Bill Gross, head of bond giant PIMCO, makes an interesting observation:
If wealth or real GDP was only being created at an annual rate of 3.5% over the same period of time, then somehow stockholders must be skimming 3% off the top each and every year. If an economy’s GDP could only provide 3.5% more goods and services per year, then how could one segment (stockholders) so consistently profit at the expense of the others (lenders, laborers and government)? The commonsensical “illogic†of such an arrangement when carried forward another century to 2112 seems obvious as well. If stocks continue to appreciate at a 3% higher rate than the economy itself, then stockholders will command not only a disproportionate share of wealth but nearly all of the money in the world! Owners of “shares†using the rather simple “rule of 72†would double their advantage every 24 years and in another century’s time would have 16 times as much as the skeptics who decided to skip class and play hooky from the stock market.
Conditions are just about as favorable for corporate profits right now as they can get. Taxes’ share is at an historic low. Labor’s share is at an historic low. How far are taxes and labor expected to fall? Zero? Doesn’t sound like a realistic expectation to me.
If it’s not a realistic expectation and conditions are as favorable as they’re likely to get, how realistic is the idea of a stock market that rises at 6.6% per year?
Tying this to something I’ve written about from time to time, public employee pension funds typically assume a return of 7% or even 8% per year to remain solvent. Bonds are practically guaranteed to earn less than stocks. If stocks earn less than 6.6% and bonds earn less than that, exactly how are they going to earn 8%?
Zero may not be realistic, but we both know they’ll continue to try and make it a reality. Neo-liberal economics concentrates on suppression of labor costs as the primary method of gaining “competitiveness,” even though after forty years of such policies we’re less competitive than ever.
The underwear gnomes will tell you how they’re going to get to 8% just as soon as they figure it out.
ALT: Through investments in green energy!
Tying this to something I’ve written about from time to time, public employee pension funds typically assume a return of 7% or even 8% per year to remain solvent. Bonds are practically guaranteed to earn less than stocks. If stocks earn less than 6.6% and bonds earn less than that, exactly how are they going to earn 8%?
Simple. Voodoo.
Seriously, this has been essayed and commented on at length recently. The answer is that those returns can’t and won’t be achieved, at least not without reckless portfolio risk.
The Fed is chasing this white whale of low interest rates. And we now have a tension between yield chase in equities, vs the low PE multiple (I know, what’s the real earnings?) driven by uncertainty.
I don’t care how you want to bake this cake, the pension funds ain’t gonna make those returns. I, and my firm, are here to help, but it would be completely irresponsible for the pension funds to allocate increasing portions of the portfolio to my asset class. But politicians being what they are……….
” public employee pension funds typically assume a return of 7% or even 8% per year to remain solvent.”
It is my understanding that private pension funds make the same assumption. Not true? Do we want 6.5% returns with 1% inflation or 8% returns with 3% inflation?
Steve
I have no idea what the assumptions of private pensions funds other than my own because, basically, I don’t care. I won’t be called upon to fund them whereas I am already being called upon to pay the pensions of public employees with underfunded funds.
I won’t be called to fund them, that is, unless they go belly up in which case they’ll fall under the PBGC. That’s a subject I’ve complained about from time to time and probably will complain about again but it’s not really relevant to this post.
But in answer to your question the problem at hand is not choosing between 6.5% growth at 1% inflation and 8% growth at 3% inflation. They’re getting 1.5% growth at 1% inflation, the best they’re likely to get is 3.5% growth over time (as the Gross letter suggests), and taxpayers are on the hook for the difference between what their bad assumptions say and what they’ll actually get.
Steve
As Dave tangentially refers, there is no official prediction. Every individual portfolio manager constructs a portfolio with expected risk and return in mind.
Again, at the risk of putting words in his mouth, Dave is observing that for political reasons public pension managers use such and such a rate. But it’s absurd on its face. Basically, it’s a lie.
