The size of the public pension overhag in the U.S. Is quite startling. What’s more startling is the discount rate assumed: 8%. It’s been a long time since public markets returned 8% on a sustained basis.
But there’s a reason for this rosy return outlook. If pension plans used a more realistic rate, their liabilities would double, according Mebane Faber, chief investment officer at Cambria Investment Management in El Segundo California.
In a paper entitled “What if 8% is Really 0%? Pension Funds Investing with Fingers-Crossed and Eyes Closed,” he argues that not is 8% not likely, but that pension funds should prepare for the worst, a Japanese scenario with 0% returns for the next 20 years.
One argument he uses is that pension funds at the beginning of the 1982 bull market had tailwinds: 10% interest rates and stocks valued at 10 times earnings. New yields are 4% and p/e’s are at 20.
Thus, he writes; “With government bonds yielding about 4% plan sponsors must invest in other outperforming assets to bring the cumulative return to 8%. The problem with allocating assets away from the risk-free rate is that they are, by definition, risky and uncertain. If a pension manager is employing the benchmark 60% stock/40% bond allocation, the 60% in equity or diversifying assets must return approximately 11% to achieve 8% total returns.”
As a result, managers “may be tempted to chase higher performing and riskier asset classes, and may end up compounding the underfunding problem even more through exposure to these risky asset mixes,” and it appears “funds using the highest return assumptions have the most underfunded pensions, a scenario that could be called, ‘fingers crossed and eyes closed’.”
In this, pension plans are imitating what Faber calls the “Endowment Model” based on the portfolio allocations used by the Harvard and Yale Endowment Funds. By investing in such assets as private equity, real estate and timberlands, such funds earned an illiquidity premium.
“Yet, as real money investors sought diversification through the same methodology, their portfolios were, in fact, becoming more correlated to each other while portfolio risks were becoming more concentrated and increasingly dependent upon illiquid equity-like investments.
“Most real money funds were not prepared for the following stress scenarios to their portfolio:
·US and Foreign Stocks declining over 50%
·Commodities declining 67%
·Real Estate (REITs) declining 68%”
Those were the peak drawdowns in 2008-2009, Faber notes and had a dual impact. First, there was no diversification benefit, at least during times of crisis. Second, funds with ongoing payout obligations found they had shorter time horizons than they had originally thought.
But most of all, their stress-testing was not adequate. Faber proposes his own stress test for the endowment model.
“A proxy can be created tracking the average US endowment with a 20% allocation each to US Stocks, Foreign Stocks, US Government Bonds, REITs, and Commodities. This monthly rebalanced allocation would have returned 5.58% over the past 10 years, in-line with the average endowment with similar volatility and a high correlation coefficient. The very best endowments, the Harvard and Yale portfolios, historically have outperformed the average endowment by about 300-400 bps.” Note that it falls short of the 8% expected return.
Now how would that model have fared in Japan? “First, that the endowment-style portfolio returned just 1.42% in Japan over the past two decades, far less than the 8% assumption employed by many U.S. public pension funds. Second, a Japanese pension fund manager who chose to chase returns by investing in equities over the past twenty years would have exacerbated his problems by generating returns of -4.62% versus Japanese government bond returns of 4.36% per year.
“By diversifying away from bonds and into risky assets, the endowment style portfolio has the potential to perform better, but also worse than the risk-free rate. Again, the attempt to chase returns using riskier equity assets can backfire as bonds returned 4.36% per year over the period.”
For Faber, return-chasing has to be replaced by risk management.
“To fully fund their obligations, pensions need higher contributions and more accurate accounting based on more realistic return assumptions, “ he says. To quote from the now retired broacdaster, “that’s not news, but that too is reality.”