What's a Pension Fund To Do?

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machinehead's picture
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Posts: 1077
What's a Pension Fund To Do?

Bloomberg has an interesting article today about how pension funds are responding to stock market turmoil. As you might expect after a severe bear market, they are cutting equity allocations. Here are the figures from the Bloomberg article:

The following are the world’s 10 largest pension funds as
ranked in September by Pensions & Investments and Watson Wyatt
Worldwide. The right column shows their equity target allocation
and whether they have cut or left it unchanged.

1. Government Pension Investment Japan Held at 20%
2. Government Pension Norway Held at 60%
3. ABP Netherlands Cut to 29% from 32%
4. California Public Employees U.S. Cut to 49% from 56%
5. National Pension Korea Cut to 15% from 17%@
6. Federal Retirement Thrift U.S. #
7. California State Teachers U.S. Cut *
8. New York State Common U.S. Held at 51%
9. Local Government Officials Japan Held at 25%
10. Florida State Board Held at 56%

@ Domestic equities.
# Doesn’t maintain a target.
* Calstrs said on July 21 that it had shifted 10% from global
equities and would adopt a new asset allocation mix to further
diversify the portfolio and reduce its stake in stocks.


Is cutting equity allocation the right thing to do now? The article provides some longer-term perspective on why most pension funds -- in the U.S. at least -- typically had more than half of their assets in equities:

The average return for U.S. stocks has trailed government bonds by about 8.6 percentage points annually since 1999, after outperforming by 8.2 points last century, based on data compiled by the London Business School and Zurich-based Credit Suisse Group AG.

Equities appreciated an average 12.91 percent a year from 1900 to 1999, while bonds returned 4.69 percent annually, according to the data from the London Business School and Credit Suisse. Since the start of the new century, bonds gained 6.36 percent, compared with a loss of 2.27 percent for shares.

As you can see, during the 20th century, total returns on stocks (price appreciation plus dividends) thrashed bonds ... although some data puts their advantage at more like 4 percent annualized instead of 8 percent. However, there's a caveat not mentioned by Bloomberg: volatility of bonds averaged around 9 percent, while stock volatility was around 15 percent. This meant that bonds gave a smoother ride than stocks, with far fewer losing years and severe bear markets. In practice, an allocation of 60 percent stocks and 40 percent bonds came to be accepted as a reasonable institutional benchmark. It captures some of the higher returns of stocks, while diluting volatility with a partly uncorrelated allocation to bonds.

The 21st century to date has featured a complete reversal of the 20th century pattern. Stocks have been in a dismal secular bear market, while bonds have roared higher in price, in response to financial crisis and deflation fears. The question is whether this is a one-decade aberration, or a new paradigm.

Part of this question is easy to answer. Even under deflationary conditions, government bonds typically offer a yield of at least 2 or 3 percent. That was true during the 1930s depression, and it was true in other countries as well. With 10-year T-note yields at a 3-handle, they simply are unlikely to appreciate much higher in price, regardless of what happens to the economy.

Stocks obviously may have further downside potential, either now or at a later cyclical bottom. By standard valuations, stocks are not particularly cheap. However, in 1999, stocks were -- by any objective standard -- absurdly, ludicrously overvalued.

In other words, the time to have shifted asset allocations out of overvalued equities into a heavier bond weighting was 10 years ago, during the loony last wave of the tech Bubble. Shifting allocations now, although it may provide some temporary benefit, is a sad case of shutting the barn door after the horses have not only escaped, but grown old and retired from service.

My belief is that government bond prices have completed a spectacular Bubble, and are entering a secular bear market as inflation begins to rise over the next decade. Rotating assets into commodities rather than bonds likely will prove beneficial. Equities in general may not be cheap. But quantitative strategies emphasizing low P/E, low price/sales, high dividend stocks should do OK. Pension funds who have developed an allergy to shares probably were buying high P/E Bubble stocks, and need to change their selection strategy more so than their overall asset allocation.

cmartenson's picture
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Joined: Jun 7 2007
Posts: 5967
Re: What's a Pension Fund To Do?

