Pension assumptions hitting the wall
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.
ASSUMPTIONS ARE ALL
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. —