Prepare for the Looming Pension Crisis

Recently, workers with employer-sponsored 401(k) plans have taken it on the chin. The bear market has hurt anyone who invested their 401(k) money in stocks, and many employees who invested too much in their employer's stock have seen huge losses.

401(k) plans have behaved so badly that many are now calling for significant reform, or even these plans' outright abolition. Yet before you decide that worker-controlled retirement plans can't stand up to real pensions, here's some bad news: Underfunded pensions could well be the last straw that moves the U.S. into a brand-new financial crisis light-years beyond what we've seen so far.

Employers have gotten hurt, too
A recent study from Standard & Poor's indicates that America's retirement safety net is in worse shape than many probably thought. Even as companies have seen their own share prices plummet, and had to cut costs through layoffs and pay cuts, they've also seen many of the investments they've made toward meeting their pension obligations get slammed.

As a result, the overall shortfall among pension funds has grown substantially. According to Standard & Poor's, those companies in the S&P 500 index have only $1.1 trillion in assets to meet estimated future obligations worth $1.4 trillion in current dollars. That shortfall comes to a little more than two years' worth of earnings for those 500 companies.

Moreover, the problem is widespread. A report from Wilshire Associates found that 92% of the 323 companies in the S&P 500 with traditional defined-benefit pensions were underfunded. The median funding ratio was just 73.3%, indicating that the amounts by which these plans fall short are generally quite significant.

What it means for investors
At the very least, pension shortfalls could force companies to divert earnings to increase pension reserves, forcing them to take charges against earnings. That could disappoint investors, although savvy companies that take the opportunity to bundle one-time charges into already subpar quarterly results might effectively keep their full impact under the radar.

Pension shortfalls could have a much greater effect on companies that are already feeling the strain of the recession on their balance sheets. Take a look at the financial condition of some companies the report cites as having shortfalls:

Source: Capital IQ, a division of Standard and Poor's. Numbers in millions as of financial statements for Dec. 31, 2008.

Not all of these companies are in terrible shape. Companies like ExxonMobil and Hershey could fund their shortfalls with just a fraction of their 2008 earnings. Others, such as GM, face the triple whammy of big debt, huge earnings losses, and major pension shortfalls. Investors can only expect bad news to get worse for these companies and their stocks.

Not just in the stock market
Moreover, the problems go well beyond the private sector. State and local governments, large colleges and universities, and other public pension systems have lost unprecedented amounts during the bear market, creating a potential trillion-dollar shortfall that could go well beyond their ability to raise revenue to remedy the situation successfully.

A collapse of the public pension system could overwhelm local economies that are already struggling to survive, even with huge inflows of funds from the federal government. A cascading loss of confidence could make the recession we've seen thus far look like a walk in the park compared to the real depression that could follow.

Investors who think the worst is behind us need to pay attention to the implications of pension shortfalls. It will take a major readjustment in workers' expectations, as well as corporate financing of pension obligations, to overcome this huge challenge -- which could very well become the next major financial crisis.

For more on preserving your retirement:

• Four warning signs that you may be destroying your retirement.
• How you can salvage your retirement.
• Are you a "set it and forget it" investor? You'll regret it.