Wednesday, March 10, 2010

Pension Funds are in Denial

Two weeks ago we wrote about how Greece and the EU were in denial.  We did not intend to single out Europe and Greece as their problems are equally present in the US and most of its states.  If you are in doubt then simply read the recent New York Times article Public Pension Funds Are Adding Risk to Raise Returns.  Let's take a look at some excerpts:

Companies are quietly and gradually moving their pension funds out of stocks. They want to reduce their investment risk and are buying more long-term bonds.

But states and other bodies of government are seeking higher returns for their pension funds, to make up for ground lost in the last couple of years and to pay all the benefits promised to present and future retirees. Higher returns come with more risk.

“In effect, they’re going to Las Vegas,” said Frederick E. Rowe, a Dallas investor and the former chairman of the Texas Pension Review Board, which oversees public plans in that state. “Double up to catch up.”

Mr. Rowe has it exactly right.  As anyone who has gone bust either first or second hand, the most common refrain is that the gambler wanted to just win back their losses.

A spokeswoman for the Texas teachers’ fund said plan administrators believed that such alternative investments were the likeliest way to earn 8 percent average annual returns over time.

Because of the bull market from 1982-2000, everyone got this idea in their head that 8%+ annual returns was the norm.  This mentality has still not been destroyed even after ten years of dissapointment.  We obviously have a long way to go.

Boeing and other companies seeking to reduce their investment risk are moving into fixed-income instruments, like bonds — but not just any bonds. They are buying and holding bonds scheduled to pay many years in the future, when their retirees expect their money.

Pension funds went big into tech stocks in the late 90s.  They went big into housing, private equity and hedge funds in the late 00s.  Now they are going heavily into long term bonds.  This, with record low interest rates all around the world and central banks practicing competitive debasement of their currencies.  Sounds about right.

The value of the bonds may fall in the meantime, just like the value of stocks. But declining bond prices are not such a worry, because the companies plan to hold the bonds for the accompanying interest payments that will in turn go to retirees, not sell them in the interim.

That is well and good, but what if the bond issuer defaults?  You can lose money just as quickly in bonds as you can in stocks.

Government pension plans cannot beef up their bonds that mature many, many years from now without dashing their business models. They use long-range estimates that presume high investment returns will cover most of the cost of the benefits they must pay. And that, they say, allows them to make smaller contributions along the way.

Most have been assuming their investments will pay 8 percent a year on average, over the long term. This is based on an assumption that stocks will pay 9.5 percent on average, and bonds will pay about 5.75 percent, in roughly a 60-40 mix.

Again, in what universe is 9.5% an expected return for stocks?  Let's pause for a second and use a little logic.  Suppose that GDP, a proxy for the economy as a whole, grows at 5% per year.  Note that this is a very fast growth rate for a mature economy.  Now, let's think about this.  How can stocks, which are priced based off of the earnings power of corporations, which in turn are a subset of the economy, grow faster than the rest of the economy?  Sure, over short periods of time this is possible but mathematically speaking, stocks cannot outperform the economic growth as a whole forever.  If they did, stocks would eventually grow to be larger than the whole economy, which of course is impossible.

The problem now is that bond rates have been low for years, and stocks have been prone to such wild swings that a 60-40 mixture of stocks and bonds is not paying 8 percent. Many public pension funds have been averaging a little more than 3 percent a year for the last decade, so they have fallen behind where their planning models say they should be. 

Stocks outperformed from 1982-2000.  Therefore, it should hardly be surprising that stocks underperformed from 2000-2010.  In fact, what would be surpring is if stocks stopped underperforming in the next eight years.  This is called mean reversion.

A growing number of experts say that governments need to lower the assumptions they make about rates of return, to reflect today’s market conditions. 

But plan officials say they cannot. 

“Nobody wants to adjust the rate, because liabilities would explode,” said Trent May, chief investment officer of Wyoming’s state pension fund.

We will dub this the Ostrich Investment Plan (OIP).  Head, meet sand.  Like we mentioned with the EU and Greece, these pension fund managers and politicians are in denial.

The $30 billion Colorado state pension fund is one of a tiny number of government plans to disclose how much difference even a slight change in its projected rate of return could make. Colorado has been assuming its investments will earn 8.5 percent annually, on average, and on that basis it reported a $17.9 billion shortfall in its most recent annual report. 

But the state also disclosed what would happen if it lowered its investment assumption just half a percentage point, to 8 percent. Though it might be more likely to achieve that return, Colorado would earn less over time on its investments. So at 8 percent, the plan’s shortfall would actually jump to $21.4 billion. Contributions would need to increase to keep pace. 

Colorado looks like they are doomed.  Of course, the game of kick the can will continue as long as possible.

Colorado cannot afford the contributions it owes, even at the current estimated rate of return. It has fallen behind by several billion dollars on its yearly contributions, and after a bruising battle the legislature recently passed a bill reducing retirees’ cost-of-living adjustment, to 2 percent, from 3.5 percent. Public employees’ unions are threatening to sue to have the law repealed.

More people in denial.  Colorado cannot afford a 2% increase, let alone 3.5%.

If Colorado could somehow get 9 percent annual returns from its investments, though, its pension shortfall would shrink to a less daunting $15 billion, according to its annual report.

Why not just assume a 30% annual return and claim a surplus?  Problem solved.  I should run for office.

That explains why plan officials are looking everywhere for high-yielding investments.

Yes, the funding shortfalls explain why pension funds are stretching for yield.  Another explanation is that record low interest rates, which are a result of Federal Reserve policies, are forcing these funds to take greater risks.  This is the downside to low interest rates.

Officials of the State of Wisconsin Investment Board declined to be interviewed but provided written descriptions of risk parity. The records show that Wisconsin wanted to reduce its exposure to the stock market, and shifting money into the inflation-proof Treasury bonds would do that. But Wisconsin also wanted to keep its assumed rate of return at 7.8 percent, and the Treasury bonds would not pay that much.

Wisconsin decided it could lower its equities but preserve its assumption if it also added a significant amount of leverage to its pension fund, by using a variety of derivative instruments, like swaps, futures or repurchase agreements.

You just have to laugh at this one.  The gall of these fund managers who think they can goose returns by using swaps, repos, etc. is hilarious.  They don't stand a chance.

Stating the Obvious
All of these wishful projections and financial shenanigans are a waste of time at best.  One or two pensions funds may get lucky and shoot the moon but as a whole, these pension funds cannot possibly outperform the market because they are simply too big.  You cannot outperform the market if you are the market, in other words.  Promises have been made that cannot be kept because there is simply not enough money.  The longer this reality is denied, the harsher the end game will be.
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