It’s unlikely that most U.S. companies can achieve the pension investment-return assumptions they have set, says Warren Buffett in his annual letter to Berkshire Hathaway shareholders.
For the 363 companies in the S&P 500 that have pension plans, this assumption averaged 8% in 2006. The average holdings of bonds and cash for all pension funds is about 28%, and on these assets, returns can be expected to be no more than 5%. Higher yields, he adds, are obtainable but there is a risk of a greater loss.
“This means that the remaining 72% of assets—which are mostly in equities, either held directly or through vehicles such as hedge funds or private-equity investments—must earn 9.2% in order for the fund overall to achieve the postulated 8%,” Berkshire’s chairman and CEO says. “And that return must be delivered after all fees, which are now far higher than they have ever been.”
“How realistic is this expectation?,” Buffett asks. During the 20th century, the Dow advanced from 66 to 11,497. The gain is just 5.3% when compounded annually. An investor who owned the Dow throughout the century would have also received dividends for much of the period, but only about 2% or so in the final years.
“Think now about this century. For investors to merely match that 5.3% market-value gain, the Dow—recently below 13,000—would need to close at about 2,000,000 on December 31, 2099,” says Buffett. “We are now eight years into this century and we have racked up less than 2,000 of the 1,988,000 Dow points the market needed to travel in this hundred years to equal the 5.3% of the last.”
He writes that dividends continue to be about 2% and even if stocks were to average the 5.3% annual appreciation of the 1900s, the equity portion of plan assets—allowing for expenses of 0.5%—would produce no more than 7% or so.
Buffett also says he is confused by the fact that of the companies that have pension plans in both the U.S. and Europe, almost all assume the U.S. plans will earn more than the non-U.S. plans. “Why should these companies not put their U.S. managers in charge of the non-U.S. pension assets and let them work their magic on these assets as well?,” he asks. “I’ve never seen this puzzle explained. But the auditors and actuaries who are charged with betting the return assumptions seem to have no problem with it.”
“What is no puzzle, however, is why CEOs opt for a high investment assumption: It lets them report higher earnings. And if they are wrong, as I believe they are, the chickens won’t come home to roost until long after they retire.”
Whatever pension-cost surprises are in store for shareholders, Buffett says U.S. taxpayers will have bigger problems to deal with, as public pension promises are large and, in many cases, funding is inadequate.
“Because the fuse on this time bomb is long, politicians flinch from inflicting tax pain, given that problems will only become apparent long after these officials have departed,” he concludes. “In a world where people are living longer and inflation is uncertain, those promises will be anything but easy to keep.”
To read Buffett’s letter to shareholders on Berkshire Hathaway’s website, click here.
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