Tuesday, December 10, 2013

Warren Buffett's Pension Wisdom?

Back in August, Stephen Gandel, senior editor of Fortune, reported on the 1975 Buffett memo that saved WaPo's pension:
One of the (many) things that surprised people about the recent $250 million sale of the Washington Post to Amazon (AMZN) founder Jeff Bezos was the health of the Washington Post's pension plan. At a time when most pension plans are struggling, the Post has $1 billion more than it needs. (As part of the deal, Bezos is getting $333 million for the new newspaper company's pension fund, which Post chairman Don Graham says is $50 million more than Bezos needs to meet his current obligations.) Graham told Fortune there are two words that explain why: Warren Buffett.

In October 1975, Buffett sent The Washington Post's (WPO) then chairman and CEO Katharine Graham a memo about the brewing problems in pension plans, and Buffett's suggestions for how the Post could avoid them. Graham took Buffett's advice, and the rest ... you know. For a story in the current issue of Fortune, Buffett talked about the story of the Washington Post's pension plan ("Kay Graham was a smart woman," says Buffett) and shared for the first time publicly the letter that he sent Graham.

Read the entire story: Warren Buffett's billion-dollar memo.

The letter alone is quite amazing. In it, Buffett identifies the pension problems that others would key in on only a decade or so later. But he also lays out perhaps for the first time -- Buffett was 45 when he wrote it and years away from attaining the investment fame he has today -- his philosophy behind what it takes to be a successful investor. His main pieces of advice: Think like an owner, look for a discount, and be patient.

Buffett's obvious wit and signature charm are evident throughout the letter. And there's an early version of Buffett's famous story of why investors shouldn't chase the hot fund managers and instead focus on how they got those returns:

"If above-average performance is to be their yard stick, the vast majority of investment managers must fail. Will a few succeed -- due to either to chance or skill? Of course. For some intermediate period of years a few are bound to look better than average due to chance -- just as would be the case if 1,000 'coin managers' engaged in a coin-flipping contest. There would be some 'winners' over a five or 10-flip measurement cycle. (After five flips, you would expect to have 31 with uniformly 'successful' records -- who, with their oracular abilities confirmed in the crucible of the marketplace, would author pedantic essays on subjects such as pensions.)"
George Luste, a 73 year-old Emeritus Professor of Physics at the University of Toronto, sent me Buffett's memo in a wonderful heart warming email where he told me of his successful treatment for brain cancer and that he's an avid reader of my blog. George shared this with me:
Re: Advice for Defined Benefit Pensions via Warren Buffett’s 1975 insightful letter

Background. While there are numerous pension issues and problems, this memo’s focus is on one aspect - the defined benefit (DB) pension plan. Today many DB plans in the US and Canada are facing financial problems. (This includes UofT, where I have been for 40+ years.) There are few DB pension plans today that are truly healthy and have a real surplus. The Washington Post DB pension plan is one. Why so? In 1975 Warren Buffett wrote a guide on defined pensions to Katherine Graham (then CEO at the Washington Post newspaper). In my opinion it provides a clear and remarkable perspective.

The Warren Buffett 1975 pension letter.

There is much we can learn from Buffett’s letter, written 38 years ago - such as his topics and in the details for –

- "The Irreversible Nature of Pension Promises"

- "Deceptive Arithmetic of Promise Now - Pay Later"

- "Illustrated Elemental Actuarial Principles"

- "Investment Management Problem Inherent in All Pension Plans"

- "Is There Hope? Can a Wise Corporation Assure Superior Investment Performance for  its Pension Plan?"

- "Major Options in Pension Fund Management"

And in reference to investment results, Buffett writes (on page 11) –

“In short, the rational expectation of assuring above average pension fund management is very close to nil.”

Retired history professor Bill Nelson (former UTFA President) wrote me the following after reading the 1975 Buffett letter:

"Buffett's pension letter to Katherine Graham at the Post thirty-eight years ago is the best general summary of pension policy and possibilities that I have seen. He demolishes the myth of everybody finding above average returns, shows commendable skepticism about hiring expensive consultants, offers, however, to suggest a modest equity portfolio for the Post that, over the years has left the paper  with a billion dollars more than it needs. And he lays this all out in the simplest and clearest way imaginable. An impressive job."
Current finance professor at UofT’s Rotman department, Laurence Booth wrote me the

"Thanks for bringing this to my attention George. As always Buffett was so far ahead of
most people. I have put his letter on my reading list for one of my grad courses.”
I thank George Luste for bringing Buffett's 1975 memo to my attention. George doesn't agree with me that defined-benefit plans are superior and stated in another memo that "a revised defined-contribution plan has a better chance of being fairer, honest and more transparent than a DB plan for current and future generations."

