Thursday, April 11, 2013

The Pension Rate-of-Return Fantasy?

Andy Kessler, a former hedge-fund manager and author of "Eat People," wrote an op-ed for the WSJ, The Pension Rate-of-Return Fantasy:
It has been said that an actuary is someone who really wanted to be an accountant but didn't have the personality for it. See who's laughing now. Things are starting to get very interesting, actuarially-speaking.

Federal bankruptcy judge Christopher Klein ruled on April 1 that Stockton, Calif., can file for bankruptcy via Chapter 9 (Chapter 11's ugly cousin). The ruling may start the actuarial dominoes falling across the country, because Stockton's predicament stems from financial assumptions that are hardly restricted to one improvident California municipality.

Stockton may expose the little-known but biggest lie in global finance: pension funds' expected rate of return. It turns out that the California Public Employees' Retirement System, or Calpers, is Stockton's largest creditor and is owed some $900 million. But in the likelihood that U.S. bankruptcy law trumps California pension law, Calpers might not ever be fully repaid.

So what? Calpers has $255 billion in assets to cover present and future pension obligations for its 1.6 million members. Yes, but . . . in March, Calpers Chief Actuary Alan Milligan published a report suggesting that various state employee and school pension funds are only 62%-68% funded 10 years out and only 79%-86% funded 30 years out. Mr. Milligan then proposed—and Calpers approved—raising state employer contributions to the pension fund by 50% over the next six years to return to full funding. That is money these towns and school systems don't really have. Even with the fee raise, the goal of being fully funded is wishful thinking.

Pension math is more art than science. Actuaries guess, er, compute how much money is needed today based on life expectancies of retirees as well as the expected investment return on the pension portfolio. Shortfalls, or "underfunded pension liabilities," need to be made up by employers or, in the case of California, taxpayers.

In June of 2012, Calpers lowered the expected rate of return on its portfolio to 7.5% from 7.75%. Mr. Milligan suggested 7.25%. Calpers had last dropped the rate in 2004, from 8.25%. But even the 7.5% return is fiction. Wall Street would laugh if the matter weren't so serious.

And the trouble is not just in California. Public-pension funds in Illinois use an average of 8.18% expected returns. According to the actuarial firm Millman, the 100 top U.S. public companies with defined benefit pension assets of $1.3 trillion have an average expected rate of return of 7.5%. Three of them are over 9%. (Since 2000, these assets have returned 5.6%.)

Who wouldn't want 7.5%-8% returns these days? Ten-year U.S. Treasury bonds are paying 1.74%. There is almost zero probability that Calpers will earn 7.5% on its $255 billion anytime soon.

The right number is probably 3%. Fixed income has negative real rates right now and will be a drag on returns. The math is not this easy, but in general, the expected return for equities is the inflation rate plus productivity improvements plus the expansion of the price/earnings multiple. For the past 30 years, an 8.5% expected return was reasonable, given +3%-4% inflation, +2% productivity, and +3% multiple expansion as interest rates plummeted. But in our new environment, inflation is +2%, productivity is +2% and given that interest rates are zero, multiple expansion should be, and I'm being generous, -1%.

So what to do? I recall a conversation from 20 years ago. I was hoping to get into the money-management business at Morgan Stanley. I wanted to ramp up its venture-capital investing in Silicon Valley, but I was waved away. It was explained to me that investors wanted instead to put billions into private equity.

One of the firm's big clients, General Motors had a huge problem. Its pension shortfall rose from $14 billion in 1992 to $22.4 billion in 1993. The company had to put up assets. Instead, Morgan Stanley suggested that it only had an actuarial problem. Pension money invested for an 8% return, the going expected rate at the time, would grow 10 times over the next 30 years. But money invested in "alternative assets" like private equity (and venture capital) would see expected returns of 14%-16%. At 16%, capital would grow 85 times over 30 years. Woo-hoo: problem solved. With the stroke of a pen and no new money from corporate, the GM pension could be fully funded—actuarially anyway.

Things didn't go as planned. The fund put up $170 million in equity and borrowed another $505 million and invested in—I'm not kidding—a northern Missouri farm raising genetically engineered pigs. Meatier pork chops for all! Everything went wrong. In May 1996, the pigs defaulted on $412 million in junk debt. In a perhaps related event, General Motors entered 2012 with its global pension plans underfunded by $25.4 billion.

