Friday, August 5, 2016

Low Returns Taking a Toll on US Pensions?

Rory Carroll and Edward Krudy of Reuters report, Low investment returns taking a toll on U.S. pension funds:
For the second straight year, U.S. public pension funds have fallen well short of their investment targets, swelling their vast unfunded liabilities and placing a greater burden on municipalities to offset the underperformance through increased contributions, estimates show.

The funds, which guarantee retirement benefits for millions of public workers, logged total returns of around 1 percent for the fiscal year ending June 30, while private pension funds earned more than triple that, according to preliminary estimates from consulting firms Wilshire Consulting and Milliman, respectively. Those figures could change as complete data for the period becomes available.

That is a poor showing relative to the 7 percent or more that pension funds seek to earn annually.

The shortfalls could add fuel to the growing debate about the long-term viability of public pensions - which financier Warren Buffett once referred to as a "gigantic financial tapeworm."

The funds have suffered from years of underfunding exacerbated by states lowering their contributions when the funds were performing well, political resistance to increasing taxpayer contributions, overly optimistic return assumptions and retirees living much longer than they used to.

The 100 largest U.S. public pension funds were just 75 percent funded, according to a 2015 study conducted by Milliman.

The pension funds have been challenged by a multi-year environment of rock-bottom interest rates and mixed stock market performance.

Public pension funds likely did worse than private funds, because the public funds had more money in short-term bonds which, during the fiscal year, underperformed the long-term bonds that private pension funds favor, said Ned McGuire, vice president and member of the Pension Risk Solutions Group at Wilshire Consulting.

Complete data on the public funds isn't available yet, but early reporters reveal significant underperformance.

The California Public Employees' Retirement System (CalPers) and The California State Teachers' Retirement System (CalStrs), the two largest public pension funds, returned 0.6 percent and 1.4 percent respectively, in the 12 months ending June 30. That is a huge miss compared with the 7.5 percent they need to reach fund their liabilities in the long run.

The New York State Common Retirement Fund, the nation's third-largest public pension fund, earned just 0.19 percent return on investments, missing its 7 percent target.

The Wisconsin Retirement System, the ninth-largest U.S. public pension fund, had a return of 4.4 percent for its core fund in fiscal 2016, well below its assumed rate of return of 7.2 percent.

In response to missing its target, also known as its "discount rate," CalPers on Monday said it was reviewing the changing demographics of its members, the economy and expectations for financial markets.

"We will conduct these reviews over the next year to determine if our discount rate should be changed sooner rather than later," CalPers said in a statement.

Public funds had a return of just over 1 percent, while corporate funds had a return of 1.64 percent, according to a report released on Tuesday by Wilshire Trust Universe Comparison Service, a database service provided by Wilshire Analytics.

At the same time, the top 100 corporate funds returned 3.3 percent, according to Milliman. Becky Sielman, an actuary at Milliman, said the most recent underperformance is harder to handle because it continues a troubling trend for public and private funds.

"It's easier to absorb one down year followed by a good year," she said. "Likely what we have here for many plans is two down years in a row."
There is a lot to cover here and while these reporters do a good job giving us a glimpse of what is going on at US public and private pensions, their analysis is incomplete (it's not their fault, they report on headline figures). As such, let me dig deeper and take you through the key points below.

The first thing I would say is returns are coming down everywhere. Pension funds, mutual funds, insurance funds, hedge funds, private equity funds, and sovereign wealth funds. Why? Well, when interest rates around the world are at record lows or even negative territory, financial theory tells you that returns across the investment spectrum will necessarily come down.

You can't manufacture returns that aren't there; the market gives you what the market gives you and when rates are at record lows, you need to prepare for much lower returns ahead. This holds true for institutional and retail investors.

Interestingly, I posted an article on Twitter and LinkedIn yesterday on how a big Wall Street cash cow is slowly getting cooked. The article explains why many big banks are seeing fees from wealth and investment management divisions fall, putting a crimp in critical revenue at a time when Wall Street is having an increasingly tough time matching their return on equity targets.

In fact, Wall Street is now bracing for its worst two years since the financial crisis. With fees coming down, the big banks' revenues are getting hit which is why they are in cost-cutting mode, preparing to navigate what will likely be a long deflationary slump. The only good news for Wall Street banks might be the $566 billion business of packaging commercial mortgages into securities (and even that isn't good news if the CMBS market crashes).

But make no mistake, record low rates are hitting all financial companies (XLF), including life insurers like MetLife (MET) which plunged more than 8.5% Thursday after reporting earnings well below expectations and a $2 billion charge related to its planned spinoff of its US retail business.

On Friday morning, following the "blowout" US jobs report, yields backed up in the US bond market but nothing frightening. At this writing, the yield on the 10-year Treasury note backed up 6 basis points to 1.57% but the bond market isn't worried of major gains ahead (quite the opposite).

In fact, while everyone is getting excited about the latest jobs report, I retweeted something from @GreekFire23 which should put a damper on expectations of a Fed rate hike any time soon (click on image):


Before you dismiss this, you should all take the time to also read Warren Mosler's analysis on Trade, Jobs, SNB buying US stocks, German Factory Orders.

My take on the July US jobs report? It definitely surprised everyone to the upside but when you dig a little deeper, the employment picture is hardly as strong as the headline figure suggests.

Either way, I remain long the US dollar for the remainder of the year and as I wrote in my comment on "sell everything except gold" two days ago, I remain long the biotech sector (IBB and XBI) and short gold miners (GDX), oil (USO), metal & mining (XME), energy (XLE) and emerging market (EEM) shares. I also still consider US bonds (TLT) as the ultimate diversifier in a deflationary world.

