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2015-11-26 12:22:27
Pension funds and endowments are too optimistic
Nov 21st 2015
KEEP your eyes on the stars, said Teddy Roosevelt, and your feet on the
ground. America s can-do spirit keeps its economy moving forward, but
over-optimism can be harmful, especially if it leads people to make promises
they cannot meet. If investment returns are lower in coming decades than they
have been in recent ones, that is the position pension funds and college
endowments will be in.
When final-salary pension schemes, which are still prevalent among America s
public-sector employees, decide how much to put aside to pay pensions, they
have to make an assumption about what returns they will earn. The higher their
estimate, the less employers have to contribute today. Similarly, endowments
have to estimate their future returns to determine how much to spend each year:
pay out too much and their funds will dwindle away.
The average American state or local-government pension fund assumes it will
earn a nominal (ie, not accounting for inflation) annual return of 7.69% in
future, according to the National Association of State Retirement
Administrators (NASRA). Based on past performance, that seems reasonable. Over
the past five years the median pension fund has earned an annualised return of
9.5%; over the past 25 years, the return has been 8.5%. College endowments use
very similar assumptions: they target a return of 7.4%, on average, according
to a survey from the National Association of College and University Business
Officers (NACUBO) and Commonfund, an asset manager. Again, this jibes with the
average annual return in 2005-14, of 7.1%.
But as the saying goes, past performance is no guide to future returns.
Investment returns come from two sources: income and capital gains. The income
portion is much lower than it used to be. The yield on long-dated Treasury
bonds 25 years ago was more than 8%; an investor who held such bonds to
maturity could lock in that nominal return. Now the yield on the ten-year
Treasury bond is just 2.3%. Yields on corporate bonds, which pay a spread over
government debt, have fallen in tandem. For equities, the dividend yield on the
S&P 500 index in 1990 was 3.7%; now it is just 2.1%. (In theory share buy-backs
make up for some of the fall in dividends, but they are offset by the issuance
of new equity for executive bonuses.)
Yields move in the opposite direction to prices. They are low because the price
of equities and bonds has risen dramatically in recent years. This has
delivered capital gains to investors, boosting total returns.
Future gains depend either on even higher valuations, or on increases in
profits and dividends. Profits usually grow in line with the economy. They can
rise faster when the economy is recovering from recession, but the American
economy has been growing for years, and profits are close to a post-war high as
a share of GDP.
So a pension fund or endowment that assumes investment returns will continue at
their recent pace is engaging in doublethink. For that to happen, either
profits will have to take an unprecedentedly high share of GDP or yields will
have to fall to an unprecedentedly low level. In other words, for future
returns to match the past, future economic conditions would have to look
completely different.
Elroy Dimson, a professor at both the Cambridge and London Business Schools, is
the co-author of a study of investment returns, covering 23 countries and more
than a century of data. He thinks the likely future long-term real return on a
balanced portfolio of equities and bonds will be 2-2.5%. AQR, a fund-management
group, has come up with a remarkably similar figure, 2.4%, by assuming annual
growth in dividends and profits of 1.5% for a portfolio priced at current
valuations and split 60-40 between equities and bonds. It applied the same
formula to valuations over the past century, and found that the current
projected return is lower than at any time in the past (see chart). Assuming an
inflation rate of 2%, such a real return equates to a nominal one of 4-4.5%,
far short of the estimates used by pension funds and endowments.
Decent investment returns are vital if pensions are to be paid in full.
According to NASRA, the total revenues the money needed to pay benefits of
American public-sector pension funds have been $5.9 trillion since 1984. Of
this, employers have contributed $1.5 trillion and employees $730 billion. The
vast bulk $3.7 trillion came from investment returns.
Yet states and local governments are not putting away enough to pay pensions,
even assuming their optimistic assumptions about returns are met. The last year
funds made the full contribution required by their plans was 2001. They have
fallen short by 10% or more in every year since 2008. As a result, the Centre
for Retirement Research (CRR) estimates that the average state and local
pension plan was 74% funded at the end of last year down from fully funded in
2001. That equates to a deficit of $1 trillion or so. As the hole gets bigger,
higher future contributions are needed. They have risen from 6.7% of payroll in
2001 to 18.6% now.
The realistic solutions to this mess are bigger contributions from employers
(higher taxes, in other words), higher contributions from employees (pay cuts)
or reduced benefits. But many pension funds seem to hope they can make up the
shortfall in returns by investing in alternative assets (property, private
equity and hedge funds). A survey by Towers Watson, an actuary, showed that
alternative assets as a proportion of American pension portfolios (public and
private) rose from 16% in 2004 to 29% in 2014.
Such diversification has not been wholly successful. So far this year a global
hedge-fund index produced by HFR, a data provider, is down by 2.6%. The index
also fell by 0.6% in 2014. Long-term returns on American property are very
similar to those from equities. Future returns from this asset class are also
likely to have fallen: the yield on property funds (REITs, in the jargon) was
more than 8% in 2000, but is now below 4%. Long-term returns from private
equity have been better (14% annualised over the past decade, according to
Bain, a consultancy), but the industry is not large enough to absorb huge
amounts of pension money. Buy-outs totalled $252 billion in 2014; American
public-sector pension funds have assets of $3.2 trillion. Investing in
alternative assets may be a sensible way of reducing risk, but it is unlikely
to boost overall returns by much.
College endowments have to make similar calculations to pension funds. If they
want to maintain their assets over the long term, they have to be prudent in
their investment assumptions. The rule of thumb, according to William Jarvis at
Commonfund, is to take the assumed investment return of 7-7.5% and deduct a
percentage point for expenses and two points for inflation. That translates
into a spending rate of 4-5% a year. The average college spent 4.4% of its
endowment on operating expenses in 2014.
If investment returns fall to 4-4.5%, and the same rule of thumb applies,
spending could drop to 1-1.5% of assets, a two-thirds decrease. Fortunately,
universities are much less dependent on investment returns than public pension
funds: they also get money from tuition fees and gifts from donors. Big
colleges (those with assets of over $1 billion) are the most exposed: they rely
on their endowments for 16.9% of their budget, compared with 4.2% for colleges
that have less than $25m in assets. But in both cases, the squeeze will not be
as great as the one that pension funds face.
Other long-term investors could also be at risk. German insurers offer savings
products with an average guaranteed return of 3.2%, well above the current
level of government-bond yields. Japanese insurers were devastated by a similar
problem in the 1990s; some had to close.
The good news is that this is a long-term problem. Low returns are like a car
with a fuel leak; it can still be driven for a while before it grinds to a
halt. The bad news is that, precisely because this is a long-term problem,
investors (particularly the politicians responsible for public pension funds)
will be tempted to leave it to their successors. That will only make the
eventual funding crisis even bigger.