A few days ago, when GMO released its quarterly thoughts, most focused immediately on the claim that the market is 75% overvalued. However perhaps an even more important analysis by author Ben Inker, and one which was largely ignored by most, is what front-loading so much market gains thanks to the Bernanke surge in the S&P means for future returns especially as it pertains to pension funds the bulk of which are already underfunded. GMO's conclusion was not a happy one.
If equity returns for the next hundred years were only going to be 3.5% real or so, today’s prices are about right. We would be wrong about how overvalued the U.S. stock market is, but every pension fund, foundation, and endowment – not to mention every individual saving for retirement – would be in dire straits, as every investors’ portfolio return assumptions build in far more return. Over the standard course of a 40-year working life, a savings rate that is currently assumed to lead to an accumulation of 10 times final salary would wind up 40% short of that goal if today’s valuations are the new equilibrium. Every endowment and foundation will find itself wasting away instead of maintaining itself for future generations. And the plight of public pension funds is probably not even worth calculating, as we would simply find ourselves in a world where retirement as we now know it is fundamentally unaffordable, however we pretend we may have funded it so far.
One person who read this part of Inker's paper and did do the calculation is none other than Bridgewater's Ray Dalio. His conclusion is terrifying.
The reason why public and all other pension funds are the least discussed aspect of modern finance, is that while Bernanke has done his best to plug the hole in the asset side of the ledger resulting from poor asset returns, it is nowhere near sufficient since the liabilities have been compounding throughout the financial crisis since the two grow independently. Which means that anyone who does the analysis sees a very disturbing picture.
Indeed, while the asset side can and has suffered massively as a result of the great financial crisis, the liabilities are compounding on a base that has grown steadily. As Dalio notes, each year a growing percentage of assets are paid out in the form of distributions, leaving less assets to compound at a given return.
This dynamic is shown in the chart below, which shows the change of pension fund assets over the past decade relative to the present value of liabilities discounted at a rate that has been roughly constant at around 7.5%, and rising to reflect the growth in future liabilities. Obviously, if the assets equal the value of liabilities, then the fund would be able to make its payments at a 7.5% asset return. The problem is that even with the Bernanke rally of the past five years, public pension assets are now at about the same level as in 2007 while commitments have grown. Sadly, this means that recent good returns have barely closed the gap. Needless to say, the gap grows much faster in the coming years if the future returns are less than the assumed 7.5%, something that was the basis for the GMO observations.
A key component of the pension fund calculation is the increasing portion of annual distributions less contributions as a percentage of assets. Since each year public pensions distribute about 5% of the future value of their liabilities, and these liabilities have been growing at a compounded rate of about 4%, the net cash out as a percentage of flat and/or declining assets has been progressively rising. Today, annual cash outflows amount to roughly 9% of total assets which contributions are a paltry 5% of assets, which has led to a 4% cash flow drag. This increase in net cash outflows from 1.5% of assets in 2000 to 4% most recently is shown in the second chart below. The take home from this chart is that funds need to return 4% a year in the near term just to avoid losing assets, and thanks to compounding, over time the rising amount of NPVed liabilities raises the required return even further. READ ON! -->