As an aside, if a private manager, as a fiduciary matter, predicted wild assed returns, he/she would be subjected to criticism. Public? Not so much.
Heh. Anyone surprised?
I know, Steve, you are reflexively pro state, but really, if you were in my business and you saw this return expectation you would avert your eyes, shuffle your feet, and be embarrassed for those predicting it. This is a travesty. Just kicking the can down the road.
As I remember it, the “common wisdom” given to me by various financial advisers over the last couple of decades is that, over the long term (a decade or more), a portfolio of well diversified stocks should earn around a 10% return per year averaged. If one wanted to be “conservative,” then the advice was to assume 8% a year.
Those expectations were certainly built into public pensions but also a whole lot of other financial planning. These numbers have huge implications for long-term saving/investment and I can certainly see how many want to stick their heads in the sand and hope for the best. I think it’s only very recently that people are starting to wake up to the unpleasant reality that the “conservative” return will instead turn out to be very optimistic. And I suspect, as Dave suggests, that the difference between expectations and reality will be socialized for public pensions and probably a lot of private pensions as well. Once my generation reaches retirement age, much poorer due to paying for the boomers as well as their debt, we’ll find ourselves just as underfunded and in even worse shape. I think the consequences to society would be pretty significant in that scenario.
“I know, Steve, you are reflexively pro state,”
I reflexively wonder what is going on. Andy has experienced what I have experienced and read. I think that the same people advising govt pensions to expect 8% returns are the same people advising private pensions (and those with 401k’s) to expect 8% returns. I happen to disagree with this ( I have repeatedly said here that I expect a prolonged recovery). I think this is at least partially a problem with the way advisers have come to be reimbursed. Article I read this morning claimed that in a survey of investment advice, selling stuff was advised only about 1% of the time. (Lost piece, darned ISP)
Steve
There needs to be some investment vehicle that would payout like a stock and would be as safe as a bond. It would need to be backed by some type of collateral that was always increasing in value. It would need to also have a AAA credit rating. If only such a thing existed all our wants and desires would be realized.
“There’s a lady who’s sure all that glitters is gold“
Andy and Steve
As someone who at the core is simply just another money manager for the pension, endowment etc crowd, I don’t have any idea what you are reading or interpreting.
Sober minds know that 8% ain’t happening any time soon.
Andy references 8% for a well diversified stock portfolio. Ibbottson is the basic reference on equity returns. They will tell you 10-11% nominal for about a century. What is the real rate? Less, but I don’t know how much.
The point is, we have had fallow periods in equities over the years. If you are a pension fund manager right now and you expect 8% real in a short term time frame you are on crack. The very essence of risky assets, and I’ve made this point repeatedly, is that they are volatile, and may not give you your expected return in a short term time frame. (defined as 5-10 years)
This is why pensioners porfolios are constructed with metered money securities and shorter term prospects. But Helicopter Ben has decided to eviscerate fixed income. It’s basically a wealth transfer from savers – many elderly – to borrowers………the government in particular.
Bend over, hold your ankles, the government is here to help. this was predicted, by people like me, and predictable. It’s also robbery. But then again, it’s government.
Why people can’t understand such basic dynamics is beyond me.
PS
Wait until they inflate their way out of the principal in your fixed income securities. That’s what they did to US savings bonds circa 1960. Criminal.
Yet people continue to vote big government.
8% returns are reasonble if you look at fund averages over the last 20-25 years, but the last ten years, returns have averaged around 6%, and 3.2% over the last five years. So, I don’t know if 7-8 percent assumptions were unreasonable not too long ago, at what point should the assumptions have changed?
A key part of the public pension problems, that I do not believe private pensions share, is failure to make regular contributions. When the economy is tough, pension payments are delayed until times are flush. I fear that dynamic may have government buying high on the market.
