Pension assumptions hitting the wall

By J Saft
January 14, 2009

James Saft Great Debate — James Saft is a Reuters columnist. The opinions expressed are his own —

That 8 percent annual return on investment you and your pension fund manager were banking on is now looking almost as optimistic as Madoff’s magic 12 percent, as deleveraging and deflation bite.

With extremely low or negative interest rates and everyone from consumers to banks trying to shed debt and assets at the same time, what seemed like reasonable projections for a mixed portfolio of stocks, bonds and other assets are now substantially too high.

The implications are a potentially huge hit to corporate earnings and the economy. Companies will be forced to pony up more to keep their pension funds adequately funded while even consumers not encumbered by lots of debt will be likely to raise their savings rate to compensate for lower returns, thus acting as a drag on consumption.

And, while higher savings rates are ultimately what the economy needs, most U.S. company pension plans that promise a payoff based on workers’ final salaries assume an overall return on assets of about 8 percent a year. Individuals and their investment counselors are often even more optimistic, penciling in 9 or 10 percent a year and often maximizing exposure to riskier assets to try and get there.

“The available return from markets has been for some time a lot lower than people have understood,” said Gary Dugan, chief investment officer at Merrill Lynch’s wealth management arm in London.

Returns have been flattered by debt; both that employed in investment strategies to magnify returns and that taken out by consumers and partly recycled into corporate profits. And remember too, if you are an investor who doesn’t leverage you are still affected, as those who did inflated valuations and will remain sellers.

“The challenge is to increase savings to pension plans or long-term savings — a very substantial increase — because long-term returns are negligible,” Dugan said. He estimates equity market returns of between 4 and 7 percent over the next few years.

It may not seem like a lot to assume a 6 or 7 percent annual return rather than 8 or 9, but a rule of thumb is that every 1 percent less in performance requires an extra 10 percent in annual funding to counteract.


David Zion at Credit Suisse in New York estimates that the pension funds of the S&P 500 companies could be $362 billion underfunded, a drop of $420 billion in the year. This is far worse than back in 2002 after the last stock market slump and leaves 70 of the 500 with underfundings equivalent to more than 10 percent of their market cap.

This can easily translate to hits to earnings if companies decide to up their contributions, which ironically if done en masse will further depress stock markets and the value of the pension fund. Rinse and repeat.

For final salary pension plans, last year was doubly awful; losses were extremely deep and the interest rates they use to value their future liabilities to pensioners moved in the wrong direction, down.

Funds use a discount rate, in the United States usually one tied to the yield on corporate debt, as a tool to determine their future obligations to pensioners; the lower the rate the bigger the obligation now.

That makes very low inflation or even deflation a real bear for pensions. The Mercer U.S. pension Index Rate, a benchmark for these valuations, fell by almost 1.50 percentage points to 6.11 percent in December, as government rates fell.

Expect this all to be an emerging trend in the next year, and not just in the United States. Of course it is possible that companies and their regulators move to a fudge, not lowering return expectations and even giving companies a break on how they value their obligations, arguing no doubt that current low interest rates are exceptional. Investors who buy shares in these companies, and whose future stream of earnings may be hit by pension costs, may not be so forgiving.

Individuals saving for their own retirements also have to make assumptions about what their investments will command and how much they need to save to reach their goals. It’s very likely that those rates of savings need to rise and the assumptions fall. It will also be interesting to see if equities as an asset class remains as popular.

Finally there is one group that will find itself very vulnerable if we face an extended period of very low inflation and investment returns: investment managers and advisers.

It is one thing to pay out 1 percent a year to a mutual fund manager if you think you can make 9 percent a year, quite another if it’s only six. As for hedge funds charging 2 percent of assets under management plus 20 percent of gains, well, the math is even worse.

— At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click here. —


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As always investment returns are always relative. If you are lucky enough to be saving above average, while others rely on unrealistic investment assumptions that deliver below average returns then in the end you will be relatively better off than average. Assuming prices in the broader economy reflect average incomes for that region then your above average savings should go further than those that saved less.

Of course, absolute sums matter, generally the more the better, but regardless of how you slice it you cannot get 8-10% returns safely out of an economy that is growing circa 3% p.a. net of inflation without using leverage in combination with credit, foreign currency or interest rate risk(s) regardless of whether you are in equity or bonds. We cannot all grow faster than trend.

