I have written several articles about pensions. Two things inspired me to write an article about how to fix the pension problem. One is my recent interview interview with Roger Lowenstein, the second is an article which appeared in the WSJ yesterday titled: Public Pension Fund Squeeze.
First let us start off with Lowenstein. Unfortunately, many people outside the value investing world have not heard the name despite the fact that he wrote several best-sellers, and wrote a book about the pension mess in 2004, far before it became the headlines that are appearing every day in the news. He was also asked to testify before The Financial Crisis Inquiry Commission, which was designated by the Federal Government to investigate the causes of the sub-prime mess and mortgage crisis.
Roger Lowenstein, a best-selling author, has published five books;Buffett: The Making of an American Capitalist, When Genius Failed, The End of Wall Street, While America Aged and Origins of the Crash . Mr. Lowenstein is a contributing writer for The New York Times Magazine and a columnist for Bloomberg. He frequently contributes articles and reviews to those and other publications. He is also a director of Sequoia Fund. His father, Louis Lowenstein, was an attorney, Columbia Law School professor and author and a noted critic of the financial industry.
Lowesntein made the following point about pensions, which I largely agree with:
Pensions are in many senses an ideal savings vehicle. They collectivize the various risks of retirement. Think about the risks of retirement. If you’re saving for yourself you have to worry you might live until 110 and consequently you’ll have to over-save. The beauty of a pension plan is that it saves for a whole group of people and you can actually make a pretty good guess that the average won’t live until 110. So you just save until the average of 84 (or whatever the average mortality is).
Most readers of this site are sophisticated investors (I know from both the emails I receive, and from looking at Value Walk’s site demographics), however, we are a tiny group. Most Americans, even very educated ones are clueless when it comes to investing.
The average American simply does not have the skill nor the knowledge to adequately plan for retirement. In general, I favor people saving for themselves, but one cannot negate the fact that it will be a financial disaster if pensions (which so many people rely on) are not fixed. I can throw out tons of statistics but here is one from cnbc.com.
According to a recent Employee Benefit Research Institute (EBRI) survey:
More than half of the workers surveyed said they’re saving for retirement but of that group, more than half said they had less than $25,000 saved. And a third of all workers surveyed said they thought they’d need less than $250,000 for a comfortable retirement.
Defined benefit plans would clearly be a solution to the problem. Making workers pay more into the system and raising the retirement age are an absolute necessiaty. Lowenstein agreed that the retirement age should be raised.
However, I wanted to focus more on the article from the WSJ. The article looked at the assumed rate of return of the largest US pension funds in the US. The majority of these firms assumed at least an 8% return.
My First point is that these funds are very large and while many people reading this article (and this author) have produced returns above 8% over the past few years while the market was practically flat, these pension funds do not have the flexibility to invest in undervalued securities, like net-nets that have market caps of $20 million. Many firms are not even legally allowed to invest in stocks below $5 or below a certain market cap. Even if the funds were allowed to invest in these securities, I doubt they would, since most follow herd mentality. Additionally, as John Bogle explains that the law of mathematics dictate that since pension funds are part of the market, the average pension fund will produce market returns minus all expenses.
This brings me to my second point. The current yield on the ten year treasury is 3.4%. Let us do some basic math on here. I am going to exclude inflation and focus on nominal not real returns, even though I think we are likely to see a inflation pick up a lot sometime in the next few years. I believe we already have inflation, it just has not shown up on the flawed CPI. But back to the math.
According to a NYT article from last year the average pension fund has a 60/40 stock/bond allocation, which is what I would assume is the industry average. I am assuming for the purpose of this article that this will stay somewhat around the same.
Let us assume that the bond portion of the portfolio will be invested in a diversified portfolio of bonds. Vanguard’s Total Bond Market Index Fund is currently yielding 3.34%, that will make up 40% of the portfolio. This is a very easy calculation to do assuming no changes are made in allocation and bonds are held to maturity. The bond portion of the portfolio will give us a return of 1.4%. Stocks will have to make up the rest to get us to 8%. Stocks will have to return 11% to give us the 6.6% to add up to 8%.
It is very tricky to figure out future stock returns, but 10% is the average return of the stock market over the past few decades. However, the pension funds are assuming an even higher rate of return going forward. This is absurd considering how overvalued the general market is. Let us take the Shiller PE, which despite its flaws, is one of the best ways of calculating future stock returns. The Shiller PE is currently at 24, the historic mean is 16.40% (data from http://www.multpl.com/). That means that the market is overvalued by 30%. If we use ten year returns going forward using the Shiller PE we should get market annualized market returns of 2.1% over the next 10 years.
Using the 60/40 formula we should get 2.1%*.6 and add that to the 1.4% calculated above for bonds. The total REAL return based on this formula is 2.7% annual returns. This is frighteningly lower than the 8% that pension funds are assuming.
Let us take caLPERs (the largest pension fund in the US), which manages $227 billion and is assuming a 7.75% return according to the Wall Street Journal article, which I linked above. Using their formula (assuming contributions and withdrawls are equal (even though withdrawals are more likely)) CALPERs should have $480 billion. Using my assumptions they will have $300 billion in ten years. This is a shortfall of $180 billion in real returns. My formula is not perfect, and as I mentioned it is very hard to predict future stock returns. Additionally, the fund has 10% of its money in Real Estate, however, 63% is in stocks and another 2% in cash yielding nothing. It is