I see drew already made similar comments. FWIW, I drew my numbers from here:
http://www.illinoisisbroke.com/news/2162
@Drew
I have heard the same thing as @Andy and @steve. I am not sure what the professional investment manager expects, but the retail sales pitch implies an average 8% return. I always thought it was insane, but it was the standard pap fed to the public.
Incidently, this is why the mortgage mess began. The CRA had NOTHING to do with it. AAA rated vehicles were needed for pension, 401k, mutual, etc. fund portfolio, and there were not enough high quality/high return investment vehicles to go around. Since nothing existed, it was created.
Banks being tricked by borrowers is nonsense. MBS’s were needed to fill CDO’s, and the CDS’s allowed them to be rated AAA. The financial collapse was the result of Wall Street’s bookmaking and number running with the extra-market CDS’s.
One quick bit of advice. Anybody who sells something or works on commission is not a consultant or an advisor. He or she is a salesman. They’re trying to sell you something. Let the buyer beware.
Tasty
8% wasn’t really an insane target all that long ago. Now we have fixed income securities being manipulated down, and poor public policy care of Obama that will bring down GDP, and therefore equity returns.
As for mortgages, I don’t know what you are talking about. These weren’t created for pensions, they were an outgrowth of public policy.
There needs to be some investment vehicle that would payout like a stock and would be as safe as a bond. It would need to be backed by some type of collateral that was always increasing in value. It would need to also have a AAA credit rating. If only such a thing existed all our wants and desires would be realized.
“There’s a lady who’s sure all that glitters is gold“
Heh. Well moving from Zep to Wayne Newton……….I like dreaming……
@Tasty- Drew thinks the subprime crisis was all the gubmints fault. All of those people making those billions in the run up are irrelevant.
” It’s basically a wealth transfer from savers – many elderly – to borrowers”
We nearly always favor creditors in this country. Look at all of our policy for the last 30 years. As Graeber noted in his book, over history there has been a healthy balance between creditors and debtors. When the pendulum swings and heavily favors creditors, you get excessively risky loans and poor evaluations of credit risk.
We are moving our pension account. The presenters were suggesting we should expect 7%-8% returns (folks like Morgan Stanley) if we let them manage our individual accounts. Yes, I know they are salesman. No, I dont believe them. However, that is what the “experts” are telling people.
Steve
@Drew
“The Fed is chasing this white whale of low interest rates. And we now have a tension between yield chase in equities, vs the low PE multiple (I know, what’s the real earnings?) driven by uncertainty.”
It’s a policy which is making it very difficult to get meaningful alpha extraction. Not to mention that savers get hurt by the accompanying bond yields.
“Wait until they inflate their way out of the principal in your fixed income securities. That’s what they did to US savings bonds circa 1960. Criminal.
Yet people continue to vote big government.”
I’ve begun to question whether we have another option when it comes to a modern economy. The vast quantities that funnel through the payments system alone, $2.1 trillion per day, require significant government involvement to ensure the system doesn’t freeze up. The battle needs to be taken to the quality of government action, because opposing its quantity has clearly failed. With either party you just get a different form of big government working for the few against the many.
Steve
That’s cheap, and intellectually dishonest. I expect more from you. Seriously.
It was not ALL the governments fault. That has never been my position. But denial of the government promoting housing for the uncreditworthy is fantasy. That markets took advantage of this ridiculous public policy is also undeniable. This is a movie we’ve seen before. And unfortunately, since we seem to never learn, will be repeated.
I have no doubt you are a fine doctor. Just as I have no doubt Reynolds is a great writer. But you read academic papers on business and finance, and viddy yourself as savvy. Do you think someone can read WebMD and be a doctor? I don’t think so.
I’ve been in the capital markets, M&A and business ownership for 20 years. I read what you and Michael view as wisdom and shake my head. It’s like a guy is going to read a book on how to swing a golf club, and he thinks he’s going to win the US Open.
Can we have some reality here?