Posted by MrBill, Eurasia | Report as abusive

With a globalized economy, outsourcing and “free” trade, it’s not just U.S. workers’ pension assumptions hitting the wall. We have given the country away in the pursuit of global corporate profits so it’s the American dream hitting the wall and with current economic policies there will be no long term bounce. In with a roar, out with a whimper.

Posted by Ray | Report as abusive

Returns fall, but so does inflation, so I’m not sure absolute returns really matter, only returns relative to inflation. It is true that the global economy has pulled down wages of US workers, but it has also kept inflation down by providing Americans with cheaper products, so once again things tend to even out. The group of people who have lately benefited most from all of this mess are people with no assets, but have wages that have stayed the same. They now have more disposable income now that gas and other commodity prices have fallen. That’s why Wal Mart is still doing better than other retailers.

Posted by John Ray | Report as abusive

First, the assumption should be more like 3%, not 6%. Retirements need both savings and investment. Relying only on investment is reckless. The potential for living to the mid eighties means that retirees should plan on 25 years for both retirement assets and income to last. So a $100,000 in retirement should be looked at as no more than $4k per year, because inflation will eat it up. The government is playing fast and loose with inflation and therefore, expect inflation to ultimately hit stocks and improve the pitiful interest rates of today. Warren Buffet lends to GE at 10% plus coupon. The government and individuals are essentially at -0- interest. This is not sustainable as the US prints money like crazy. Lets get those interest rates up and stop consuming gewgaws from Japan and China and blood oil from Iran and the Arab countries.

Posted by George | Report as abusive

Saft’s comments are both accurate and misleading. Accurate in that attaining an 8% return in the next year or two will be challenging. Misleading for those with a longer horizon.

The 8% assumption was never meant to be an every year number but rather an average with some years doing much better and others doing much worse. For those who have a short-term horizon in terms of retirement, Saft’s point is correct and a problem.

For those with a reasonably long horizon it is still a reasonable benchmark. Despite the current market, the average annual compound return of the S&P 500 for the past 39 years remains in 10% range (about 8% capital increase + about 2% dividend return). Unless one believes the economy will never recover, the long term assumption of 8% remains reasonable.

Posted by Dave | Report as abusive

“MrBill” is right: our investments can’t grow 8% per year when our productivity grows 3% (or less) per year.

The 8% figure has ALWAYS been a fraudulent sales pitch. It’s amazing that even with the current economic crisis, only a handful of people realize this.

Wise up folks; you’re going to have to save a LOT more of your income (or retire a LOT later, or die a LOT earlier) if you’re going to avoid running out of money during retirement.

Posted by Mark | Report as abusive

[…] Reuters […]

Posted by Pension assumptions hitting the wall | Crash Survival Zone | Report as abusive

The U.S. needs to examine billions of dollars in tax giveaways in the form of transfer payments. We are far too generous to those who have provided virtually nothing to pay for the benefits they assume as an entitlement. In effect, we are the slaves of those who always take but don’t give. Transfer payments are the largest slice of the federal budget, and without action, may grow to levels not sustained by revenue. Sound familiar?

Posted by Fred | Report as abusive

The stock market returns of the last 20 years we’re based on conditions that are no longer are sustainable. We are no longer a well off country. We have burned the candle at both ends and now the jig is up. Anyone that would like to return to the good old days should not have voted for Bush. You will still be able to get an 8% return from stocks but only from emerginng markets.
Most pension funds will now start investing globally to get those returns. The United States is no longer the country of the future.

Posted by Stan Trexler | Report as abusive

Stan, please always remember, buy low, sell high. It may sound trite, but it is a truism. If emerging markets get too expensive relative to earnings then there is no upside despite growth. You’re not buying growth, but future profits. The same for the USA. If US stocks get too cheap relative to earnings that is what you want to buy. Any asset can either be too expensive or relatively cheap.

Dave, the yield on the S&P500 is about 3% p.a. right now. That means that on average you will break even only after 30-years with a current P/E of around 10. That may be historically about average, but there is nothing that says that future returns will either match or outperform average returns. If you are a buy and hold investor you have not made any money in the past twenty years net of inflation from the stock market. In order to make money you either needed to time the market and/or you needed to be in and out of foreign markets as well.