Knowing full well the benefits of DB plans, I respectfully disagree with George and believe his views on pensions have been shaped by the way the University of Toronto has completely mismanaged their defined-benefit plan. They are not alone. Many Canadian universities are asking for pension solvency relief and I believe their DB pensions should have been managed by larger, well-governed public provincial plans like the Ontario Teachers' Pension Plan.

Getting back to Buffett, he was among the first to point out that current pension accounting rules encourage companies to mislead investors by pumping up earnings. David Crane, a Lecturer in Public Policy and SIEPR Research Scholar at Stanford University and president of Govern For California, noted the following on Warren Buffett's pension fund investment return assumptions:
Excerpted from the Chairman’s Letter, 2007 Berkshire Hathaway Annual Report:

Decades of option-accounting nonsense have now been put to rest, but other accounting choices remain – important among these the investment-return assumption a company uses in calculating pension expense. It will come as no surprise that many companies continue to choose an assumption that allows them to report less-than-solid “earnings.” For the 363 companies in the S&P that have pension plans, this assumption in 2006 averaged 8%. Let’s look at the chances of that being achieved.

The average holdings of bonds and cash for all pension funds is about 28%, and on these assets returns can be expected to be no more than 5%. Higher yields, of course, are obtainable but they carry with them a risk of commensurate (or greater) loss.

This means that the remaining 72% of assets – which are mostly in equities, either held directly or through vehicles such as hedge funds or private-equity investments – must earn 9.2% in order for the fund overall to achieve the postulated 8%. And that return must be delivered after all fees, which are now far higher than they have ever been.

How realistic is this expectation? Let’s revisit some data I mentioned two years ago: During the 20th Century, the Dow advanced from 66 to 11,497. This gain, though it appears huge, shrinks to 5.3% when compounded annually. An investor who owned the Dow throughout the century would also have received generous dividends for much of the period, but only about 2% or so in the final years. It was a wonderful century.

Think now about this century. For investors to merely match that 5.3% market-value gain, the Dow – recently below 13,000 – would need to close at about 2,000,000 on December 31, 2099. We are now eight years into this century, and we have racked up less than 2,000 of the 1,988,000 Dow points the market needed to travel in this hundred years to equal the 5.3% of the last.

It’s amusing that commentators regularly hyperventilate at the prospect of the Dow crossing an even number of thousands, such as 14,000 or 15,000. If they keep reacting that way, a 5.3% annual gain for the century will mean they experience at least 1,986 seizures during the next 92 years. While anything is possible, does anyone really believe this is the most likely outcome?

Dividends continue to run about 2%. Even if stocks were to average the 5.3% annual appreciation of the 1900s, the equity portion of plan assets – allowing for expenses of .5% – would produce no more than 7% or so. And .5% may well understate costs, given the presence of layers of consultants and high- priced managers (“helpers”).

Naturally, everyone expects to be above average. And those helpers – bless their hearts – will certainly encourage their clients in this belief. But, as a class, the helper-aided group must be below average. The reason is simple: 1) Investors, overall, will necessarily earn an average return, minus costs they incur; 2) Passive and index investors, through their very inactivity, will earn that average minus costs that are very low; 3) With that group earning average returns, so must the remaining group – the active investors. But this group will incur high transaction, management, and advisory costs. Therefore, the active investors will have their returns diminished by a far greater percentage than will their inactive brethren. That means that the passive group – the “know-nothings” – must win.

I should mention that people who expect to earn 10% annually from equities during this century – envisioning that 2% of that will come from dividends and 8% from price appreciation – are implicitly forecasting a level of about 24,000,000 on the Dow by 2100. If your adviser talks to you about double- digit returns from equities, explain this math to him – not that it will faze him. Many helpers are apparently direct descendants of the queen in Alice in Wonderland, who said: “Why, sometimes I’ve believed as many as six impossible things before breakfast.” Beware the glib helper who fills your head with fantasies while he fills his pockets with fees.

