Many pensions face severe underfunding that jeopardizes their future ability to pay all promised benefits. If you are expecting pension income at a future date you need to be prepared that at least some of your promised benefits won’t be received. Pension cuts will become a reality for many.

Some estimate the PBGC (Pension Benefit Guaranty Corporation) could go broke in 5 years. A report from the PBGC itself revealed it’s ‘guarantee’ for multi-employer benefit plans will run out in 2025. Some multi-employer programs have already succumbed to the financial strains of their obligations. Central States Pension, a plan of mostly truck drivers and, commenced a rescue plan even after achieving a 7.1% return over the last decade, outpacing the average fund of its size.* The problem is that employer contributions aren’t enough to keep up with the promised benefit obligations. Central States realized that its $2 billion annual gap would only growth without the rescue. The decisions came to reduce benefits by an average of 22.6%.

This is likely to be a major election issue with a determined group of democrats vowing to make pension cuts illegal. The fear is that without being proactive, the pension funds that are in trouble will delay their reforms and eventually be left with nothing.

Many multi-employer pensions exist in the construction, mining and areas where workers shuffle around between employers more often than other industries. Single-issuer pensions might fair better and they are easier to hedge.

If your pension fund was smart enough to offload some of their funding obligations to an insurance company, great. If not, you need to understand what your pension fund is and what it’s invested in. Your pension fund is essentially an annuity, which promises you a stream of income for the rest of your life, based the years of service to your employer.

The problem is, these pension funds are invested in many different areas of finance, many risky, and believe they are diversified. They may be diversified, but their portfolios are at risk. One large asset class they are invested in is private equity.

Many pension funds have gotten quite aggressive in recent years, trying to close their funding gaps (the difference between the assets they currently have and the assets they’ve promised to pay out in the future). Another severe stock market downturn will probably hinder many more pensions.

Pension funds invest in many exotic vehicles which include an alphabet soup of investments-CLOs, CDOs, CMBS, RMBS. Further, they invest in higher yielding  ‘asset’-backed securities including credit card receivables, auto loans and student loans have probably reached their limit and have begun to deflate.

It seems many pension funds are listening too closely to consultants who advise them to get out of hedge funds and into lower cost alternatives like passive ETFs. Unfortunately, this capitulation towards passive investing almost certainly signals a top in the markets and these pension funds will wish they had some of their assets in hedged strategies. The California Public Employees’ Retirement System liquidated it’s entire $4 billion allocation to hedge funds last year and more are following suit. Hedge funds are a non-correlated asset so they shouldn’t be compared with the S&P 500 as many fund are doing.

Group Annuity Contracts

Another alarming trend is the amount of defined benefit plans (pensions) that are beginning to utilize buy-ins and buy-outs of their plans by insurance companies. The buy-outs are actually group annuity contracts and are again backed only by the specific insurance company.

How to Hedge Against Pension Cuts

If your pension fund has opted for a buy-out with an insurance company you have a chance to hedge against a disastrous outcome in case the insurer gets into serious trouble. Prudential has assumed many pension plan’s future liabilities. You could buy a put option on Prudential, dated out as far as the expirations will go in the options chain (called LEAPs). It is basically a protective put since you essentially are long PRU (actually more like a bond holder since it’s a solvency risk more than an equity issue but a credit default swap is an impractical solution). If something happens to the insurer which could jeopardize your future payments stream, you’d be partially offset by an increase in the value of the put option. You could also buy a put option on an insurance ETF, preferably one with a high concentration of major life insurers.

Also, you could buy an inverse ETF on the financial sector, which contains several large insurance companies and should act in similar fashion to the insurers in the wake of another financial crisis. Depending on the severity of the sell-off, your inverse ETF could increase in value, offsetting some losses to your pension benefits.

We’d avoid short-selling the particular insurer since 1- its a financial and they have experienced short selling bans in prior crises. This could leave you with additional risk of trying to cover in a massive short squeeze 2- there is a likelihood of an above average dividend yield you’ll have to pay when borrowing the stock, lessening it’s attractiveness as a hedging vehicle.

http://blogs.wsj.com/washwire/2015/10/09/pensions-timebomb-keeps-ticking-in-year-of-funding-challenges/

http://www.cspensionrescue.com/

http://www.bna.com/central-states-official-b57982059309/