“Retirement & Pension Plans – A Wake-up Call”
Sydney M. Williams
Personal and government debt remains too high. The number of unemployed continues to pain individuals and harms economic growth. Monetary policy has kept interest rates at record lows, benefitting borrowers, but harming the prudent and the elderly. Above this scenario hovers a retirement prospect that is dismal for all but the wealthy and those protected by governments’ pensions – promises made by bureaucrats to government employees and paid for by taxpayers. Aggravating the situation, is the fact that defined benefit corporate-sponsored retirement plans, for those that still have them, continue to use unrealistic expected return numbers of 7.5% to 8.5%, with most plans grossly underfunded.
For two decades, outsized returns to both bond and stock funds kept the beast of reality at bay. Through 2000, twenty-year compounded annual total returns for the S&P 500 approximated 18%. Returns to bond funds were similar. It was widely assumed that while such returns may have been somewhat above average, they were not abnormal. As it turned out, of course, they were. For the past twenty years, the price return to the S&P 500 has been a far more modest 6.3%. Price returns for the years 1992-2002 were 10.4%; for the last ten years, 2.0%. It is not just the volatility, but the abysmal returns over the past ten years that have chased investors from stocks and that have wrecked havoc with pension plans. In a January 19, 2012 article, Reuters reported that the pension plans of S&P 500 companies hit a record underfunding in 2011 of $458 billion. The Wall Street Journal noted a year ago that pension fund deficits at state and local governments was three times that of corporate plans. For investors, taxpayers, unions and Washington, this should be a wake-up call.
Coming off the highest interest rate levels in a hundred years, U.S. Treasuries have rallied for thirty years. Anyone who bought and held a million dollars worth of a Thirty-year US Treasury in September 1981 received as compensation annual interest of $146,800. After reinvesting his original million dollars at the end of last September, his annual income would have dropped 80 percent to $29, 210. That is an extreme example, but that is what has been happening to savers and the prudent among us. Treasuries may continue to rally, with yields continuing to fall, but even the most aggressive bull has to admit that most of the gains in the bond market are behind us. When rates do rise, bond prices will collapse.
Relatively low stock prices and high volatility – now low, but high in last year’s second half – have created a problem for defined benefit pension plans investing in equities, as mark-to-market rules have chased money from equities into lower yielding bonds where assets and liabilities can more easily be matched.
The principal advantage of mark-to-market accounting is that they keep financial statements realistic, allowing shareholders to determine the viability of a company, or its pension plan. The disadvantage is that money gets forced from long duration assets, like equities, at the worst possible time into low yielding, but safer Treasuries. Short term downdrafts in equity markets can cause managers to react foolishly, despite a liability against which those assets are deployed that may be several years in the future.
Most studies of investment returns over very long periods of time give an edge to stocks over bonds. However, that has not been true for the last couple of decades – a combination of a flat dozen years for stocks and an historic bond market rally. For ten years the S&P 500 compounded annual total returns at 4% versus 6.3% for the PIMCO Total Return fund. Of course, ten years ago the yield on the U.S. Ten-year was 5.78%; today it is 1.97%, and the multiple on the S&P 500 was about 18X; today it is closer to 13X. Extrapolation of recent history often causes investors to do exactly the wrong thing at the most inopportune moments.
Besides the risk of driving investors from historically higher-returning stocks into lower yielding bonds, there are other aspects of pension accounting that are bizarre. Because defined benefit plans do not use current market results when determining the cost of a pension plan (as an individual would), they use an “expected long-term rate of return,” typically between 7.5% and 8.5%, as mentioned above. Among the reasons that “expected returns” have been kept at what seem to be elevated levels is that accounting rules allow stated returns to be added to the company’s net income. For example, (according to the same Reuters article cited above) if a company borrows $100 million at 4% to help fund its pension plan and uses an expected return of 7.5%, the company might add $3.5 million to its net income line, even in those instances where the plan’s assets declined and the company’s unfunded obligations rose. Also, when interest rates do go up, the value of the bond portfolio will decline, but because rates are higher, companies will use a higher discount rate when estimating future contributions to the plan, thereby lowering the amount they must pay in.
Government employee pension funds total about $4 trillion, paid for by tax payers and managed by Wall Street. Unless pension reform is instituted, taxes will rise to make up for any shortfall between what has been promised by government and union leaders, and what the managers of the fund have delivered. All of this means that the world will inexorably continue to move toward defined contribution plans, leaving most people woefully ill equipped to provide for their retirement needs.
We find ourselves in this unpleasant place in large part because of arcane pension accounting rules that appear irrelevant to the need of long term investors, because equity markets overextended in the 1990s, because of interest rates which have been kept at artificially low rates for too many years by the Federal Reserve, because of a federal government that encourages dependency at the expense of personal responsibility, and because of a culture our society has fostered that encourages consumption over savings. Reversing this trend will not be easy. Government can help, but that will require of Washington a 180 degree turn from the direction we are now heading.
Ironically, for investors though, a need for increased savings and personal investment for retirement should offset the natural outflow from riskier investments by retiring baby boomers and that, over the longer term, should be good for stocks – a silver lining in an otherwise darkening cloud.