Posted by MrBill, Eurasia | Report as abusive

I’d only read this article to cheer myself up… but now I’m beginning to wish I read a different article.

Posted by Peter H | Report as abusive

Mr. Madoff lacks the relative security of a jail cell. Given that neither his employees nor his family were aware of his misdeeds I would imagine that prosecutors would have no case if he expired. Is it possible that the deafening silence of his “victims” is the result of unreported income from Mr. Madoff?

Posted by jeff | Report as abusive

[…] Δημοσιεύθηκε από A Lord of the Night στο Ιανουαρίου 15, 2009 09/01/14/pension-assumptions-hitting-the -wall/ […]

Posted by Pension assumptions hitting the wall « A Lord of the Night is Wandering | Report as abusive

Public employee pension plans — and thus future taxpayers and public service recipients — are in far worse shape, but perhaps not as bad as Mr. Saft believes.

In the late 1990s, at the peak of the asset price bubble, unions and politicians cut deals that allowed earlier retirement with higher payouts in exchange for lower contributions to the plans. All justified by an assumption of increased earnings FROM THOSE INFLATED ASSET PRICE LEVELS. Clearly, the more the bubbles inflated, the lower expected future returns should have been, not the reverse.

Today, the lower asset prices fall, the higher future returns will be. If the S&P 500 falls to 450 or so, for example, an assumption of an 8% return FROM THAT LEVEL may not be so unreasonable if expected inflation is 3%.

Things are bad. I expect just about any entity with a defined benefit pension plan to go broke, and for those pensions in the end to be exposed as a false promise — like the 401K. But there is no need to exaggerate by compounding both lower current asset levels and a lower expected return.

Posted by WT Economist | Report as abusive

Dave does not get the essense of Jame’s article. The world has changed. Moreover it changed ten years ago. The new world of democratic capitalizism has very quickly driven down investment returns because there is too much capital chancing a finite number of productive investments. Pension funds have been lookin outside the stock market for some time, accepting less than 8% on infrastructure projects. Hedge funds, that are a conduit for pension funds, have been superchanging stock market returns with leverage. The truth is that the emperor does not have any clothes. Individuals must come to grips with a deflationary world where average investment returns are less than 8%. Unforetuneately, I get the feeling that we are collectively turning a blind eye to the pension plan subject knowing deep down that it is going to be a mess.

Posted by John Mulligan | Report as abusive

Best Comment? Most delusional, definitely! Dave has conveniently picked 1970 for his 39 year (?) rate of return. How’s that 10 year looking, Dave? The S&P has gone from 1286 to 823 (as of right now..). Anyone 45 and under who has funded a 401K and followed the lemmings into the “sensible” equity strategy is negative at almost any entry point over the last 20 years. For the love of God, please stop listening to the professional thieves known as investment advisors. I am 43 and my wife is 41. I have been timing the market for the past 18 years as we funded our 403B and 401K. (In addition, my main conventional pension is in a multi-employer plan that was still marginally overfunded on 1/1/09; they were at 131% mid-year. I can’t take credit for that one, but I’m damn glad it’s there!) Buy and hold is economic slavery. You are not Warren Buffett. Obviously, I don’t hit every extreme but it is really not that hard. My most recent major move was go to cash in October 2006. I was a bit early, but thank God we were out for this debacle. We had zero equity exposure for two years. I moved 25% back in (about $100,000) in November at about the S&P 850 mark. I missed the brief drop into the 700’s. At the time, it was a longer term move, but when the sucker’s rally moved over 930 I sold it all, hitting the peak this time with the close on 1/2/09 (I can only settle at the closing price- it’s TIAA-CREF). So now I’m looking for another gradual entry. I’ll hold from these levels if things stay steady, but I think there may be a long time frame to move back in. Stop being a sucker!

Posted by Curmudgeon | Report as abusive

If you own a company that makes just enough to cover materials, labor and other routine costs – ie, there is no profit or loss – the investment value of that company is $0. Nobody would buy that company from you. It makes no sense to put in $1 only to take out $1 at a later date. We face a systemic decapitalization of Western markets due to the maturity, efficiency and saturation of various key sectors. This presumption of growth in faulty. Repent now.

Posted by Don | Report as abusive

By the way, if we get a melt this afternoon, I may move 10% back in at the close..

