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Pension Funds Will Return Less Than 3% Annually Over The Next Decade

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 CapitalistWhen Genius FailedThe End of Wall StreetWhile 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.

 

rober shiller ten year pe annualized chart
click to enlarge

 

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 fair to say that there will be a massive shortfall.

Raising the retirement age is an obvious and easy solution, but it is not enough. Either the State Governments’ themselves or the Federal Government should assume that returns will be based on current market valuations and not an automatic 7 or 8% return. It will not be easy to come up with an exact formula, but it surely beats the current system.  If we want to save the pension system, and provide security to seniors and people who will be retiring there must be a major reform of the system.

Disclosure: None


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  • Jacob Wolinsky

    I did not realize the underfunding was so low, I understand the power of the unions and while they accomplished great things in the early part of the 1900s, they are crippling our economy now state by state, city by city. Maybe I am living in fantasy land, but I really hope we can fix these problems before we go broke. Here is another great article I found about pensions (largely agrees with my assumptions) http://www.investors.com/NewsAndAnalysis/Article/567229/201103251914/Public-Pension-Plans-Underfunded-Even-With-Rosy-Forecasts.htm

    Here is a great comment you made on SA about caLPERs, I am going to re-post it here for the readers to enjoy.

    “That “saved” it 400 million this year.” I appreciate you putting “saved” in quotes. I guess CalPers is really deferring another 400 million debt over the next 15 years while only charging 7.75% on the deferred money; a burden to paid by taxpayers for services already consumed. I guess we can add that to the already deferred 122 billion.

    I read Jacob Wolisnky’s comments (first post – link: http://www.valuewalk.com/?p=6828 ) and I agree with him that CalPERS has grossly over estimated their potential returns. He states that CaLPERS will have a 180 billion dollar shortfall over the next ten years based on his projections. I think it is already much worse than 180 billion for several reasons:

    1) CalPERS is already 122 billion under funded on a market value basis (based on a funding ratio of 65% and 227 billion in assets). Full funding is therefore 349 billion.

    2) CalPERS formula of a 7.75% rate of return is based on 100% funding.

    3) CalPERS rate of return might not impact the current MVA numbers but it does grossly underestimate the “actuarial value” numbers, and hides the true cost of the pension plan.

    4) CalPERS smoothing policy extends the amortization period beyond the 5 year industry standard. CalPERS has extended their smoothing policy at least three times over the past eight years in an effort to keep costs to their members (cities‘, counties, special districts) from literally bankrupting everything.

    5) CalPERS continue to lie about the severity of the issue; they prefer to get as much employee service credited at the guaranteed rate of return of 7.75%. Did I mention the unions control CalPERS?

    If CalPERS 7.75% rate of return is based on 349 B in assets they need to return 27 billion in investment earnings. Unfortunately for the taxpayers that are on the hook for any and all shortfalls, CalPERS needs to return that 27 billion based on what they have in assets, which is 227 B. That’s roughly a 12% return just to keep the unfunded liability from growing. If, as Jacob projects, the return is 2.7%, CalPERS will resemble a train wreck and expect the many Counties, Cities‘, and Special District pension plans that they manage to cover the cost of their union dominated Boards mis-management. That will manifest itself in the form of increased pension contributions that some are projecting will be 60-70% of payroll. California cities can’t absorb that cost and all fiscal hell will break loose if we don’t get honest with this problem.

    Some people think Illinois pension system is in the worst shape and it probably is. But California, and CalPERS, is using accounting gimmicks to hide the true nature of the problem. The rate and velocity of the pensions is California is growing at an alarming clip. Pension formulas are a huge problem and amongst the most generous country. When you compound the effects of generous pension formulas, retirement at 50-55, and the highest wages in the nation is it any wonder that pension are an issue. It is almost standard that public safety employees retiree as early as 50 with 100-150k in pensions.

    The smoothing policy used by CalPERS is a sham. They have extended payment on unfunded liabilities out so far, for work that has already been consumed, that future generations will be paying for work that performed before they were born. Some people are referring to this as “intergenerational theft” and I don’t disagree. I equate it to buying a used car with about one year of life left and financing it over 15-30 years. Anyway, Girard Millar, a pension expert, writes about calPERS smoothing policy. Here is the link for those who may be interested: Pink Slips and Pension Red Ink: http://www.governing.com/colu...

    Here is an excerpt:

    “How high will this flood crest? Local employers are now skeptical that they have been told the full truth about how high their pension costs will ultimately surge. Unlike the vast majority of public pension funds, CalPERS uses a 15-year actuarial smoothing process that camouflages the genuine economic impact of market fluctuations. I have no issue with normal industry-standard actuarial smoothing periods of 5 years, in light of the average length of a business cycle — which is 6 years based on 14 recession cycles in the past 84 years. But the CalPERS process is opaque and flunks the transparency test that taxpayers, public managers and municipal bond investors are entitled to expect. As I have explained before, such extraordinary “smoothing” practices deserve SEC investigation as an “artifice and device” to conceal relevant financial information from the investment community — as well as the employers who must now bear the financial brunt of unsustainable pension benefits.”