Thought of the Day
“Retirement & Pension Plans – A Wake-up Call”
February 8, 2012Personal and government debt remains too high. The number of unemployed continues to pain individuals and harms economic growth. Monetary policy has kept interest rates at record lows, benefitting borrowers, but harming the prudent and the elderly. Above this scenario hovers a retirement prospect that is dismal for all but the wealthy and those protected by governments’ pensions – promises made by bureaucrats to government employees and paid for by taxpayers. Aggravating the situation, is the fact that defined benefit corporate-sponsored retirement plans, for those that still have them, continue to use unrealistic expected return numbers of 7.5% to 8.5%, with most plans grossly underfunded.
For two decades, outsized returns to both bond and stock funds kept the beast of reality at bay. Through 2000, twenty-year compounded annual total returns for the S&P 500 approximated 18%. Returns to bond funds were similar. It was widely assumed that while such returns may have been somewhat above average, they were not abnormal. As it turned out, of course, they were. For the past twenty years, the price return to the S&P 500 has been a far more modest 6.3%. Price returns for the years 1992-2002 were 10.4%; for the last ten years, 2.0%. It is not just the volatility, but the abysmal returns over the past ten years that have chased investors from stocks and that have wrecked havoc with pension plans. In a January 19, 2012 article, Reuters reported that the pension plans of S&P 500 companies hit a record underfunding in 2011 of $458 billion. The Wall Street Journal noted a year ago that pension fund deficits at state and local governments was three times that of corporate plans. For investors, taxpayers, unions and Washington, this should be a wake-up call.
Coming off the highest interest rate levels in a hundred years, U.S. Treasuries have rallied for thirty years. Anyone who bought and held a million dollars worth of a Thirty-year US Treasury in September 1981 received as compensation annual interest of $146,800. After reinvesting his original million dollars at the end of last September, his annual income would have dropped 80 percent to $29, 210. That is an extreme example, but that is what has been happening to savers and the prudent among us. Treasuries may continue to rally, with yields continuing to fall, but even the most aggressive bull has to admit that most of the gains in the bond market are behind us. When rates do rise, bond prices will collapse.
Relatively low stock prices and high volatility – now low, but high in last year’s second half – have created a problem for defined benefit pension plans investing in equities, as mark-to-market rules have chased money from equities into lower yielding bonds where assets and liabilities can more easily be matched.
The principal advantage of mark-to-market accounting is that they keep financial statements realistic, allowing shareholders to determine the viability of a company, or its pension plan. The disadvantage is that money gets forced from long duration assets, like equities, at the worst possible time into low yielding, but safer Treasuries. Short term downdrafts in equity markets can cause managers to react foolishly, despite a liability against which those assets are deployed that may be several years in the future.
Most studies of investment returns over very long periods of time give an edge to stocks over bonds. However, that has not been true for the last couple of decades – a combination of a flat dozen years for stocks and an historic bond market rally. For ten years the S&P 500 compounded annual total returns at 4% versus 6.3% for the PIMCO Total Return fund. Of course, ten years ago the yield on the U.S. Ten-year was 5.78%; today it is 1.97%, and the multiple on the S&P 500 was about 18X; today it is closer to 13X. Extrapolation of recent history often causes investors to do exactly the wrong thing at the most inopportune moments.
Besides the risk of driving investors from historically higher-returning stocks into lower yielding bonds, there are other aspects of pension accounting that are bizarre. Because defined benefit plans do not use current market results when determining the cost of a pension plan (as an individual would), they use an “expected long-term rate of return,” typically between 7.5% and 8.5%, as mentioned above. Among the reasons that “expected returns” have been kept at what seem to be elevated levels is that accounting rules allow stated returns to be added to the company’s net income. For example, (according to the same Reuters article cited above) if a company borrows $100 million at 4% to help fund its pension plan and uses an expected return of 7.5%, the company might add $3.5 million to its net income line, even in those instances where the plan’s assets declined and the company’s unfunded obligations rose. Also, when interest rates do go up, the value of the bond portfolio will decline, but because rates are higher, companies will use a higher discount rate when estimating future contributions to the plan, thereby lowering the amount they must pay in.
Government employee pension funds total about $4 trillion, paid for by tax payers and managed by Wall Street. Unless pension reform is instituted, taxes will rise to make up for any shortfall between what has been promised by government and union leaders, and what the managers of the fund have delivered. All of this means that the world will inexorably continue to move toward defined contribution plans, leaving most people woefully ill equipped to provide for their retirement needs.
We find ourselves in this unpleasant place in large part because of arcane pension accounting rules that appear irrelevant to the need of long term investors, because equity markets overextended in the 1990s, because of interest rates which have been kept at artificially low rates for too many years by the Federal Reserve, because of a federal government that encourages dependency at the expense of personal responsibility, and because of a culture our society has fostered that encourages consumption over savings. Reversing this trend will not be easy. Government can help, but that will require of Washington a 180 degree turn from the direction we are now heading.
Ironically, for investors though, a need for increased savings and personal investment for retirement should offset the natural outflow from riskier investments by retiring baby boomers and that, over the longer term, should be good for stocks – a silver lining in an otherwise darkening cloud.
Labels: TOTD
posted by Thought of the Day @ 5:01 AM
1 Comments
1 Comments:
Wonderful article, thanks for putting this together! This is obviously one great post.
Automatic Enrolment & Workplace Pensions Bristol
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