When final-salary pension schemes, which are still prevalent among America’s public-sector employees, decide how much to put aside to pay pensions, they have to make an assumption about what returns they will earn. The higher their estimate, the less employers have to contribute today. Similarly, endowments have to estimate their future returns to determine how much to spend each year: pay out too much and their funds will dwindle away.
“KEEP your eyes on the stars,” said Teddy Roosevelt, “and your feet on the ground.” America’s can-do spirit keeps its economy moving forward, but over-optimism can be harmful, especially if it leads people to make promises they cannot meet. If investment returns are lower in coming decades than they have been in recent ones, that is the position pension funds and college endowments will be in.
The average American state or local-government pension fund assumes it will earn a nominal (ie, not accounting for inflation) annual return of 7.69% in future, according to the National Association of State Retirement Administrators (NASRA). Based on past performance, that seems reasonable. Over the past five years the median pension fund has earned an annualised return of 9.5%; over the past 25 years, the return has been 8.5%. College endowments use very similar assumptions: they target a return of 7.4%, on average, according to a survey from the National Association of College and University Business Officers (NACUBO) and Common fund, an asset manager. Again, this jibes with the average annual return in 2005-14, of 7.1%.
But as the saying goes, past performance is no guide to future returns. Investment returns come from two sources: income and capital gains. The income portion is much lower than it used to be. The yield on long-dated Treasury bonds 25 years ago was more than 8%; an investor who held such bonds to maturity could lock in that nominal return. Now the yield on the ten-year Treasury bond is just 2.3%. Yields on corporate bonds, which pay a spread over government debt, have fallen in tandem. For equities, the dividend yield on the S&P 500 index in 1990 was 3.7%; now it is just 2.1%. (In theory share buy-backs make up for some of the fall in dividends, but they are offset by the issuance of new equity for executive bonuses.)
Future gains depend either on even higher valuations, or on increases in
profits and dividends. Profits usually grow in line with the economy.
They can rise faster when the economy is recovering from recession, but
the American economy has been growing for years, and profits are close
to a post-war high as a share of GDP.
Yields move in the opposite direction to prices. They are low because the price of equities and bonds has risen dramatically in recent years. This has delivered capital gains to investors, boosting total returns.
So a pension fund or endowment that assumes investment returns will continue at their recent pace is engaging in double think. For that to happen, either profits will have to take an unprecedentedly high share of GDP or yields will have to fall to an unprecedentedly low level. In other words, for future returns to match the past, future economic conditions would have to look completely different.
Elroy Dimson, a professor at both the Cambridge and London Business Schools, is the co-author of a study of investment returns, covering 23 countries and more than a century of data. He thinks the likely future long-term real return on a balanced portfolio of equities and bonds will be 2-2.5%. AQR, a fund-management group, has come up with a remarkably similar figure, 2.4%, by assuming annual growth in dividends and profits of 1.5% for a portfolio priced at current valuations and split 60-40 between equities and bonds. It applied the same formula to valuations over the past century, and found that the current projected return is lower than at any time in the past (see chart). Assuming an inflation rate of 2%, such a real return equates to a nominal one of 4-4.5%, far short of the estimates used by pension funds and endowments.
Decent investment returns are vital if pensions are to be paid in full. According to NASRA, the total revenues the money needed to pay benefits of American public-sector pension funds have been $5.9 trillion since 1984. Of this, employers have contributed $1.5 trillion and employees $730 billion. The vast bulk $3.7 trillion came from investment returns.
Yet states and local governments are not putting away enough to pay pensions, even assuming their optimistic assumptions about returns are met. The last year funds made the full contribution required by their plans was 2001. They have fallen short by 10% or more in every year since 2008. As a result, the Center for Retirement Research (CRR) estimates that the average state and local pension plan was 74% funded at the end of last year down from fully funded in 2001. That equates to a deficit of $1 trillion or so. As the hole gets bigger, higher future contributions are needed. They have risen from 6.7% of payroll in 2001 to 18.6% now.
The realistic solutions to this mess are bigger contributions from employers (higher taxes, in other words), higher contributions from employees (pay cuts) or reduced benefits. But many pension funds seem to hope they can make up the shortfall in returns by investing in alternative assets (property, private equity and hedge funds). A survey by Towers Watson, an actuary, showed that alternative assets as a proportion of American pension portfolios (public and private) rose from 16% in 2004 to 29% in 2014.
College endowments have to make similar calculations to pension funds.
If they want to maintain their assets over the long term, they have to
be prudent in their investment assumptions. The rule of thumb, according
to William Jarvis at Common fund, is to take the assumed investment
return of 7-7.5% and deduct a percentage point for expenses and two
points for inflation. That translates into a spending rate of 4-5% a
year. The average college spent 4.4% of its endowment on operating
expenses in 2014.
Such diversification has not been wholly successful. So far this year a global hedge-fund index produced by HFR, a data provider, is down by 2.6%. The index also fell by 0.6% in 2014. Long-term returns on American property are very similar to those from equities. Future returns from this asset class are also likely to have fallen: the yield on property funds (REITs, in the jargon) was more than 8% in 2000, but is now below 4%. Long-term returns from private equity have been better (14% annualized over the past decade, according to Bain, a consultancy), but the industry is not large enough to absorb huge amounts of pension money. Buy-outs totaled $252 billion in 2014; American public-sector pension funds have assets of $3.2 trillion. Investing in alternative assets may be a sensible way of reducing risk, but it is unlikely to boost overall returns by much.
If investment returns fall to 4-4.5%, and the same rule of thumb applies, spending could drop to 1-1.5% of assets, a two-thirds decrease. Fortunately, universities are much less dependent on investment returns than public pension funds: they also get money from tuition fees and gifts from donors. Big colleges (those with assets of over $1 billion) are the most exposed: they rely on their endowments for 16.9% of their budget, compared with 4.2% for colleges that have less than $25m in assets. But in both cases, the squeeze will not be as great as the one that pension funds face.
Other long-term investors could also be at risk. German insurers offer savings products with an average guaranteed return of 3.2%, well above the current level of government bond yields. Japanese insurers were devastated by a similar problem in the 1990s; some had to close.
The good news is that this is a long-term problem. Low returns are like a car with a fuel leak; it can still be driven for a while before it grinds to a halt. The bad news is that, precisely because this is a long-term problem, investors (particularly the politicians responsible for public pension funds) will be tempted to leave it to their successors. That will only make the eventual funding crisis even bigger.