Complexity Theory and the 8% Projected Return on Pension Assets

Cry havoc, and let slip the actuaries!

With apologies to William Shakespeare

Cheap money, persistent disequilibria, actuarial follies & the looming pension fiasco

June 2, 2012

                       

Delaying the day of reckoning – assumed pension asset growth

Yesterday the yield on the 10 year bond of the United States slipped under 1.5% for the first time since December of 1941. At the same time the assumed rates of return for most public pensions in the US remains at 7.5-8.0% – a 600-650 BP (basis points) excess return above the 1.5% benchmark risk free asset. By way of comparison, public equities are normally assumed to return around 350 BP above the risk free rate (over the long term) and alternative investments around 500-900 BP to compensate for the additional risk and loss of liquidity associated with these asset classes. I would like to take a look at the reasonableness of the 8% total return assumption and what it may mean vis-à-vis public policy.

There are around $16 T of pension assets in the US, with about 43% or $6.9 T in defined benefit plans – those in which the risk for the returns lies with the plan sponsor – typically states, municipalities and major corporations. This requires around $550 B in annual returns (both yield and realized gains) to produce the minimum return of 8.0%. These returns are earned on assets including bonds (31% of total or $2.1T), public equities (44% or $3.0 T) and alternative investments (25% or $1.7 T) – typically venture capital and private equity.

Three Cases – The Model, The Actual and the Projected with Rate Increases

I thought that it might be interesting to take a minute to look at the impact of ever declining interest rates on the pension assets of the US – particularly in light of the assumption 8% rates of return on assets into perpetuity.

Shown below are three model cases: 1) Case 1 looks at how actuaries are looking at the present and future for returns by major asset classes. This is important because it tests the reasonableness of their assumptions based on historical norms. 2) Case 2 looks at actual returns for the last several years, and highlights the impact that persistent declines in interest rates to historically low levels have had on asset performance. 3) Case 3 looks at the case when interest rates rise even a little – and what happens to the nations accumulated pension assets and obligations.

Case 1 – Model returns on Actual US Defined Benefit Pension Assets and Assumed returns

Assumes 2.5 % Risk free rate

	Bonds	Public Equities	Alternative Investments	Total
Total Assets	$2.1 T	$3.0 T	$1.7 T	$6.9 T
Assumed Returns	3.5%	6%	9.5%	6.0%
Risk Premium above 2.5%	100 BP	350 BP	700 BP
Assumed $ Returns	$73.5 B	$180 B	$161.5 B	$415.0

Model Portfolio Produces Shortfall of $135 B or 2.0%

A review of the available literature indicates that the current shortfall in pension assets is about $1.0 T for states and municipalities, and $400 B for corporations, for a total of $1.4 T. This implies a shortfall of $112 B in yield – which is a reasonable confirmation of the $135 B estimate shown above.

It is important to note that the last decade has produced returns far less than the assumed risk adjusted returns shown in the Table above in public equities and alternative investments, and far in excess of the modeled returns in bonds. The superior performance in bonds has been due entirely to the long term secular decline in interest rates, being led by initiatives sponsored by the Fed, beginning under Chairman Greenspan in 1987.

The Secular decline in interest rates has propelled bond returns

Case 2 – Typical Recent Returns on Actual US Defined Benefit Pension Assets

Assumes 2.5 % Risk free rate

	Bonds	Public Equities	Alternative Investments	Total
Total Assets	$2.1 T	$3.0 T	$1.7 T	$6.9 T
Typical Returns	15.5%	2.5%	5.0%	7.0%
Performance Premium above 2.5%	1300 BP	0 BP	250 BP
Typical $ Returns	$325.5 B	$75 B	$85 B	$485.0

Typical Return Portfolio Produced Shortfall of $65 B or 1.0%

The impact of the bond portfolio on typical returns in the last few years has been overwhelming. Despite limited success in alternative investments, and the virtual stall in public equities, the returns on bonds has vastly outperformed other asset classes (and all reasonable expectations). This has been due entirely to the decline in interest rates, as the overall credit quality has deteriorated markedly in all sectors other than corporate debt. This decline in interest rates is obviously a one-way ticket, as interest rates cannot go below zero, and will under normal conditions return to historical norms. The question is – what happens when interest rates rise to the returns illustrated below?

Case 3 – Model returns on Actual US Defined Benefit Pension Assets and Assuming Interest rate increases – to 7%

(Assumes 7 % Risk free rate)

	Bonds	Public Equities	Alternative Investments	Total
Total Assets	$2.1 T	$3.0 T	$1.7 T	$6.9 T
Projected Returns	(15)%	7%	7.0%	0.2%
Performance Premium above 2.5%	(1750) BP	0 BP	0 BP
Case 3 Model $ Returns	($315 B)	$210 B	$119 B	$14.0

Model (increasing rates) Return Portfolio Produces Shortfall of $536 B or 8.0%

A Persistent Disequilibrium- Strip Mining the Yield Curve

Complexity theory would suggest that any persistent disequilibrium causes complex systems to increasingly consume resources and then degrade into chaos as the disequilibrium ends. The multi-decade decline in interest rates – driven entirely by the Fed – has been intended to stimulate economic activity as the Fed uses its limited tool kit to fulfill its dual mandate. After running out of room to lower rates at the short end of the curve, the Fed switched to targeting the long end – effectively strip mining the yield curve – and leaving a pile of slag and overburden for future generations. As Case 3 above illustrates, even a modest increase in interest rates will create an irreparable hole in the fabric of the American pension system – a future turn of events artfully disguised by the actuarial legerdemain of projecting 8% returns in a 1.5% environment.