Posted by Curmudgeon | Report as abusive

Companies that are still viable from a production standpoint do not necessarily have investment value. I guess for traders, it is a bit like buying a share for $20 and then selling it for $20 thirty years later. But in such a scenario, the net result is the same if I buy the share for $0.002 and sold it at $0.002. So there is no inherent value in the investment. Or if you really do own a business where you just make enough to pay the employees, and there isn’t a whole lot left to pay yourself, obviously the right thing to do would be to close the business. The problem is that nobody would buy it from you since it is worthless.

Posted by Don | Report as abusive

Companies still viable from a production standpoint will be the essential aspect of a greater economic recovery. Jobs are retained by companies whose business models do not over-rely on investment-related capital. Certainly a downturn hurts everyone, as consumer spending decreases, but Cmon people. We all knew massive consumer debt to finance greater consumption was Madness.

Perpetual growth is not a tenable assumption.

As several reasonable people have pointed out already, INVESTMENT growth is entirely relative to current price, which fluctuates. Buy low, sell high.

We must remember & carry forward the lessons of Enron, Tyco & Worldcom. Bernie Madoff is merely the latest chapter. The common thread is using the PERCEPTION of value to scam everyone who believes it. Behavioral economics is the lesson we need to learn.

I see no intrinsic value in the reflection of a stock price. I see how many fools want a piece of the action. Show me a company that produces a good product, for a good price, with good market placement, & I’ll show you a company that will sell that product & survive in this economy. Provided they did not ruin themselves in the markets or with the various retirement savings debacles.
Thank you everyone for intelligent comments.

Posted by Damon | Report as abusive

So the inherent value of productive assets is worth nothing? Sure if you’re not willing to sit down and actually produce something – and then not bust your ass selling what you make to someone who doesn’t want to buy anything you make anyway. Lifetime income has value but as penny dividends the economy of scale incentive isn’t there.

Posted by Jolly Roger | Report as abusive

It is interesting to see the comments from wealth bankers and journalists now telling us not to expect the returns we have seen in the past and explaining that we may have to save more.

I think in reality this is just speculation for the long term and a statement of the obvious in the short term.

Given the spurious advice we have had from such ‘experts’ in the past I dont think the opinions or quotes are worth the paper they are written on.

Posted by charlie robertson | Report as abusive

I can get an apparent 15% or more return in this country by avoiding income taxes on investment income. If my broker agrees not to report the income then I have the option to report it or not. Someone may have been doing this “undectected” for many years. There is no stability in an 8% return. Who would disagree? An intelligent investor would recognize that a dollar saved is a dollar earned. Some fifty billion dollars seems to agree with the strategy if not the outcome. This whole thing is just so obvious that no one will believe it. Ask a “victim”. The silence is deafening.

Posted by Jeff | Report as abusive

The major issue in this debate is who needs to be worried. Plans like the State of NC pension plan are well funded. Funds like the State of Rhode Island are down around 50% unfunded liability and in serious long term trouble having a legal mandate to annually pay down the debt. If there is a shortfall for paying next years existing benefits plus the obligation to pay down the amortized debt payment, and the markets are trading flat, it is estimated that RI’s required annual taxpayer payment could reach $500 million. RI is currently choking on an entire budget shortfall of $350 million. Imagine what happens when layering an additional $500 million appropriation to that amount.

Posted by Gary | Report as abusive

To piggyback on comments so far:
1. New US federal statutory rules starting in 2008 require US qualified defined benefit plans to use for funding a periodically federally-published set of yield curve derived rates that currently average around 6%. So the 8% is moot with respect to funding these plans starting in 2008.
2. Under US Statements of Financial Accounting Standards 87, 88, 132R and 158 for reporting of plans on plan sponsors’ financial statements, sponsors select a discount rate for purposes of discounting future streams of pension payments. This assumption is usually set in a manner not much different from the rates in (1) above. Sponsors also must select a long term rate of return assumption on plan asset growth. This rate has typically been in the 7.5% to 8% range. Perhaps it should come down slightly but remember two points: (a) it is meant to be a very long term assumption as noted in earlier comments. In this regard, 8% may not be far from the mark. (b) It really has nothing to do with what has happened with investments to date; it applies to investment results only going forward.

Posted by Dave S (pension actuary) | Report as abusive