Peril for Pension Funds

by Dave Schuler on July 31, 2014

I hope the managers of public pension funds and, even more importantly, the politicians who construct the plans they administer, take Bill Gross of bond giant PIMCO’s advice:

The U.S. for sure is near the top of the “more certain” list, but 2% real growth since the Great Recession is nothing to brag about. It would have been a bare minimum expectation back in 2010. Elsewhere, an investor not only has to wonder, but perhaps retreat from the lack of growth sunshine. South America is in virtual recession with its big three – Brazil, Argentina, and Venezuela – approaching lockjaw conditions of one sort or another. Euroland is above water, but floating on water wings with peripheral country unemployment (Spain, Portugal, Italy) averaging close to 20% – unprecedented except for the 1930s. Russia is retreating for geopolitical reasons. And Japan/China are supported only by credit creation of a magnitude that reminds one of Minsky, or Ponzi, or Potemkin with his mythical villages of growth due to paper, not productivity. Where is the growth? The world as McCulley correctly analyzes it, is demand deficient and supply rich.

Asset price growth therefore – capital gains in market speak – will be harder to come by. Without the tailwind of declining interest rates which have increased profit margins as well as decreased cap rates, they will instead face structural headwinds. Let me be clearer though – clearer than I was to my Vietnamese friend. PIMCO is not saying that asset prices will go down – they just won’t go up as much as many expect. And income – not capital gains – will be the dominant driver of future returns. “Good evening,” capital gains. “Good morning,” more dependable income – even in this age of artificially low interest rates.

These funds frequently assume returns of 7% or even 8% annually. That’s significantly above inflation and significantly above the real rate of growth. Where is such growth to come from?

The only possibility open to them is investing in increasingly risky assets which inevitably means that some of them will lose which in turn means either that legislators will need to make up the difference or promises to public employees cannot be honored. State and local budgets are already seriously pressed by healthcare costs and increases in tax rates are not yielding proportional increases in revenues.

We need to start questioning the assumptions.

{ 11 comments… read them below or add one }

Guarneri July 31, 2014 at 9:17 am

I don’t know how Gross arrives at the conclusion that asset prices will not fall. I can speak definitively about alternatives (PE) and will tell you that current purchase multiples are inflated by debt availability. It flows right through to prices, and if it cycles down (it always has)….. Try making money when you buy at 8x and sell at 6x. Publics? Again, I think liquidity and absence of re-investment is more important in valuations than interest rates. For those who don’t know, Mr. Gross has come under scrutiny for some rather odd personal behavior and his total return fund has lagged for a couple years.

That all said, the general thrust here is correct. Everyone from retail to pension fund managers are walking up the risk curve. Either by liquidity needs or by charter pension funds will be restricted in this march for yield to only so much equities or near-equities in their portfolios. (Not a bad thing, should the bubble burst) Implicitly then, 7-8% is a pipe dream. For the interested reader, look at the Barclays index.

I know the reaction of some will be that the public pensioners are “owed because they earned” their pensions. But they made a deal with the devil. Early retirement (many times allowing for a second career and yet another pension……or a lower handicap) and outsized payments were unsustainable from the outset. Just no chance. And they knew it. The fact that the chickens have come home – to coin a phrase – is a self inflicted wound. A look at the donor list for Gov Quinn in IL is instructive (published yesterday in the Sun Times). Public unions everywhere.

This will not end well.

TastyBits July 31, 2014 at 9:50 am


We need to start questioning the assumptions.

The assumptions are more general and basic, and they are not limited to pension funds. Pension funds did not always assume these levels of growth. Why did this start? How did this start? When did this start?

These funds need the type of financial instruments Wall Street was providing prior to the 2008 collapse. Wall Street was not pushing garbage onto the pension funds. The pension funds were demanding AAA products with junk bond returns.

With the Glass-Steagall wall demolished, Wall Street was able to manufacture products to satisfy the pension fund requirements. None of this occurred in isolation. The same forces were pushing everybody towards unrealistic expectations.

These growth rates are built upon the same assumptions as the general economy. The fundamental basis is hyper credit creation. Without this hyper credit creation, the economy cannot grow at the rate needed to sustain the funds, and this is the problem for the economy overall.

Of course, this does not fit anybody’s narrative, and therefore, it must be wrong.

jan July 31, 2014 at 1:49 pm

“These funds frequently assume returns of 7% or even 8% annually.”

I think of California’s CALPERS pension funds when I see those return assumptions. Obviously, it’s no where near those numbers. So, who will be on the hook to cough up the pensions predicated on such ludicrous math?

“I know the reaction of some will be that the public pensioners are “owed because they earned” their pensions.”

That’s the exact response from indignant public union members. “You promised us this amount!” is the cry that consistently goes up whenever a proposition even breathes on a ballot, relating to some kind of pension reform measure needed to save a community from bankruptcy or insolvency.