It is important to note that the concept of maintaining robust equity and alternative investment yields in Case 3 above is more an of actuarial mercy than a hard eyed view of reality. We have seen the circumstances in which interest rates hit 7% in Europe – and it has a devastating impact on equity values and alternative investments as well. In Case 4 Below, I consider more realistic case in which all asset classes get suitably whacked as interest rates rise – it is not hard to imagine.

Case 4 – Stress Test Recent Returns on Actual US Defined Benefit Pension Assets

Assumes 7.0 % Risk free rate

	Bonds	Public Equities	Alternative Investments	Total
Total Assets	$2.1 T	$3.0 T	$1.7 T	$6.9 T
Typical Returns	(15)%	(20%)	(30)%	(20%)
Performance Premium above 2.5%	(1750) BP	(2250)BP	(3250) BP
Typical $ Returns	($315 B)	$(600) B	$(510) B	$(1.4)T

While Case 4 may be perceived as unnecessarily draconian by the actuarial community – which is considering 8% returns proceeding happily into the future, it is considerably less dire than we saw at the start of the great recession, and considerably better than the situation in much of Europe today.

When the going gets rough – run for the exits

On Friday, GM and Ford both announced plans to exit as many of their defined benefit pension obligations as possible – both through lump sum distributions and annuities purchased through third parties. These are currently profitable companies – currently enjoying a renaissance in domestic auto demand. They are clearly responding to actuarial assumptions which are lagging reality – the assumptions of 8% returns – and the end of the bond market run. They are getting out of the pension business for a very simple reason – because they can.

Very small items – like an assumption of unrealistic returns on pension assets – can have markedly outsized impacts on complex systems – like the world economy. The projected rate of return of 8% is wholly unrealistic based on current interest rates, and wholly unsupportable when considered relative to the only existing comparable – Japan. These seemingly small and innocuous points of actuarial fantasy are precisely the triggers for future chaotic market conditions.

Can you hear the butterfly’s wings flapping?

White Horse Ledge and Henderson Ridge in Huntington Ravine – Matterhorn Prep Climbs

Matterhorn Prep Climbs

White Horse Ledges and Huntington Ravine

May 12 & June 9, 2012

             

White Horse Ledge, North Conway NH

Preparation for the Matterhorn

Last summer I had a couple of great trips with my climbing partners, Gary and Jill Rogers, and really got the bug for climbing big mountains – particularly those with a reasonable amount of “low intensity” rock climbing. I really loved climbing the Grand Teton, and started looking around for comparable mountains – lots of vertical with climbing not much exceeding 5.5. A little research led me directly to the Matterhorn – the storied Swiss peak first climbed by Edward Whymper in 1865. This gigantic hunk of limestone offers about 50% more mountain than the Grand Teton, but with the addition of fixed ropes and other protection to facilitate climbing fast – a key element of safety.

A little more scouting around led me to International Mountain Guides – an outfit with a great reputation. These types of expeditions always require some pre-qualifications – this is a dangerous and difficult climb and experience is key to success. The folks at IMG suggested that I spend at least 3-4 days with Eastern Mountains Sports really getting ready for the rock climbing requirements that the Matterhorn presents. They did not need to ask twice. The guys at EMS were fully conversant with the Hornli Ridge Route and plotted out 3-4 days of training with one of their guides, Keith Moon.

The Matterhorn, with Hornli Ridge in the center

White Horse Ledge with Keith Moon

Keith Moon is a young EMS Guide from the topographically challenged state of Minnesota. He loves the mountains – climbing, skiing – whatever, and really knows every inch of the Hills in the Mt. Washington Valley. We set out for White Horse Ledge in North Conway, named for a long vanished outline of a horse on its granite face. This is a multi-pitch climb, with a bunch of friction slabs grading into blocky pitches over its total height of over 1,000 feet. The day was spectacular, the Hill crowded, and the views terrific – Mt. Washington had more snow on it in mid-May than it did in late March. This was a single climb day – but a great way to start training.

Keith Moon of EMS Climbing School

Views near the summit of White Horse Ledge

Mt. Washington from White Horse Ledge

 

 

Henderson Ridge and North Gulley – our first route of the day

A Multi-Climb day in Huntington Ravine

This was a top down day – we drove to the top of Mt. Washington and descended into Huntington Ravine via the eponymous trail to do a couple of down and up laps. Huntington ravine is a large glacial cirque, and has some large crystal gneiss – which makes for some great climbing. This country is remarkable similar to the topography on the Matterhorn – but with obviously less total exposure. I had never spent any time in Huntington Ravine, although it has some of the classic ice climbing routes in the eastern US. We descended the somewhat challenging Huntington Ravine Trail, and ascended the Henderson Ridge and then into the North Gulley. This was simply wonderful climbing, with the highlight being a trip out onto the diving board, a rock slab thrust out over the Gulley – and a lot of clear air.

 

Keith on the Diving Board

Wes considering the view from the diving board

The second trip up and down the Ravine was fast and pretty straight forward – more exercise than climbing – but still a lot of fun.

The trip home was marked by a visit to my favorite North Country pizza parlor, and included a chance to visit with some people traveling with their dog (in a side-car) on a motorcycle – simply fabulous.

Eating ice cream in the side-car

Adios from Huntington and White Horse