Uhh, I thought when I used gubmint I was making it clear I was being hyperbolic. When it comes to actual business finance you are way ahead of me, but when we are, in essence, discussing macro, I think we are all blind guys trying to describe the elephant, but I like my description best.
Steve
Oh, and just FTR Drew, I would bet on you understanding health care finance, not actual health care, better than 95% of physicians. I think this is the better comparison.
Steve
Drew,
and
We are not experts. Investing isn’t our day job. You shouldn’t assume that stuff which seems obvious to you is obvious to us or anyone else. We can either go it alone and muddle along or we can consult “experts” for investment advice. Most people do the former, I try to do the latter. The advice is pretty much what I described which isn’t too far removed from what you said about Ibbottson. Yes, I’m skeptical. My family isn’t saving over 25% of our income for nothing (that’s in addition to promised pensions), which is far more than most. We’re trying to do the right thing and we’re cognizant that we could well end up getting screwed.
I had assumed that pension funds assumed an average of 8% over the long term – is that not correct? Or is 8% the lower bound – the minimum they have to get each year?
Yes, I think that’s about right. IMO there’s a “multiplier” that amplifies government and private malfeasance. The revolving door and political influence doesn’t help.
Dave,
Yep, learned that one the hard way long ago.
Steve
If I misunderstood your hyperbole, I apologize. After all, I’m the king of hyperbole. Further, I take your point on health care finance, although I think we would differ. But you know me, I only go for the throat in what I know, and stay in the weeds for what I only understand tangentially.
@Drew
@Andy commented:
As I remember it, the “common wisdom†given to me by various financial advisers over the last couple of decades is that, over the long term (a decade or more), a portfolio of well diversified stocks should earn around a 10% return per year averaged. If one wanted to be “conservative,†then the advice was to assume 8% a year.
You replied:
Andy and Steve
As someone who at the core is simply just another money manager for the pension, endowment etc crowd, I don’t have any idea what you are reading or interpreting.
… Ibbottson is the basic reference on equity returns. They will tell you 10-11% nominal for about a century. …
You now replied to me:
8% wasn’t really an insane target all that long ago. …
Make up your mind. I have no idea of what the rate should, but I agree with @Andy and @steve about the retail claims. I understand that these are sales pitches, but when all the salesmen say the same thing, most people tend to believe the salesman especially when they do not know much about investing.
Many pension, 401k, mutual funds, etc. are required to have AAA rated instruments, and they are required to have a high rate of return. The number of high return & AAA rated is not large enough for the demand. Portfolio managers for these funds need a product they can include in the portfolio.
To supply the demand for high quality/return instruments, MBS’s & CDO’s were “improved” to be able to use more low quality mortgages as collateral, and with a CDS, they were able to attain an AAA rating. The number of high quality mortgages is limited, and the number of low quality mortgages is almost unlimited. Therefore, the number of low quality mortgages need to be generated to fill the MBS’s, and the banks began originating mortgages for anybody with a pulse.
These mortgages were NOT made by the banks affected by the CRA. Had the banks been required to only accept high quality mortgages, these mortgages would have been made, and the vast majority of the low quality mortgages did go into MBS’s.
In the real world, investment vehicles are created to make money not forward public policy. Unless the public policy is to shovel as much money into the economy as possible, but that is a different issue.
I do not get the Wayne Newton reference. My Zeppelin link was not really relevant, but it gave me the chance to listen to “Stairway to Heaven”. Since you cited Zeppelin in another thread, I wanted one to!!!
Andy
Please understand that I simply have this up front plain spoken style.
Air kisses and hugs aren’t my style. I know very well it can rub the wrong way. But as I’ve quipped many times before, you should see our investment committee meetings. Blood transfusions are sometimes required. But it’s OK, we are in a serious business, and it’s not for the faint of heart. We actually like each other, we just have a diversity of views. That’s why it works.
As for returns. Illiquid and equity assets must be viewed over the long haul. That’s 5 to 10 years. I’ve said it before, I’ll say it again, pension assets must be more conservative, because of funding considerations, and current policy is a mess.
