Wednesday, October 14, 2009

The Pension Fund Managers Impossible Task

Pensions fund managers must seek above-average returns even as asset classes move together.

Pensions funds both public and private has suffered huge losses and are underfunded. Fund managers face an impossible task: finding long-term returns of 8% per year in a world in which most asset classes now move in tandem.

The plight of pension plans has been in the news recently; here is Mish's blunt appraisal: Five Major Pension Problems - One Simple Solution.

How did pension funds manage to over-promise benefits while losing a third of their value? The standard explanation is that the politicos in charge of awarding the benefits to public employees drank the "this time it's different" Kool-Aid in the late 1990s stock market bubble. Convinced that 10% per annum returns were "the new normal," authorities raised the benefits being promised to distribute all that endless "free money."

Alas, the 10% per year returns have slipped to -30% declines, and most observers think funds will be fortunate to book 3% returns on average, not the 8% they need to pay their promised benefits.

That shortfall dooms the plans to insolvency, as the only "bagholder" left to fill the gap is the local taxpayer, 10% of whom have lost their jobs, 8% of whom have seen their hours or wages cut and one-third of whom have seen their house equity vanish to zero or below. They will likely not be thrilled to face gigantic increases in local taxes to fund pension fund shortfalls.

In the good old days, fund managers could rotate out of one asset class into another to preserve absolute returns. When bonds weakened, stocks rose. When paper assets fell then real estate and commodities rose, and so on. Asset classes did not move in lockstep, enabling the canny manager to exit one class and move the money into some other asset class which would outperform.

That sort of rotation still works within equities, various types of commercial paper and commodities, but in the overall view all asset classes began moving in lockstep some time ago.

The Great Bull market in equities ran parallel with the Great Bull market in bonds, real estate, commodities, shipping and precious metals from about 1995 to 2000. Stocks dipped into recession, and money flowed into real estate in 2001-2003, and then it was off to the races in all asset classes once again. Oil rose, gold rose, real estate rose, bonds rose, U.S. stocks rose and international stocks rose.

Then in 2007 all asset classes except precious metals and bonds tanked together. (Bonds topped out at the peak of the 2008 financial panic, while gold and silver have suffered dizzying dips on their climb.)

One explanation of this parallel movement in asset classes is that with interest rates dropping (boosting bonds' value) and governments creating rivers of money, there was so much credit and leverage available that there was enough money to boost all assets, regardless of fundamentals such as earnings and return on investment.

While the world waited for inflation to kick in from this vast expansion of money supply, what happened instead was the money chased returns, inflating a bubble in all asset classes.

So where does a pension fund manager go for outperformance now? A reinflated global equity bubble totally dependent on governmental "quantitative easing"? A bond market which assumes near-zero interest rates forever? A precious metals market too small to absorb all the capital seeking long-term "safe" returns? An imploded, overbuilt global real estate market? A commodities market which soars and plummets by turns?

Going short may well be the "safest" bet around, but it's hard to buy large enough short positions to protect tens of billions of dollars in restless assets.

Yes, fund managers can buy U.S. Treasuries--since trillions of dollars of T-bills will be coming on the auction block for years to come--but the short-term returns are pathetic and the long-term returns only positive if deflation boosts the enemic coupon rate.

Meanwhile, the "clock" is ticking. Every year that the fund nets 4% instead of 8%, the gap between what was promised and what is funded widens.

Suppose some "unforseen event" occurs and global interest rates start rising. (After all, Australia just raised rates.) Then the value of all those bonds paying 1% and 2% plummet fast and plummet hard. So much for the "safety" of bonds.

Rising interest rates would also gut equities and gold, as investors would be attracted to the higher real returns and the lower risks.

Since pension funds have already lost 30%, what's to keep them from losing another 30%? Absolutely nothing, if all asset classes except cash earning interest fall together.

Can interest rates stay near-zero forever? Does anything stay the same forever? Here is my forecast for rising interest rates: No Easy Money: The case for raising interest rates.

We cannot know much of the future, but we can know that pension funds which over-promised benefits and expected 8% real returns forever will go broke.

Permanent link: The Pension Fund Managers Impossible Task

Check out my article in American Conservative Magazine No Easy Money: The case for raising interest rates.

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