What all this translates into is a whopper of a battle between public servants and, well, the public.  Decades of entitlement are about to smash into other realities chief among them the fact that we face a minimum of a decade of insufficient growth to fund the retirement dreams of an entire generation.

CalPERS actuary says California's public pension costs are 'unsustainable'

The CalPERS chief actuary says pension costs are "unsustainable," and the giant public employee pension system plans to meet with stakeholders to discuss the issue.

So, are the critics right: Do overly generous pensions threaten to eat up too much of state and local government budgets?

An historic stock market crash wiped out a quarter of the CalPERS investment fund last fiscal year. Some experts are forecasting limited investment earnings in the years ahead, making it difficult to replace the losses.


Ron Seeling, the CalPERS chief actuary, described the process used to "smooth" the rate increases that will be imposed on the 1,500 local government agencies in CalPERS in 2011 in the wake of the stock market crash.

Instead of a rate increase of 4 to 20 percent of pay, the smoothing will reduce the rate hike to a more manageable 0.5 to 2 percent of pay.

"I don't want to sugarcoat anything," Seeling said as he neared the end of his comments. "We are facing decades without significant turnarounds in assets, decades of -- what I, my personal words, nobody else's -- unsustainable pension costs of between 25 percent of pay for a miscellaneous plan and 40 to 50 percent of pay for a safety plan (police and firefighters) ... unsustainable pension costs. We've got to find some other solutions."

The choices, unfortuantely, are going to be painful.

As I wrote last March on the subject of pensions:

So we are now facing the first actual set of hard choices in several generations. Choices that increasing look like they can no longer be passed to the future. The future is here, it has arrived.

Will states decide to pay their retirement obligations, pave roads, educate children, or feed the hungry? These are the choices that now sit before us and I remain skeptical that we will successfully borrow our way out of the predicament this time.

It would seem that decades of intellectually weak and fiscally negligent political leadership has finally caught up with us.

The pain of this adjustment is going to send up a mighty hue and cry from the populace and politicians alike and the response, I fear, will be the same as it always is; print more money.

That is the weak and easy road to take, and so, with history as our guide, we can be nearly 100% sure that our leadership will follow that route as certainly as water will seek a drain. 

machinehead's picture
Status: Diamond Member (Offline)
Joined: Mar 18 2008
Posts: 1077
Re: What's a Pension Fund To Do?

Underlinng Dr. Martenson's reference to the dire state of public pension systems, take a look at the historical return data quoted in the Bloomberg article linked in the first post.

If you assume a 50/50 stock/bond allocation, the blended return of this portfolio during the 20th century according to the Bloomberg numbers was 8.80% compounded annually (that is, the average of the equity returns and the bond returns).

But during the 21st century to date, the blended return of the 50/50 stock/bond portfolio was only 2.05% -- a shortfall of 6.75% compounded annually. Let's do the math -- compound the difference of 6.75% for 9 years, and you get 80%. That is, if the 50/50 blended portfolio had continued to achieve the historical returns of the 20th century (as most pension funds actually assumed), its ending value today would be 80% higher than what actually has been achieved.  OOPS -- losing an 80 percent cumulative gain that you had COUNTED ON is a huge gap.

As various commentators ranging from Bill Gross of Pimco to Dr. John Hussman of Hussman Funds have pointed out, we are going to be living in a lower return world for awhile. If high-grade bonds merely hold at their present elevated prices and avoid a bear market, they will return about 4 percent annually. Dr. Hussman has estimated that at present valuations, stocks may return 7 percent compounded over the next decade, slightly outperforming bonds. For a 50/50 blended portfolio, those optimistic assumptions would give a 5.5 percent annual return -- far short of the 8.8 percent historical return that so many funds were projecting into the future.

Under these circumstances, if I were on a fund board, I would recommend an allocation to a third asset class of commodity-related vehicles. This asset class can offer a hedge against  the related phenomena of inflation and dollar weakness. If a secular inflationary trend should develop, the commodity asset class would likely improve returns of the blended portfolio. Sustained inflation would cause stocks to trade at lower P/E ratios, and bonds to trade at lower prices and higher yields. Total returns would be depressed for both asset classes.

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