Some companies have pension plans in Europe as well as in the U.S. and, in their accounting, almost all assume that the U.S. plans will earn more than the non-U.S. plans. This discrepancy is puzzling: Why should these companies not put their U.S. managers in charge of the non-U.S. pension assets and let them work their magic on these assets as well? I’ve never seen this puzzle explained. But the auditors and actuaries who are charged with vetting the return assumptions seem to have no problem with it.

What is no puzzle, however, is why CEOs opt for a high investment assumption: It lets them report higher earnings. And if they are wrong, as I believe they are, the chickens won’t come home to roost until long after they retire.

After decades of pushing the envelope – or worse – in its attempt to report the highest number possible for current earnings, Corporate America should ease up. It should listen to my partner, Charlie: “If you’ve hit three balls out of bounds to the left, aim a little to the right on the next swing.”

Whatever pension-cost surprises are in store for shareholders down the road, these jolts will be surpassed many times over by those experienced by taxpayers. Public pension promises are huge and, in many cases, funding is woefully inadequate. Because the fuse on this time bomb is long, politicians flinch from inflicting tax pain, given that problems will only become apparent long after these officials have departed. Promises involving very early retirement – sometimes to those in their low 40s – and generous cost-of-living adjustments are easy for these officials to make. In a world where people are living longer and inflation is certain, those promises will be anything but easy to keep.

Link to full report: http://www.berkshirehathaway.com/2007ar/2007ar.pdf
Clearly Buffett foresaw the looming public pension catastrophe but does this mean he's against well-governed defined benefit plans?

I'm not sure. When I recently covered Warren Buffett's pension strategy, I stated the following:
What does the article say about Buffett's strategy for managing the defined-benefit plans Bershire inherited through acquisitions? First and most important, there is no talk of switching people out of defined-benefit to defined-contribution plans. Buffett plans to honor those commitments (Interestingly, I've tracked a lot of activity on my blog from Omaha, Nebraska over the last few years. Could it be the Oracle of Omaha?).

Second, fees matter a lot and Buffett isn't going to waste his time farming out the bulk of these pension assets to outside managers using useless investment consultants when he has the expertise to manage them in-house There is no mention of allocating money to hedge funds or private equity funds either. Again, fees matter a lot to Buffett and so does liquidity and performance. He is handily winning on a wager he made in 2008 with Protégé Partners, a fund of hedge funds manager, betting the S&P500 would beat a group of hedge fund managers selected by Protégé.

Third, Buffett and his team are not just great stock pickers, they also know how to engage in more sophisticated derivatives strategies. Buffett might have called derivatives "financial weapons of mass destruction," but the truth is Berkshire made a killing on the same long-term option strategy that allowed HOOPP to gain 17% in 2012.

Fourth, and hardly surprising, Buffett is not bullish on bonds given the current near record low interest rates. In this regard, he joins pensions that are massively betting on a rise in interest rates. This is understandable given that Buffett made his fortune picking great companies and he prefers stocks over bonds in the long-run. He thinks market timing is a loser's proposition and many long-term investors (like Doug Pearce at bcIMC) agree with him.

Keep in mind, however, that Buffett enjoyed the greatest bull market in stocks and never managed money during a prolonged debt deflation cycle (doubt he will ever see one in his lifetime). Also, the Fed's quantitative easing (QE) policy has been a boon for risk assets and I'm seeing a lot of activity in the stock market reminiscent of the 1999 liquidity melt-up in tech stocks. Momentum chasers trading high-beta stocks are loving it but be careful as the market's darkest days might be ahead.
I hope you enjoyed this comment. Below, a 2011 CNBC interview with Warren Buffet on state employee pension reform and collective bargaining. I think the Oracle of Omaha would agree with most of my views on the public pension problem.

I also embedded Buffett's memo to The Washington Post's then chairman and CEO Katharine Graham (to enlarge, click on the icon in the lower right corner). Read it and you'll understand why very few active managers and hedge fund "gurus" can consistently deliver above average returns. You can drill into the portfolios of many top money managers, including Warren Buffett, by scrolling through my comment top funds' activity during Q3 2013.