From The Economist's Buttonwood's Notebook blog:
PensionsWay off Base
IF YOU assume a high return on your assets, it is easy to imagine that the pension problem will go away.* There is a neat illustration in the latest report from the Center for Retirement Research at Boston College. By and large, it is a fairly sensible report; the team there has a deserved reputation for careful research. They use the official pension numbers (the ones that allow states to discount liabilities by the assumed level of investment return) to reckon that the funding level of state pension plans fell from 75% to 73% in 2012.And here is his follow-up post:
They also use a more realistic discount rate of 5% to come up with a funding ratio of 50%, akin to the one calculated by Moody's last week. They calculate that liability growth has slowed because states have been able to reudcue cost growth, largely by reducing staff, freezing salaries or, in some cases, reducing the cost-of-living adjustment for pensions in payment. Nevertheless, the annual retired contribution for states has risen from 6.4% of payroll in 2001 to 15.3% last year.**
GASB is introducing new rules which go some way to meeting the view of economists that pensions are a debt-like liability and should be accounted for accordingly. The CRR also calculates the funding ratios under those rules and finds that it is around 60% (an alarming figure on its own).
But what made your blogger spill his coffee was the section of the report that dealt with the outlook for equity returns; the CRR has three scenarios, a baseline of 7.75%, an optimistic return of 11% and a pessimistic return of zero. How is that baseline figure calculated? Turn to the footnotes. The assumptions are that output grows 5.75% a year (3.5% real, 2.25% inflation), profits rise in line with GDP, and the p/e is 17 at the end of 2016. In essence, you get profits growth of 5.75% a year plus your dividend yield of 2% to get to 7.75%.
The baseline GDP forecasts is 3.5% real growth. Seriously? We would all be delighted if it happened but it can't be the standard assumption. (The pessimistic case is 2% a year, which is not that downbeat.) In the last 5 years, US productivity growth has been 1.6% a year and the population has been growing at 0.7% a year, or 2.3% combined. Surely that should be the baseline case? And then there's the idea that profits should keep up with GDP. But the St Louis Fed numbers show that profits are at a post-1945 high relative to GDP; can one assume as a base case they will stay there? And as for the market multiple, well surely the folks at BC are aware of Professor Shiller's work at Yale which shows how historically high valuations are. In short, these baseline assumptions are clearly on the optimistic side. Of course, the folks at BC might be right. But it would be foolish of anyone, including the taxpayers who fund public sector pensions, to count on such optimism being fulfilled.
* In fact, the level of bond yields is vitally important. The recent jump in government bond yields has improved the funding ratio of many pension funds; Mercer reckons US corporate pension plans are now 88% funded, up from 74% at the start of the year.
** This is still lower than it ought to be, if a more realistic discount rate for liabilities were used. It is generally agreed that 25% of payroll is needed to fund inflation-linked final salary pensions in the private sector. There are different benefits, of course, but public sector workers tend to retire earlier which bumps up the cost.
More on long-term returnsThere is a way to get to 7.75% returns in an economy that will probably never again average 3% annual growth and that is to have 5% annual productivity gains.
Of course the only way to do that is to fire all the employees and automate everything but it is possible.
We have hundreds of posts on expected future returns and/or equity risk premia, here's a sampling:
A Really Smart Guy On Stocks, Bonds and Expected Returns
"The Real Role of Dividends in Building Wealth" (Clearing Up Muddled Thinking about Dividends)
Up and Down Wall Street: Rob Arnott "After Lost Decade, It's Still Tough to Find Returns "
Correlations: "Stock Synchronicity and Future Returns" (SPY)
Does Stock-Market Data Really Go Back 200 Years?
P/E10 and Future Stock ReturnsElections and Markets: Okay, Rob Arnott isn't ALWAYS Right
*Here's a nice little paper that über-quant Cliff Asness did with Arnott:"WHAT KIND OF RETURNS CAN WE EXPECT OVER THE NEXT DECADE?"
Surprise! Higher Dividends= Higher Earnings Growth
John Hussman: Current Market Gains are Destroying Future Expected Returns
Expected future returns.Hulbert: "Stocks’ future return: Just 5.6% annualized"
One of our favorite topics, along with agricultural commodities and production, materials science, really, really fast computers, advanced manufacturing technology, energy and Dogbert's schemes for world domination.
"Mr. Market's Estimate Of Expected Stock Returns"
Some Depressing Thoughts on Expected Future Equity Returns
"Gross Profitability as a Stock Return Predictor" (and a look at John Mauldin's track record)
Equity Valuation and Forecasting Future Returns and a Gift for our Readers
Growth of the Economy, Stock Market Returns and Real Risk
And previously on the Risk Premium Channel:
What Risk Premium Is “Normal”?
A Really Smart Guy On Stocks, Bonds and Expected Returns
"The Real Role of Dividends in Building Wealth" (Clearing Up Muddled Thinking about Dividends)
The Equity Risk Premium: "Using Garbage to Measure Consumption"
Equity Risk Premium: "Why the market’s rate of return—and your nest egg—may never recover"
Some recent posts on growth. First, a couple links to the Gordon paper:
A Strong Case That Economic Growth as We Know it Is Over
Is U.S. Economic Growth Over?: A Century of Stagnation
And more generally:
McKinsey--"Manufacturing the Future: The next Era of Global Growth and Innovation (DDD; SSYS
Jeremy Grantham "On the Road to Zero Growth" as His Co-head of Asset Allocation Does the Full Monty
How Persistant is Economic Growth in Industrial Civilization?
"When the Growth Model Changes, Abandon the Correlations"
YCombinator's Paul Graham on "Startup = Growth"
And a bit older:
Limits to Growth: Is the U.S. Economy Running at Max Growth Rate?
Growth of GDP per Capita vs Stock Prices since 1871