Enough on my investment thoughts, let's get back to analyzing the article above. Investment returns are coming down as rates hit record lows but that is only part of the picture.

Importantly, all pensions around the world are getting slammed by lower returns but more worryingly by higher future liabilities due to record low rates.

Remember what I keep harping on, pensions are all about managing assets AND liabilities. When risk assets (stocks, corporate bonds, etc.) get hit, of course pensions get hit but when rates are at record lows and keep declining, this is the real death knell for pensions.

This is why I keep warning you deflation will decimate all pensions. Why? Because deflation will hit assets and more importantly, liabilities very hard as it means ultra low and possibly negative rates are here to stay. [For all you finance geeks, the key thing to remember is the duration of pension liabilities is much bigger than the duration of pension assets so a drop in rates, especially from historic low levels, will disproportionately and negatively impact pension deficits as liabilities soar.]

This is the reason why UK pensions just got hammered following the Bank of England's decision to cut rates. Lower rates mean pensions have to take more risk to meet their actuarial return target in order to make sure they have enough money to cover future liabilities.

But lower rates also mean public and private pensions need to get real about their investment assumptions going forward. When I went over whether CalPERS smeared lipstick on a pig, I didn't blast them for their paltry returns but I did question why they're still holding on to a ridiculously high 7.5% annualized investment projection to discount future liabilities. And CalPERS isn't alone, most US public pensions are delusional when it comes to their investment projections. There's definitely a big disconnect in the pension industry.

By contrast, US corporate plans use corporate bond yields to discount their future liabilities and most of them practice much tighter asset-liability matching than public pensions. This effectively means they carry more US bonds in their asset mix as they derisk their portfolios which explains why the top 100 corporate funds returned 3.3% as of the fiscal year ending in June when public pensions returned only 1% during the same time (domestic bonds outperformed global equities during this period).

But if you go look at the latest report on Milliman's Pension Funding Index, you will see despite higher returns, corporate plans aren't in much better shape when it comes to their funded status:

The funded status of the 100 largest corporate defined benefit pension plans dropped by $46 billion during June as measured by the Milliman 100 Pension Funding Index (PFI). The deficit rose to $447 billion at the end of June, primarily due to a decrease in the benchmark corporate bond interest rates used to value pension liabilities. As of June 30, the funded ratio decreased to 75.7%, down from 77.5% at the end of May.

The decision of the U.K. to separate themselves from the other 27 European Union countries will cause the most damage (compared to expectations) to the balance sheet of employers with a fiscal year that ends on June 30, 2016, and collateral damage to pension cost for fiscal years starting on July 1, 2016. The impact on pension cost could vary depending on the selection of a mark-to-market methodology or smoothing of gains and losses.

The projected benefit obligation (PBO), or pension liabilities, increased to $1.839 trillion at the end of June from $1.785 trillion at the end of May. The change resulted from a decrease of 23 basis points in the monthly discount rate to 3.45% for June, from 3.68% for May. The discount rate at the end of June is the lowest it has been in 2016 and is the second lowest in the 16-year history of the Milliman 100 PFI. Only the January 2015 discount rate of 3.41% was lower. We note that the funded status deficit in January 2015 was $427 billion. The highest funded status deficit in dollars was $480 billion in October 2012.
And again, US corporate plans use corporate bond yields to discount their future liabilities. If US public pensions adopted this approach, most of them would be insolvent

I leave you with something I wrote in my last comment on Chicago's pension woes:
There's an even bigger problem which I want policymakers to wrap their heads around: chronic public pension deficits are deflationary.

Let me repeat that: Chronic and out of control public pension deficits are DEFLATIONARY. Why? Because it forces governments to introduce more property taxes or utility rate increases (another tax) to address them, leaving less money in the hands of consumers to spend on goods and services.

The other problem with raising taxes and utility bills is they are regressive, hurting the poor and working poor a lot more than Chicago's ultra rich. 

Now I'm going to have some idiotic hedge fund manager tell me "The answer is to cut defined-benefit pensions and replace them with cheaper defined-contribution plans." NO!!! That is a dumb solution because the brutal truth on DC plans is they are failing millions of Americans, exposing them to pension poverty which is even MORE DEFLATIONARY!!

I want all of you to pay attention to what is going on in Chicago because it's a cancer which will spread throughout parts the United States where chronic pension deficits are threatening municipalities, cities and states. And this slow motion train wreck will have drastic economic consequences for the entire country.
I cannot over-emphasize how important it is to get pension policy right. Good pension policy based on facts, not myths, is good economic policy for the very long run.

The problem with US public pensions isn't their nature (we under-appreciate the benefits of DB plans), it's the ridiculous investment assumptions, poor governance and lack of risk-sharing that underlie them.

Alright, I'm going back to trading my biotech shares which are moving these days (click on image):


I definitely don't get paid enough for sharing my pension and investment insights with you and this is a good time to remind all of you, especially the hundreds of institutional (as well as retail) investors that regularly read my comments to please show your support by donating or subscribing via PayPal at the top right-hand side.

Just because it's free, it doesn't mean you can't support my efforts, especially if you're reading, learning and profiting from my comments.

I thank the few loyal subscribers and those that have donated and wish you all a great weekend!

Below, CNBC's Rick Santelli is joined by Ed Lazear, Stanford professor and former chairman of the President's council of economic advisers, discussing the big July jobs beat. Interesting discussion even if I don't agree with either of them on the Fed being behind behind the curve in terms of raising rates (it is ahead of the deflation curve).

And CNBC's Kate Kelly reports the loss in popularity of hedge funds with state pension funds as investments. You know my thoughts, hedge funds aren't going to save US public pensions and while I don't agree with public sector unions waging war on them, they do raise valid concerns on fees and performance.


No comments:

Post a Comment