Careful, Tasty.
Don’t even think to lecture me on this subject.
8% wasn’t unreasonable that long ago. It isnow, given the Feds stance o fixed income securities. As for the AAA vs return requirement, that’s simply not true. You can’t have it both ways. risk and reward. You can’t be AAA and get yield.
Moving on, CRA was defi ately a driver of low quality loans, I worked at a bank at the time. saw it first hand. Deny if you uwish.
As for Wayne Newton, it’s his famous song. Me, I prefer Zep. In fact, after picking up my daughter from dance tonight I’ll be putting into my system The Song Remains the Same. Re-living lost youth I guess. I’m a Stones-ophile. But Zep did heavy better than anyone. Can’t wait to get home……..
I’ve really enjoyed following this discussion!
It seems we all have corners of expertise or comfort zones. Wondering out of them, we become as vulnerable as the next guy to making judgment errors. I don’t know why, but Drew’s comment —-> “Do you think someone can read WebMD and be a doctor?” made me laugh. But, when it comes to consulting the ‘experts,’ I think it’s also not a failsafe method to give others 100% credence, allowing them total sway over our finances, without any effort on our part to understand at least some of the fundamentals of a venture or a decision.
Here in CA the public sector defined benefits, pension plans were designed on an assumption of a 7-8% return on their investments. Of course this didn’t pan out. However, because these plans were poured into cement, it won’t be the beneficiaries, or the people managing these investments, who become responsible for these shortages. It will be the people of CA, via their taxes. I find this kind of risk-aversion retirement troublesome, as the private sector certainly doesn’t have such iron-clad guarantees. If our investments go south, so do we. Maybe that’s why, while we consult others, we also do additional homework and brainstorming when moving assets around, so that we assume at least partial ownership whether something goes right or wrong. Recently we made a foolish move in not accepting an offer on something — opting to wait. Our broker tried to convince us to do otherwise. But, we went with our own instinct, which proven to be wrong. Consequently, we have ourselves to blame — live and learn.
@Drew
Don’t even think to lecture me on this subject.
It depends upon which portion.
… You can’t be AAA and get yield.
I understand that, but when there is a demand for both, a supply will be created. The re-engineered MBS was used to satisfy the demand, and the Fed was pumping out dollars as fast as they could. This is the dynamic that was driving the housing bubble. The political aspects was dressing for politicians.
Moving on, CRA was [defiately] a driver of low quality loans, I worked at a bank at the time. saw it first hand. Deny if you [wish].
I am not sure when you were at a bank, but if it was before the early 2000’s, I will not deny the CRA effect. Sometime around 2002, money began flowing into MBS’s, and those MBS’s needed to be filled with mortgages. Those MBS’s were going to be filled with mortgages with or without government support. Fannie and Freddie did play a large part, and they are quasi-governmental. There was a lot of shennanegains going on with them, but much of it was extracurricular activities.
Low quality trash was turned into AAA gold by the Wall Street alchemists. As I understand you, you try to turn low performing companies into high performing companies, but you use hard work to achieve the same result. I understand the difference. Unfortunately, the Wall Street hustlers are affecting your (and others) reputation.
@jan
… It will be the people of CA, via their taxes. …
I have a feeling we will “spread the debt” among all the states. Since we are bailing out everybody else, why not California?
Many companies had defined benefit pension plans, and until GM, they renegotiated, went bankrupt, or closed. But, you do not get votes that way. (Mitt Romney gets 5 gold stars for his solution.) There a lot of cities that need to go bankrupt.
… If our investments go south, so do we. …
… so that we assume at least partial ownership whether something goes right or wrong. …
Unfortunately, the GM bond holders thought they had invested wisely. Now you need to factor in getting screwed.
TastyBits
“Now you need to factor in getting screwed.”
Boy, isn’t that the truth! Ah, the time’s they are achanging!