In other words, you can't wish this stuff away. Over time, returns are going to be subpar and the contributions demanded from cities across California and companies across America are going to go up and more dominoes are going to fall. San Bernardino and seven other California cities may also be headed to Chapter 9. The more Chapter 9 filings, the less money Calpers receives, and the more strain on the fictional expected rate of return until the boiler bursts.

In the long run, defined-contribution plans that most corporations have embraced will also be adopted by local and state governments. Meanwhile, though, all the knobs and levers that can be pulled to delay Armageddon have already been used. California, through Prop 30, has tapped the top 1% of taxpayers. State employers are facing 50% contribution increases. Private equity has shuffled all the mattress and rental-car companies it can. Buying out Dell is the most exciting thing they can come up with. Expected rates of return on pension portfolios are going down, not up. Even Facebook FB +3.55% millionaires won't make up the shortfall.

Sadly, the only thing left is to cut retiree payouts, something Judge Klein has left open. There are 12,338 retired California government workers receiving $100,000 or more in pension payments from Calpers. Michael D. Johnson, a retiree from the County of Solano, pulls in $30,920.24 per month. As more municipalities file Chapter 9, the more these kinds of retirement deals will be broken. When Wisconsin public employees protested the state government's move to rein in pensions in 2011, the demonstrations got ugly—but that was just a hint of the torches and pitchforks likely to come.

Meanwhile, it's business as usual. California Gov. Jerry Brown released a state budget suggesting a $29 million surplus for the fiscal year ending June 2013 and $1 billion in the next fiscal year. Actuarially anyway.

Or as Utah Rep. Jason Chaffetz told Vermont Gov. Peter Shumlin, upon learning at a 2011 House hearing about that state's unrealistic pension assumptions: "If someone told me they expected to get an 8% to 8.5% return, I'd say they were probably smoking those maple leaves."
The issue of rosy pension investment assumptions is something I've covered many times in this blog. Kessler is right, most members of the National Association of State Retirement Administrators (NASRA) are delusional with their investment return assumptions, smoking some hopium.

When it comes to investment assumptions, pensions need to follow Bill Gross and look in the mirror. If that 8% projection turns out to be 0%, or even 4% in the next decade, someone is going to have to make up the shortfall. Tough decisions will be made which will likely include cutting the benefits of retirees. Of course, public pensions risks vary widely, and some cities like Stockton and Chicago are confronted with hard choices now. They simply can't afford to wait any longer.

Kessler's article is a wake-up call to pensions pumping money into alternatives, enriching Wall Street, but he's way too harsh on actuaries and some critics like Dean Baker, think this op-ed piece is just more scaremongering on public pensions.

My biggest beef is that Kessler only focuses on the asset side of the equation. Go back to read my comment from earlier this week on corporate America's pension time bomb. I clearly stated the following:
The most important thing to remember when reading these articles is that interest rates are the main driver of pension liabilities. This is because the duration of liabilities is longer than the duration of assets, which in plain English means any decline in interest rates will widen pension deficits because liabilities will grow much faster than assets.
Conversely, any increase in interest rates will disproportionately lower liabilities relative to assets, which is why the Fed and the Bank of Japan are pumping massive liquidity in the system to fight deflation and raise inflation expectations.

Importantly, the best possible outcome is that we get a decade of rising stock market gains and rates slowly "normalize" back to historically normal levels of 2.5-3%. A concurrent rise in assets and interest rates will significantly reduce or wipe out pension deficits.

But so far the titanic battle over deflation isn't sinking bonds or spurring employment growth but it is leading to more risk-taking behavior, which is good for stocks and other risk assets. So that still begs the question, what is the appropriate discount rate to value future liabilities?

The Oracle of Ontario has many older members and uses a discount rate of 5.4%, one of the lowest in the world for public pension plans. Most large Canadian public plans use a discount rate closer to 6.3%. Large U.S. corporations like Boeing use a discount rate of 3.8% for their plan which is based on highly rated corporate bonds. The corporate bond rally didn't augur well for their pension plan deficit.

