While the mainstream media and more than a few of us living our lives outside of that particular sphere, myself included, are all wrapped up in the bipartisan debt talks flustercuck in Washington, surprisingly, there is other news out there that is also of interest to those of us who follow government debt issues closely. Unfortunately, this news is not particularly good over the long term.
Mebane Faber, with Cambria Investments in California, released a research paper entitled "What if 8% is Really 0%" in the Quantitative Research Monthly report in June 2011. This paper outlines the issue of pension under-funding, an issue that will be of greater and greater concern as the years pass since a massive number of baby boomers will be retiring over the next 20 years and for some reason will be expecting to collect a regular "paycheque". I'll outline some of the key points in Mr. Faber's paper; while the data is specific to the United States and particularly state level pensions, keep in mind that under-funded pensions are a very common occurrence in Canada and the United Kingdom as well.
Mr. Faber opens by explaining the title of his paper. Pensions have historically used a projected rate of return of 8 percent; this rate is used for all public government and corporate pension plans. The magical 8 percent number is used because, over the past 25 years, public pension funds have averaged this rate of return so it seemed that it might be a reasonable assumption moving forward. However, if the 8 percent rate of return (ROR) is not met, the gap between the growth of the pension and the liabilities (the monthly payout to pensioners) of the pension grow enormously over the long periods of time involved in pension investing. As it stands today, the gap between the projected size of the pension and its projected payout (the funding ratio which is calculated as total pension plan assets divided by total liabilities discounted back to the present) has declined to 80 percent on average for American private and public pensions.
Let's put the 80 percent funding rate into perspective. In 1999, an aggregate of all state pension plans in the United States had a funding rate of 102 percent. This has declined to 84 percent by 2008 with some states (Illinois) reporting a funding rate of only 54 percent. In addition, 21 states had funding rates of less than 80 percent with an overall gap of $460 billion on assets of $2.31 trillion in 2008.
Now let's add the 8 percent rate of return into the equation. Considering the extended period of low interest rates and volatile stock market returns, if we use a more reasonable rate of return such as that on "risk-free" government bonds (he said with tongue planted firmly in cheek), the average funding ratio for all public pension funds drops from a scary 83 percent to a sleep losing 45 percent. Using this risk-free rate of return, the 50 United States state pension funds that have $1.94 trillion in assets and $5.17 trillion in liabilities end up with a funding ratio of only 38 percent and unfunded pension liabilities of $3.23 trillion. To put this $3.23 trillion figure into perspective, the publicly traded debt of the states is currently $0.94 trillion. This will force state governments to raise addition funds through the issuance of additional debt at the same time as the federal government is gorging itself on an already strained bond market.
Let's step back and take a look at that 8 percent number again. Since the Fed, in its great wisdom, has seen fit to maintain a very long period of historically low interest rates, pension fund managers have been forced to look far and wide for investments that will give them a return that keeps their funding gap to a minimum. This was an easy task 25 years ago; long, risk-free government bond rates averaged 10 percent and the P/E ratio for most American stocks was less than 10. Things are now substantially different. Long bonds are yielding 4 percent on a good day and the P/E ratio for American stocks is over 20. This makes reaching that magic 8 percent number very, very difficult and pension managers are actually having to work for a living. This low rate of return on long bonds has forced pensions into investing in more and more risky products. As Canadians, we need look no further than to watch the changing portfolio of the Canadian Pension Plan Investment Board (CPPIB) as shown here:
Note the increase in equity holdings as a percentage of the total Canada Pension Plan portfolio. Also note the massive hit that the portfolio took in 2009 when the market tanked. That's Canadian's future pension income that is being invested in increasingly risky products despite the Investment Board's protestations to the contrary.
Pension managers are now using a 60% equity/40% bond mix as a benchmark for pension management. If this is the case, stocks must return 11 percent so that the low yielding bond returns are averaged up to the magic 8 percent return. While this sounds easy, over the past ten years, the stock market has proven to be increasingly volatile making an 11 percent rate of return anything but a sure thing. As well, by investing in equities, as noted above for the CPPIB, pension principal is no longer guaranteed and accumulated funds can disappear as if by magic.
Mr. Faber goes on to look at the example of Japan. Japan has experienced a very lengthy period of very low (think nearly zero) interest rates and a stagnant stock market. Here is a graph showing what has happened to the Nikkei 225 since 1984 showing how hard it is to guarantee a reasonable rate of return from Japanese equities and how easy it is to pick a loser:
Here is a graph showing what has happened to Japan's 10 year bond rate since 1987:
Pretty hard to get a reasonable return on a Japan 10 year bond too, isn't it? We have to keep in mind that Japan's economy has been subject to the world's longest quantitative easing experiment by the Bank of Japan and one need look no further than these two charts to see how well it has worked for the country. One would think that Mr. Bernanke would have taken notice before imposing QE1 and QE2 (and possibly QE3) but, apparently not.
To scare you even more, here is a table showing the rates of return historically by decade for both the United States and Japan:
Japan's rate of return on all investments for the past 20 years has been rather negligible at best and negative at worst. Overall, a buy and hold philosophy yielded a massive 1.42 percent rate of return and an equity investment philosophy would have lost 4.62 percent compared to a rather paltry gain of 4.36 percent on 10 year bonds. While Japan's economic situation does seem to be atypical, we must remember that in the early 1980's it appeared that the Japanese economy had nowhere to go but up, up, up. It was the economic superpower of the world. Does any of this sound familiar? Just in case you don’t think that it can happen in the United States, here’s a link to a 2010 paper by James Bullard, President and CEO of the St. Louis Federal Reserve, in which he discusses the probability of a Japanese-style deflationary scenario for the United States. Here’s a quote from “The Seven Faces of “The Peril”:
“I emphasize two main conclusions: (1) The FOMC”s extended period language may be increasing the probability of a Japanese-style outcome for the U.S., and (2) on balance, the U.S. quantitative easing program offers the best tool to avoid such an outcome.”
Apparently, he hasn’t looked at these charts either!
With the ongoing debt talks, it is readily apparent that the United States Social Security program may simply not exist in its current form for those of us who will be retiring in the next two decades. While that is terribly unsettling, it is even more unsettling to think that our privately and publicly funded pension plans might not be there for us either. To complicate matters even further, Americans are constitutionally obliged to cover these pension shortfalls one of two ways; through cutbacks in service or through increases in taxes. Oh brother, we just can’t win for losing.