Recent news that British Telecom (BT) is paying £2bn into its pension fund to help cover its deficit is a fitting reminder of the shortfalls facing many pension funds. The crux of the matter is that many funds are still living in the past. The falling nominal interest rates and cheap equity valuations that were redolent of the 1980s led to exceptionally favourable conditions for bonds and equities. The standard pension fund portfolio of 50% bonds and 50% equities fared very well.
(click on chart for better viewing)
The financial crisis wreaked havoc in the markets. Equities suffered huge falls and the government bonds of countries deemed financially sound – the US, UK, Germany, etc – soared. Nevertheless, the capital gain on the bonds was not enough make up for the losses on equities and many pension funds saw their asset-liability mismatch widen. (The chart above doesn’t capture any losses incurred when fund managers cut equities at the lows of March 2009 and waited too long to get back in, missing much of the ensuing rally.)
The crisis has left in its aftermath a completely different financial environment. Real rates across the developed and much of the emerging-market world are negative, and equity valuations look rich. John Hussman of Hussman Funds projects the 10 year annual total return for the S&P500 – based on current valuations of a P/E of 14 and a dividend yield of less than 2% – to be under 5%. With official inflation at 2.9% (and actual inflation likely much higher), and this figure likely to rise over the next decade as a consequence of the extremely loose monetary policies of global central banks, it is barely likely stocks will provide any real returns. Government bonds of some of the largest markets –US, UK, Germany, Japan– are exceedingly overbought and are also very unlikely to provide any returns after inflation over the coming years.
Yet pension funds are still living in the past. Many are still projecting annual returns over the next ten or twenty years of 5 to as high as 8%. This is a dangerous assumption.
A 2010 paper from Stanford University highlights the difference in the funding ratios (assets divided by liabilities, so anything less than 100% implies that their liabilities are underfunded) using stated, likely fanciful, expected returns; and also using lower, more realistic returns. The data is shown for some of the US’s biggest pension funds: CalPERS, CalSTRS (Californian public employees and teachers), and UCRS (UniversityofCalifornia Retirement Scheme).
(click on table for better viewing)
As can be seen (click image to see a much clearer version), under the inflated assumption of a 7.75% discount rate, the funding shortfall for CalPERS of 13.9% (100% – 86.1%), jumps to over 50% if a discount rate of 4.14% is used. Remember, an estimate for the annualized 10 year return of the S&P 500 is a little under 5%, and for bonds much less, so around 4% is a realistic assumption.
The power of compound interest, which Einstein reputedly called the “eighth wonder of the world”, never fails to stagger. The American Indians who sold Manhattan to a Dutch trader for $24 worth of beads, had they invested the money at a compound interest rate of 6% for 380 years, would now have over $100 billion. With this they could have bought a good slice of the island back, complete with roads, buildings, sewers etc.
And compound interest is critical to pension fund forecasts, which is why estimates of rates of return on assets should be taken very seriously. As illustrated above, a change in the assumed discount rate of only a few percentage points can have a colossal effect. We have focused on the US in this short blog post, but the situation in the UK, Japan and much of Europe is similar, or worse. The net result is many of us are going to have significantly less than we expect when we retire.
Workers today will have to more actively manage their portfolios (perhaps using SIPPs or 401ks), or employ managers who are not attached to the buy-and-hold strategies of yesteryear which will flounder in this new financial environment. Protection of purchasing power is key, which is why gold should be a constituent of any portfolio.
We have written on this topic before. Please see Pensions – A Tipping Point in Sight for an analysis of which portfolios are best for protecting purchasing power over the long term, while keeping volatility low. You can be sure they are not the sort of portfolio your anachronistic pension manager is investing in.