  • Reform

    Jacob,

    I enjoyed the article but I’m not sure I agree with your conclusion. While I agree with your math I don’t think using 227 billion as the starting point is the correct approach. CalPers has 227 billion in assets but they also have 122 billion in unfunded liabilities, for a total of 349 billion (based on calpers being 65% funded). You can correct me if you think I’m wrong, but the pension model is predicated on expected rates of return, or the discount rate, based on full funding (349 billion). If CalPERS 7.75% rate of return is based on 349 B in assets they need to return 27 billion in investment earnings. Unfortunately for the taxpayers that are on the hook for any and all shortfalls, CalPERS needs to return that 27 billion based on what they have in assets, which is 227 B. That’s roughly a 12% return just to keep the unfunded liability from growing.

    Now, if you calculate based on your 2.7% projected rate of return, you will see how precarious our situation is out here in not so golden California. Changing the retirement age might seem like an easy and logical remedy – until you understand that unions want no part of it. And the unions control our democratic state.

    Here is an example of what is going on in my city. What calPERS considers the “Normal Rate” for a [email protected] retirement plan was 8-9% of payroll. The Normal Cost has grown to over 10% payroll. The total “employer cost” will be over 21% of payroll beginning July 1. This extra 11% is being charged is to help cover a “portion” of the unfunded liability and also pay for some additional pension perks (CalPERS has been nice enough to allow us to pay our debt over a 15-30 year period at 7.75% interest – known as smoothing – so we don’t get too upset about the increased costs that would occur assuming they used a standard 5 year smoothing policy). On top of the 21% of payroll we also pay the “employees” 8% contribution. Employees pay zero (and do NOT pay into social security), and taxpayers pay 29% of payroll toward pensions (about 26k per year).

    The average salary of a worker in this plan (general employees and management) is 88k (BTW, this CalPERS plan was only 52% funded on June 30, 2009). One of the additional pension perks I mentioned allows employees to include the 8% the city pays on their behalf as compensation for the purpose of determining their pension. So assuming the person retired at the average pay, with 30 years of city employment ([email protected]), the numbers would look like this: 88k * (1 + 8%) = 95K * (30*2.7) 81% = 77K per year.

  • Reform

    Jacob,

    I enjoyed the article but I’m not sure I agree with your conclusion. While I agree with your math I don’t think using 227 billion as the starting point is the correct approach. CalPers has 227 billion in assets but they also have 122 billion in unfunded liabilities, for a total of 349 billion (based on calpers being 65% funded). You can correct me if you think I’m wrong, but the pension model is predicated on expected rates of return, or the discount rate, based on full funding (349 billion). If CalPERS 7.75% rate of return is based on 349 B in assets they need to return 27 billion in investment earnings. Unfortunately for the taxpayers that are on the hook for any and all shortfalls, CalPERS needs to return that 27 billion based on what they have in assets, which is 227 B. That’s roughly a 12% return just to keep the unfunded liability from growing.

    Now, if you calculate based on your 2.7% projected rate of return, you will see how precarious our situation is out here in not so golden California. Changing the retirement age might seem like an easy and logical remedy – until you understand that unions want no part of it. And the unions control our democratic state.

    Here is an example of what is going on in my city. What calPERS considers the “Normal Rate” for a [email protected] retirement plan was 8-9% of payroll. The Normal Cost has grown to over 10% payroll. The total “employer cost” will be over 21% of payroll beginning July 1. This extra 11% is being charged is to help cover a “portion” of the unfunded liability and also pay for some additional pension perks (CalPERS has been nice enough to allow us to pay our debt over a 15-30 year period at 7.75% interest – known as smoothing – so we don’t get too upset about the increased costs that would occur assuming they used a standard 5 year smoothing policy). On top of the 21% of payroll we also pay the “employees” 8% contribution. Employees pay zero (and do NOT pay into social security), and taxpayers pay 29% of payroll toward pensions (about 26k per year).

    The average salary of a worker in this plan (general employees and management) is 88k (BTW, this CalPERS plan was only 52% funded on June 30, 2009). One of the additional pension perks I mentioned allows employees to include the 8% the city pays on their behalf as compensation for the purpose of determining their pension. So assuming the person retired at the average pay, with 30 years of city employment ([email protected]), the numbers would look like this: 88k * (1 + 8%) = 95K * (30*2.7) 81% = 77K per year.