Basically, it’s easy to give, but much harder to reform or take away, once a fiscal policy is in place.

Guarneri July 31, 2014 at 3:32 pm

Tasty -

Pension funds and endowments are my clients/bosses. In 17 years of doing this I have never seen a manager seek “junk bond returns for AAA risk.” That presumes a lack of sophistication bordering on outlandish.

TastyBits July 31, 2014 at 5:19 pm

@Drew

Many of the pension funds require AAA rated investments, but they need high returns. For 8% annual growth, there will need to be individual higher growth instruments to offset the lower performers. “They need exceedingly high returns for AAA risk.”

Before the 2008 financial crash, this need was supplied through MBS’s, and this is why Sen. Dodd and Rep. Frank were protecting the financial industry.

It was never about houses for poor people. It was about putting money into rich people’s pockets.

Guarneri July 31, 2014 at 7:58 pm

Tasty -

Not to pull rank, but I must have seen close to 100 such portfolio’s. They construct them with a range of securities from short term “safe” fixed income, less safe fixed income, public equities, RE, PE forest land etc. Different pensions and endowments have different allocations, but, as you point out, none have a chance at getting at 8%. But they know exactly what the risks are in their asset allocations.

As for MBS, the little known fact is that these were cut into tranches from AAA to basically junk. When you hear that the “people thought they were going to get high returns for AAA, or that the AAA securities were incorrectly valued” you know that the person doesn’t know that there were different buyers for different tranches, and they knew what they had but for one exception: probability analyses were done for the likelihood of default based on declines in collateral (housing values) read: they misgaged the size of the bubble. But it was eyes wide open. The steve’s of the world love the dummy investor meme, but it ain’t so.

steve July 31, 2014 at 9:07 pm

” The steve’s of the world love the dummy investor meme”

Hey Drew. I have a buddy who wants someone to finance his business. I told him you could find him a bank that will give him money w/o asking if he has any income or assets. What ya think?

Steve

TastyBits July 31, 2014 at 10:11 pm

@Drew

… But it was eyes wide open. …

That is part of my point. With a few exceptions, Wall Street was not pushing these securities onto doe-eyed fund managers. These guys needed what Wall Street had, and they needed more than Wall Street could provide.

To make matters worse. The GSE’s were buying up any piece of garbage, and their whores (Dodd and Frank) were protecting “daddy” any way they could.

I typically do not go into the lower quality tranches because it only tends to cloud the discussion. To my knowledge, the lower rated tranches are what the high risk/high return funds want, and they are not relevant to pension funds.

… The steve’s of the world love the dummy investor meme, but it ain’t so.

I have been trying to keep history from being tossed down the memory hole, but I am getting tired. There are limits to how many times I can explain an Alt-A loan, and why it is a legitimate type of loan.

Guarneri August 1, 2014 at 12:00 pm

Tasty -

Perhaps we have been talking past each other.

“To make matters worse. The GSE’s were buying up any piece of garbage, and their whores (Dodd and Frank) were protecting “daddy” any way they could.”

Absolutely, but doesn’t fit the GWB regulatory dove meme.

“I typically do not go into the lower quality tranches because it only tends to cloud the discussion. To my knowledge, the lower rated tranches are what the high risk/high return funds want, and they are not relevant to pension funds.”

The tranche’d nature of the securities is crucial to understanding the bogus false AAA meme. The pension comment is correct. I, at least, have never seen them in pension or endowment portfolios.

Just to put icing on the cake, and illustrate how closely these fund managers know and pick their asset classes……

They even carve up their private equity allocations by size and type.
eg A large industrial oriented fund. (IGP)
A small industrial oriented fund. (us)
Turnaround fund. (Sun Capital)
Roll ups (GTCR)
Quasi-venture – “growth equity” (Whitney)
Sector focus funds – medical devices, business services, financial firms, real estate etc

The fund managers don’t know how to find, manage and exit M&A deals, but they know their asset classes.

steve August 1, 2014 at 12:18 pm

““To make matters worse. The GSE’s were buying up any piece of garbage, and their whores (Dodd and Frank) were protecting “daddy” any way they could.”

Only late into the subprime surge. And how Frank controlled the House as a minority Congressman has always been a mystery to me. Ryan is a member of the majority in the House and he can’t even get his legislation put into law. How did Frank do that?

Steve

TastyBits August 1, 2014 at 1:11 pm

@steve

Why do you think Glass-Steagall was repealed? You cannot get a housing bubble without access to endless credit.

Are you so naive that you really believe the bullshit your political leaders feed you. The GSE’s were a payoff to get Rep Frank and the Democrats to go along with the Republicans, but do not think the Democrats were not “in bed” with the financial industry.

It must be nice living in your world. I hope you never break those rose colored glasses.

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