This is why in my comment on corporate America's pension time bomb, Bernard Dussault, Canada's former Chief Actuary, was adamant not to be alarmist on corporate pension deficits:
Due to the unrealistic low yield used in computing pension liabilities, the funding ratios are grossly understated. International accounting standards applying to the valuation of pension liabilities do not provide realistic, reliable or sensible values and thereby make a bad situation look unduly worse and too alarmist.
All true but what if we head into a Japan-style deflationary trap, a point that Jim Koehane, President and CEO of the Healthcare of Ontario Pension Plan (HOOPP), was referring to when he went over HOOPP's stellar 2012 results and warned:
...the "risks of not owning bonds is huge" because there is an asymmetric tradeoff depending on whether interest rates rise of fall. In particular, the duration of most pension plan assets is shorter than the duration of their liabilities (for HOOPP, it is 12 vs 15), so if long bond yields fall by one percentage point, it will be destructive. "If we enter a Japan scenario, you will get killed not owning bonds." Conversely, if rates rise, your liabilities will go down more than your assets, so you will not be hurt as much.
Indeed, a Japan scenario would mean rates are heading lower, which would be catastrophic for pensions struggling with pension deficits. One hedge fund manager shared these great insights with me:
...the assumption that discount rate is too low largely depends on another assumption: that central bankers can prevent deflation. Regardless of what academic economic theories say about the effectiveness of monetary policy to stop deflation, there is a REAL risk that they can only do this in the short run and that a Japan-like lost decade(s) scenario is now upon us in the developed world (as demographics would suggest).

If rates remain low and stay there, or even fall further, a Japan-like situation means equities enter a long term bear market. Against this type of shock, funding ratios are underestimated. This risk goes hand-in-hand with deteriorating state and local budgets making it more likely that these governments skip pension contributions to balance budgets. So demographics, equity risk, interest rate risk, and inflation risk are not independent, and must be treated holistically to really understand whether or not current funding ratios are 'too alarmist'.

With so much riding on macroeconomic "theory" about the long term effectiveness of the radical and untested policy measures of the last 4 years, adding equity-like risk to the asset side of the balance sheet in an effort to close the gap is not prudent long term risk management for a pension fund. If monetary policy falls short of expectation, the short run volatility of these assets can easily overwhelm the advantage of being a long term investor who is able to step into risk assets when everyone else is selling.

It is only a pension fund who limits exposure to this shock now who will be in a position to "grab yield" buying heavily discounted bonds and clipping premium selling insurance after the storm (see HOOPP), thereby dealing with funding risk tactically instead of reacting to it. That means going against the herd right now, shunning short duration, illiquid assets in the hope of closing a gap with the latest "historically back-tested" trend in asset class allocation. Yes you may under-perform your benchmarks in any one year or even over a couple of years, but ultimately its no consolation that you outperformed your peers by 2% for 3 years when you're down 40% in year 4. Sadly, five years after 2008, we are right back to the same short term thinking that created some of the worst problems of that period.

What should be very alarming is that after four years of an all-in monetary and fiscal policy, Bernanke and Draghi are both still warning about deflation risk. Setting aside the hyperinflationary conspiracy theory that seem to dominate intelligent macroeconomic policy debates these days, it's clear that these guys are in a position to know what is going on systemically, and have tried and continue to try everything in their power to prevent this outcome. Yet the 10-year US Treasury bond yield is still below 2%. Furthermore, we are in front of a major reversal of one of the two pillars of the recovery to-date from fiscal stimulus to austerity. In the EU, we already have a sense of what this reversal means for long term growth prospects.
Keep this in mind as you watch the developed world struggle with the biggest jobs crisis since the Great Depression. Without good solid paying jobs with benefits, there will be no pensions or savings to retire on, only more people collecting disability. The ongoing jobs crisis and demographic shift are two major deflationary headwinds.

Below, AMP Capital Investors Head of Dynamic Asset Allocation Nader Naeimi discusses Japanese stocks and the yen. He speaks with Rishaad Salamat on Bloomberg Television's "On the Move Asia."

And Robert Madsen, a senior fellow at MIT Center for International Studies, discusses the outlook for the Japanese yen and Bank of Japan monetary policy with Susan Li on Bloomberg Television's "First Up."