Thursday, December 7, 2017

Mr. Index Worried About US Pensions?

Lisa Abramowicz of Bloomberg reports, Jack Bogle Is Worried About U.S. Pensions:
Jack Bogle isn’t optimistic about the state of U.S. pensions over the next decade.

The founder of Vanguard Group thinks a conservative portfolio of bonds will only return about 3 percent a year over the next decade, and stocks won’t do much better, with a 4 percent annual gain over a similar period. This is “totally defeating” for pensions, which “are not going to be able to meet their 7.5 percent or 8 percent obligations,” Bogle said in a Bloomberg Radio interview that aired Thursday.

Bogle is well known for first conceiving of low-fee funds for individual investors, pegging strategies to indexes rather than giving managers free reign to buy what they wanted. This philosophy has helped Vanguard grow into a $4.5 trillion behemoth that will likely reach $10 trillion in assets within the next 10 years.

Bogle, 88, also has a self-professed knack for making accurate market calls. His prognostications on stocks have had about an 81 percent correlation to what actually happens, while his bond predictions have been accurate 95 percent of the time, he said.

“The only return you get on a bond is from the interest coupon,” with fluctuations in prices eventually evening out and becoming relatively negligible over the longer term, he said. Given a portfolio of about half corporate bonds and half U.S. Treasuries, the blended yield is about 3 percent today.

“So that’s what you get over the next decade,” he said.

This is a huge problem for pensions, which rely on bonds to provide steady, reliable income needed to cover benefit payments to plan participants. For example, the largest U.S. pension, California Public Employees’ Retirement System, is considering more than doubling its bond allocation to reduce risk and volatility as the bull market in stocks approaches nine years.

Pensions have generally lowered their returns targets over the past few years, but they’re still aiming for annual gains of more than 7 percent on average. To Bogle, that’s an unlikely scenario.

“It is almost a given that it will end badly,” he said.
Jack Bogle is absolutely right, this will end badly as there is no way US public pension funds will attain a 7 or 8 percent annualized rate of return over the next ten years without taking huge risks -- risks that can place them in an even worse predicament than they already are.

Let me repeat this, even if US pension funds aggressively allocate more to alternative investments -- hedge funds, private equity, real estate, infrastructure, etc. -- there is still little chance of attaining a 7 or 8 percent annualized rate of return over the next ten years.

And if my worst fears of deflation headed to the US materialize, even 4% annualized rate of return over the next ten years will be difficult to attain.

To understand why, go back to read my recent comment on pensions' brave new world where I noted the following:
Interestingly, the Alpine Macro report did discuss return scenarios under the deflation and inflation surprises, which you can see in table 2 below (click on image):



Quite shockingly, the authors conclude higher inflation would result in a worse outcome:
This is primarily because the P/E ratio would be compressed significantly, and the ERP would rise, both undercutting expected returns for stocks. For example, if we assume that steady-state inflation in the U.S. were to rise to 3.5%, with 2.5% steady-state real growth, equilibrium bond yields would be 6%. With the ERP at 200 basis points, the expected total return for U.S. stocks would be 3.2%. After inflation, the real return will be -0.3%.
I say shockingly because for pensions managing assets and liabilities, there is no question that unexpected inflation (which leads to higher rates) is a much better outcome than unexpected deflation.

I guess it all depends on what deflation scenario we're talking about because a prolonged debt deflation scenario I'm worried about will roil assets and make liabilities soar as the yield on the 10-year US Treasury note hits a new secular low. Mild disinflation is fine, prolonged debt deflation is a nightmare.
Let me quantify this so you understand my worst-case scenario for pensions. Prolonged deflation for me means an episode that lasts more than five years, where debt defation drives the yield on the 10-year Treasury note down to 0% or even negative territory.

We can argue whether this is a disaster scenario which is unlikely to occur barring another financial crisis of epic proportions, but if this happens, that 4% bogey won't be easy to attain for pensions even if they're heavily invested in alternative investments.

The problem now is stocks are quietly melting up and all risk assets are extremely overvalued, so people roll their eyes when I talk about the risks of prolonged debt deflation.

That's fine, even if we take Jack Bogle's sensible analysis which is nowhere near as dire as my worst case scenario, there is little chance US pensions will attain their desired rate of return.

So what does that mean in practice? Well, since many US public pensions are already chronically underfunded, what this means is contribution rates need to go up, benefits need to be cut or both to shore up these plans.

And neither unions nor state and local governments want to pump more money into their pensions but the problem is taxpayers don't want to see more hikes in their property taxes either, so something has to give.

No problem Leo, the Mother of all US pension bailouts is coming our way, Congress will quietly pass it and the Senate will approve it. Secretary Mnuchin will instruct the US Treasury to float a 50-year bond, and voila, the pension problem will disappear.

If you believe in fairy tales, be my guest, I prefer to stick to reality. And the truth is one way or another, US public pensions need to drop their pension rate-of-return fantasy even if that means contribution rates need to rise, benefits need to be cut or both.

By the way, it's not just Jack Bogle warning US public pensions to get real. Yale's David Swensen said the exact same thing recently, slamming US public pensions who justify a discount rate of 7.5 percent when he thinks they should be using the 10-year bond yield plus 50 basis points (roughly 3 percent).

Below, Vanguard's Jack Bogle isn’t optimistic about the state of US pensions over the next decade and talks about the inflows into passive investment products in Vanguard and BlackRock. See my comment on passive investing taking over and what that means exactly for investors.

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