervention is possible. In the case of either public or corporate pension funds, contribution requirements for current workers can be raised. Yet, it’s important to note that this type of move isn’t usually well received by the current workforce. Younger workers (often rightly) perceive that they’re being asked to pay for the current cohort of retirees’ pensions, while they stuck with a less generous version of the pension in the future (to save costs). On the other end of the pension spectrum, taxes could be levied to save a public pension fund caught in a death spiral, but of course, that’s usually not well-received by voters.

If the sick pension fund is a corporate fund, then the parent corporation could make a cash infusion, instead of raising worker contributions. Investors typically dislike these types of interventions. They might choose to hammer the company’s stock price by selling off large holdings. As a result, corporations will often freeze pension funds caught in a death spiral. New workers are diverted into Defined Contribution (DC) plans (i.e. 401Ks). At that point, the frozen fund can be slowly wound down over time with smaller cash infusions, or sold to an insurance company through a transaction known as Pension Risk Transfer. In the worst cases of a corporate pension fund death spiral, such as when the corporation goes bankrupt, the Pension Benefit Guarantee Corporation (PBGC) can step in and at least provide partial payments.

The Underlying Causes

So, now you see why I said that this current (2019) bout of volatility and investment risk may or may not affect your pension. It depends on the health of your pension fund. If your pension fund is healthy and well managed, then no amount of volatility should impact its long-term health. It should have enough cash on hand to smooth out the worst impacts of the volatility. It should also be diversified enough to sell the asset classes that rise in value when other asset classes sink during the volatility roller coaster, to replenish that cash reserve.

Since I covered pension fund health exhaustively in Part 1 of the Pension Series, I’m not going to re-visit the issue here. Instead, I want to address one particular underlying cause to this latest round of volatility, and how it impacts your pension. The issue is the recent interest rate cut by the U.S. Federal Reserve of the Federal Fund Rate. The Federal Fund Rate impacts, among other things, U.S. Government bond interest rates. In other words, it affects the amount of interest the U.S. is willing to pay on the money it borrows.

If a borrowing institution setting the interest rate for the money it borrows from lenders sounds strange to you, it is! Imagine if you could do that with your home mortgage or credit card. The U.S. can get away with it though because the U.S. ensured that the U.S. dollar (rather than the UK’s Pound Sterling) became the world’s reserve currency after World War II. How the U.S. maneuvered the dollar into this key position is a fascinating story, but not germane to this article. The only thing you need to know is that as a result, the U.S. gets to call the shots on the underlying interest rates against which it borrows. You also need to know that the U.S. borrows by issuing Government Bonds — a.k.a. U.S. Treasuries.

Who Buys Bonds?

Do you know what institutions love to buy U.S. Treasuries? Pension funds, that’s who. Not just U.S. pension funds either, but pension funds around the world. Why? Because U.S. Treasuries are the closest thing to a sure bet that exists in the financial world today. That statement is based on the fact that the U.S. always pays its borrowers back with the interest agreed upon when the bond was first issued. Always. If it didn’t, like Argentina or Greece, the world’s financial system might collapse.

As an example, a 30-year U.S. Treasury with a 5% interest rate might guarantee a pension fund an annual return rate of 5%. As a result, if the pension fund’s annual target return rate is 7% per year (to meet all its current and future obligations), then it need only risk enough money in stocks, real estate, commodities, or private equity to earn a 2% annual return. In other words, high-interest rate environments are great for pension funds, because it limits exposure to risk. On the other hand, low-interest rates force pension funds to risk more money searching for higher returns in other asset classes, which of course exposes them to more volatility.

What’s It All Mean, Basil?

Is volatility (defined as price fluctuation over specific periods by certain types of asset classes used for investments) bad for your pension? It very much depends on the health of your pension fund. If your pension fund is well-managed, invested in a wide variety of asset classes, and if it possesses a large cash reserve, then no amount of monthly (or even quarterly) volatility should impact it. It would require something much more than volatility (i.e. a major economic downturn or recession) to threaten the safety of your pension. On the other hand, if your pension is poorly managed, chronically underfunded, and/or in a death spiral; then yes, volatility might very well impact your pension. It may even hasten the end of the pension fund.

That said, some of the underlying reasons for the market volatility might inflict harm to your pension fund’s health, and therefore your pension. For example, during the most recent bout of stock market volatility (JUL – AUG 2019), the most worrisome contributing factor (for pension funds) was the U.S. Federal Fund Rate cut. Low-interest rate environments force pension funds to risk more money through investments in other asset classes (like stocks) to achieve their targeted rate of return. Those other asset classes are far more prone to volatility than bonds. This volatility can turn into risk if your pension fund is forced to sell certain types of assets during a price drop.

Hopefully, that’s not going to happen, though. Hopefully, you’re in the world’s most well-managed pension fund. That way you can rest easy knowing that you can ignore the daily headlines…from a pension perspective at least.